The Federal Reserve's Toolkit

Why this matters

Central Banks and Monetary Policy covered what the Federal Reserve is trying to do and who decides. This lesson covers how: the mechanics that turn a decision in a meeting room into a rate that banks, money market funds, and bond traders actually pay. The tools have changed a great deal since 2008, and several common descriptions of how the Fed works, such as banks being forced to hold a set share of deposits in reserve, no longer apply.

Setting the rate: administered rates

Banks hold accounts at the Federal Reserve, and the money in them is called reserves. Since 2008, when Congress authorized it, the Fed has paid interest on those balances.¹ Since March 2020, banks haven't been required to hold any minimum amount of reserves.²

The Fed now steers short-term rates mainly by setting the rates it pays and charges, known as administered rates, rather than by adjusting the quantity of reserves. It committed to this approach in 2019, describing a regime in which an ample supply of reserves lets it control the federal funds rate and other short-term rates primarily through those administered rates.³

Rate	Level	What it does
Primary credit rate (discount window)	4.00%	What banks pay to borrow from the Fed
Standing overnight repo rate	4.00%	What eligible firms pay to borrow overnight from the Fed against securities
Target range for the federal funds rate	3.75% to 4.00%	The policy decision itself
Interest on reserve balances (IORB)	3.90%	What banks earn on reserves
Overnight reverse repo rate (ON RRP)	3.75%	What eligible firms earn by lending cash to the Fed overnight

Federal Reserve implementation note.⁴ On October 13, 2026, the effective federal funds rate, the rate actually paid in the market, was 3.88%.⁵

The logic is about alternatives. A bank that can earn 3.90% risk-free at the Fed should be unwilling to lend overnight to anyone else for less, and a firm that can lend to the Fed through the reverse repo facility at 3.75% should be unwilling to accept less elsewhere. The Fed describes the reverse repo rate as playing the same role for those firms that the interest rate on reserves plays for banks.⁶ At the top, the lending facilities give borrowers a ceiling of sorts: there's little reason to pay much more than the Fed charges. When the committee moves its target range, the Board typically moves the interest rate on reserves with it, which puts pressure on a whole range of short-term rates.¹

Why "ample" reserves

This works because reserves are plentiful. A Fed staff note describes banks' demand for reserves as steep when reserves are scarce and nearly flat when they're abundant: beyond some point, banks gain little from extra reserves except the interest the Fed pays on them. On that flat part, the market rate settles close to the interest rate on reserves, whatever the exact quantity.⁷

Before the 2008 crisis it was the other way round. Reserves were scarce, and the Fed intervened in markets daily to fine-tune their supply and hit its rate. Swings in demand for reserves were often hard to anticipate and at times led to excess rate volatility and liquidity shortages.¹ The difference in scale is striking: reserve balances were about $5.7 billion at the end of 2007 and about $3.0 trillion in October 2026.⁸

The rest of this lesson is for members

Still to come in this lesson: The balance sheet, Lender of last resort, Communication, Rules as benchmarks, the key takeaways, and 2 quiz questions with explanations.

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