My own assessment {in December 2013} was that the economy would gradually recover. I projected that by the fourth quarter of 2014 the unemployment rate would decline to 6.2 percent, and year-over-year PCE inflation would rise to 1.8 percent. Consistent with that view of gradual economic recovery, I believed that an appropriate monetary policy would require the funds rate to rise to 1.25 percent by year-end 2014.

With the economy having already reached my year-end 2014 forecast for inflation and unemployment, and appearing to be well on its way toward achieving my 2015 forecasts approximately a year ahead of schedule, the funds rate setting remains well behind what I consider to be appropriate given our goals.

"...the economy's equilibrium real federal funds rate--that is, the rate that would be consistent with full employment over the medium run--is probably well below its historical average, which the intercept of simple policy rules is supposed to approximate."

The rationale for not going all the way to zero has been that we want the short-term money markets, like the federal funds market, to continue to function in a reasonable way because if rates go to zero there will be no incentive for buying and selling federal funds, overnight money in the banking system. And if that market shuts down, if people don't operate in that market, it'll be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future.

So there's really a technical reason having to do with market function that has motivated the 25-basis-point interest on reserves.

That being said, it would have a bit of effect on monetary policy conditions, and we would certainly -- we're certainly considering that as one option.

From the Q&A session

One option you might want to consider is that our policy rate is the interest rate on excess reserves and we let the fed funds rate trade with some spread to that.

In a Q&A session with journalists, as reported by Bloomberg News

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs.  To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities.  Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize.  In addition, some programs--those authorized under the Federal Reserve's so-called 13(3) authority, which requires a finding that conditions in financial markets are "unusual and exigent"--will by law have to be eliminated once credit market conditions substantially normalize...

As lending programs are scaled back, the size of the Federal Reserve's balance sheet will decline..  A significant shrinking of the balance sheet can be accomplished relatively quickly. .. as the various programs and facilities are scaled back or shut down.  As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy--namely, by setting a target for the federal funds rate.

Although a large portion of Federal Reserve assets are short-term in nature, we do hold or expect to hold significant quantities of longer-term assets, such as the mortgage-backed securities that we will buy over the next two quarters.  Although longer-term securities can also be sold, of course, we would not anticipate disposing of more than a small portion of these assets in the near term, which will slow the rate at which our balance sheet can shrink.  We are monitoring the maturity composition of our balance sheet closely and do not expect a significant problem in reducing our balance sheet to the extent necessary at the appropriate time.

Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited.  Indeed, the actual federal funds rate has been trading consistently below the Committee's 1 percent target in recent weeks, reflecting the large quantity of reserves that our lending activities have put into the system. In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target.¹ We will continue to explore ways to keep the effective federal funds rate closer to the target.

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1.  Banks have an incentive to borrow from the GSEs and then redeposit the funds at the Federal Reserve; as a result, banks earn a sure profit equal to the difference between the rate they pay the GSEs and the rate they receive on excess reserves. However, thus far, this type of arbitrage has not been occurring on a sufficient scale, perhaps because banks have not yet fully adjusted their reserve-management practices to take advantage of this opportunity.

I would now like to say a few words about the adequacy of our toolkit during periods of financial disruptions. We have several ways to add liquidity to the economy in addition to the normal open market operations: the discount window—extended to term borrowing and the new Term Auction Facility—and foreign exchange swaps to help enhance liquidity abroad. In these operations we accept as collateral assets that others see as less readily marketable. I do not think this adds undue risk since we only lend to qualified solvent institutions and the collateralization rates include appropriate haircuts on riskier assets. In addition, we sterilize the effects of the borrowings on aggregate reserves, so that the liquidity injections are done while maintaining the fed funds rate target. This keeps the funds rate at a level we see as consistent with achieving our announced policy goals.

In managing the quantity of reserves in the banking system to achieve the FOMC’s objective of having the Fed funds rate trade, on average, around the target rate—now at 5.50 percent—we are adding or draining reserves to keep supply and demand in the Fed funds market in balance. In doing this, however, we do not seek to achieve an "average" rate around the target by consciously offsetting deviations from target on previous days.

If the rate is high on a Monday, we do not seek to create a low rate on Tuesday in order to "average" around the Committee’s target. Rather, we strive to guide the funds rate on a path toward the target over all of the remaining days of each two-week maintenance period, and to let bygones be bygones with respect to higher or lower rates on previous days.