The success of the new tools so far has been important for instilling confidence that policymakers can control overnight interest rates at levels appropriate to meet their goals. It also means that, in future, the Federal Reserve will not have to face the same technical constraint that leads to a conflict between easing strains in broad money markets and controlling the policy rate whether it uses a floor or corridor system. This could make the Federal Reserve System more agile and better able in future circumstances to provide the elastic currency that has been one of our stated purposes since the Federal Reserve Act became law more than a century ago.

So, if we were denied that tool, at the present time, we would not be able to easily raise the level of short-term rates.

So we would likely, to regain effective control of short- term interest rates, need to shrink our portfolio from this current large level, back to the kinds of levels we had before the crisis. And we have set over several years, a plan for how we would normalize policy that relies not on selling long-term assets but on adjusting short-term interest rates.

I believe that if we were to follow the plan of selling off long- term assets, it could prove very disruptive to the expansion. It is a strategy that I think could harm the economic recovery and it certainly is not what we have set out to the public. We said we would shrink our balance sheet in a gradual and predictable way so as to not be disrupted.

In sum, arbitrage activities by banks, complemented as needed by ON RRP operations, should cause a higher IOER rate to lead to higher levels of market rates. However, if the pressure on market rates from the Feds administered rates turns out to be insufficient, the Committee has a range of other tools including term deposits, term RRPs, and asset salesthat could be used to help tighten the stance of policy. Given the array of tools at our disposal, I am confident that the FOMC can adjust and control short-term interest rates as needed to foster its objectives of maximum employment and price stability. Given the range of available tools, I am confident in our ability to raise short-term interest rates from the zero lower bound when the time to do so arrives. Nevertheless, the FOMC is prepared to adjust the details of its approach to policy normalization in light of economic and financial developments and the Desk stands ready to innovate in order to efficiently and effectively implement policy consistent with the Committees directive.

The Committees normalization principles and plans do not detail the manner in which IOER as a primary tool would be combined with supplementary tools such as ON RRPs to move the fed funds rate into the target range. However, as reflected in the minutes to the July FOMC meeting, most Committee participants anticipate that, at least initially, the IOER rate could be set at the top of the target range for the funds rate, and the ON RRP rate could be set at the bottom of that range. This is also consistent with the views of many market participants as reflected in surveys conducted by the Desk. [A]s the Chair noted during her September press conference, the Committee expects that the effective fed funds rate may vary within the target range and could even move outside of it on occasion. For example, the effective rate could move outside the target for a day or two around key financial reporting dates, such as quarter-ends, when some banks marginal balance sheet costs are particularly high. However, such transitory movements should have no material effect on financial conditions or the broader economy. What matters for policy transmission is the predictability that on most days money market rates will be close to the target range set by the FOMC.

WINKLER: So you mentioned the balance sheet earlier in this discussion, which is now more than $4 trillion. The Fed has said that in the long run it should be reduced to the smallest level consistent with, "the efficient implementation of monetary policy." So what would say is the new normal for the balance sheet post crisis?

  DUDLEY: Well that statement was I think is a little bit deliberately vague because I don't think we really know what monetary policy regime for sure is going to be the right monetary regime in the long run. We're going to get a lot of information over the next few years conducting monetary policy with a large balance sheet, relying on the interest on excess reserves as the main tool of monetary policy. If that turns out to be fabulously successful it's possible that we could run monetary policy with what's called a floor system where we set an interest rate that actually has essentially the magnet-setting rates in money markets broadly. Or we could decide that this isn't so - this doesn't work so well, and we want to go back to the system that we had before the crisis, which was just a very small amount of reserves in the system with the federal funds rate balanced by the Federal Reserve adding and subtracting reserves to keep things in balance. I think my own view is it's too soon to make that call. That call will be made by future committees.

And my own personal opinion is let's see how things go. Let's learn. And as we learn then we can figure out what regime is right. And then that will determine the size of the balance sheet. Now what the principals are basically saying though, whatever regime we pick we're going to want to keep this balance sheet as small as possible, consistent with that regime being effective.

So we've indicated that the main tool we will use is the interest rate we pay on overnight reserves. The overnight RRP facility that you refer to I think of is a backup tool that will be used to help us control the federal funds rate, to improve our control over the federal funds rate. I think it's a very useful and effective tool. We have gleaned that from the initial testing that we have done.

But as you mention, we do have concerns about allowing that facility to become too large or to play too prominent a role and for precisely the reason that you gave: If stresses were to develop in the market, in effect it provides a safe haven that could cause flight from lending to other participants in the money markets.

So two tools that we can use and are discussing to control those risks, one would be to maintain relatively large spread between the interest rate we pay on overnight reverse RPs, and the interest rate on excess reserves, the larger that's spread, the less use that facility will be. Also, we can contemplate limits on the extent to which it can be used, either aggregate limits or limits that would apply to individual participants, and all of that is figuring into our discussions.

The Fed has kept its short-term policy rate between zero and a quarter of a percentage point since December 2008, and Kocherlakota told the Greater Rochester Chamber of Commerce that "we should be thinking about" pushing it even lower.
"It's really about demonstrating a commitment to stay with the recovery for as long as it takes to get the economy fully recovered," he said.
…
"We would be better off having more of a collective vision as a committee to what the change in conditions would have to be that would lead us from ending the asset purchase program to raising rates… Unless we communicate as a group about what those conditions are, then we face this instability that two words in a press conference, or two words in a speech or an answer to a Senator can end up moving financial markets participants' vision of what we are trying to do with policy."

The Federal Reserve should do more to boost both inflation and jobs, a top Fed official said on Tuesday, including possibly pushing its main interest rate even lower or cutting the rate it pays banks on excess reserves kept at the U.S. central bank.

"The key is for us to be able to demonstrate in an effective fashion that we are committed to the recovery," Narayana Kocherlakota, president of the Minneapolis Federal Reserve Bank, told reporters after a speech.

YELLEN: So this fixed rate overnight reverse, repurchase facility is one where we're essentially borrowing from non-banking -- from -- from entities other than banking organizations. We're offering the to pay a low, fixed rate, and are offering our counter- parties in return for their loans to us, collateral which comes in the form either of treasury or agency mortgage backed securities.
And we're engaging in this program. As you mentioned, this is something technical. But we want to be table to firmly control short- term money market rates when the time ultimately comes, which it's not -- it's probably a long way off, but when the time comes we do want to tighten monetary policy and raise our target for short-term interest rates. We would like to be able to execute that in a very smooth way so that we have good control over the level of short-term interest rates.
And the -- paying interest on reserves, that's something that is one tool we will be using to boost when the time comes, the level of short-term rates. But using this new facility can also help us gain better control, I think, than we could through interest on reserves alone.
So, at the moment, we have been gaining experience with developing this facility, making sure we can smoothly execute these transactions with a range of potential lenders.
We have put limits both on the magnitude of loans that we will be willing to take on, and what we're paying, as you mentioned, the limit so far has been five basis points. We're pleased by what we're seeing about our ability to carry out the exercises, and it's part of prudent planning that the Fed has been doing for quite some time.
HAGAN: And what about the dollar volume?
YELLEN: It varies from day-to-day depending on how much interest there is in the markets. It's up to the markets to decide. We've typically had limits on the amount that any one firm we lend to us overnight.
HAGAN: It was $3 billion. Now it's up to $5 billion?
YELLEN: Yes. I think there were days at the end of the year -- given the pressures that existed toward the end of the year when I believe the volume rose to $30 billion or $40 billion. But I can get you exact details on the quantities if you would like further information.
HAGAN: What are the monetary policy effects of raising this offer rate beyond other range set than the FOMC’s resolution?
YELLEN: Well, these are very, very low rates.
HAGAN: Right.
YELLEN: And so we're not raising rates by doing this. We're only going up to five basis points. We're paying 25 basis points on interest on reserves and there's really only any take up at times when there would be, you know, pressure for unusual reasons for rates to fall to below that.
But we're not pushing up the general level of short-term rates with this facility at this time.

Tarullo said he has an “open mind” on whether the Fed should try to encourage lending by reducing the interest rate it pays banks on excess reserves.

“There’s been a good bit of back and forth on whether the rate should be lowered now, in an effort to push more lending out the door,” Tarullo said in response to an audience question. “I’ve got an open mind on that.”

Williams is a strong supporter of the Fed's bond-buying program. On Tuesday, he said he believes that the Fed needs to do more to prove it is committed to keeping short-term rates low as long as needed to support the recovery.

Most importantly, he said, the Fed should give better guidance on what would induce it to raise rates once the U.S. unemployment rate falls to 6.5 percent, the level at which the Fed said has said it would consider an interest-rate hike.

…

"Most participants" at the Fed's latest policy-setting meeting thought lowering the rate was "worth considering at some stage," according to minutes of the meeting released last month.

Critics worry whether money markets can still function if rates fall to zero; indeed, over the years, the Fed has considered and rejected the idea of reducing the rate in part because of that very concern.

But a new central bank tool blunts that risk, Williams said on Tuesday.

Known as a fixed-rate full-allotment reverse repo facility, the tool has been touted as a way to mop up excess cash in the financial system once the Fed needs to start raising rates.

But it could also be helpful should the Fed decide to lower the rate it pays to banks, Williams said.

"We do have this ability through this reverse repo that's been tested by the New York Fed that basically makes sure we can control short-term interest rates even if we ... lowered the interest on reserves closer to zero,"

Senator, that is something that the FOMC has discussed and the board has considered on past occasions, and it is something we could consider going forward. I think our assessment -- we've worried that if we were to lower that rate too close to zero, we would begin to impair money market function and that that's been a consideration on the other side. But it certainly is a possibility, Senator.

In response to a question about lowering the interest rate on reserves.

Under a goal-oriented approach, the Committee would respond to this weak outlook by providing more monetary stimulus—for example, by lowering the interest rate being paid to banks on their excess reserves.

The Committee could also promote a goal-oriented approach to monetary policy by making other changes to its communication… I’ve recommended that the FOMC announce its intention to keep the fed funds rate extraordinarily low at least until the unemployment rate falls below 5.5 percent, as long as the one-to-two-year-ahead outlook for the inflation rate stays below 2.5 percent. A recent working paper by senior Board of Governors staff suggests that this policy stance could indeed have material benefits in terms of the evolution of prices and employment.4
Beyond these changes in communication, the Committee could also take concrete policy steps to demonstrate commitment to a goal-oriented approach to policy. In its most recent statement, the Committee says that it expects the unemployment rate to decline gradually and the inflation rate to be below 2 percent over the medium term. Under a goal-oriented approach, the Committee would respond to this weak outlook by providing more monetary stimulus—for example, by lowering the interest rate being paid to banks on their excess reserves.

BERNANKE: Well, banks are currently being paid on their reserves 25 basis points -- one-fourth of one percent. They're actually receiving less than that on net because they also have to pay FDIC premiums on -- on the deposits that they hold on the other side of the balance sheet. So they're receiving just a few basis points on their -- on their reserves.

If we cut the interest on reserves, say, to zero or slightly negative, which is possible, it would have a very, very small effect in the right direction, but a very, very small effect on the incentives of banks to make loans. Basically, they're not finding as many loans as they like to make when they're earning eight basis points on their reserves. Would it help to get it down to zero?

It's in the right direction, as I said, but one of the reasons that we've hesitated to do that is because it would also lower returns throughout the money markets in our economy and would create some problems in terms of the functioning of money markets, the federal funds market, and other short-term cash markets. So it's not clear that the benefits in terms of more stimulus outweigh the costs in terms of market functioning.

That being said, it's always been something that we have kept on the table and talked about periodically.

MEEKS: So it's something that's still on the table and you're still talking about? Because I like movement in the right direction.

BERNANKE: It's not a powerful tool, though, in any sense.

US Federal Reserve officials fear a backlash from paying billions of dollars to commercial banks when the time comes to raise interest rates. The growth of the Fed’s balance sheet means it could pay $50bn-$75bn a year in interest on bank reserves at the same time as it makes losses and has to stop sending money to the Treasury.

…

Mr Bullard said that neither interest paid to banks nor possible losses on exit made any difference to the substance of monetary policy.

“I think it’s more just a question of the optics, and how you’re going to play the optics,” he added, referring to the perception of losses by the central bank. “And since it shouldn’t matter in a monetary policy sense you might as well play the optics in a better way than the one we’ve got planned.”

…

One possible answer to the Fed’s larger balance sheet is to sell assets earlier in the exit process. Mr Bullard said that the Fed could consider creating accounting reserves now for any losses it expects in the future.