The Federal Reserve has four main monetary policy tools: open market operations, the discount rate, interest on reserve balances, and reserve requirements. Each one pulls a different lever, but they all move the same thing — the cost of borrowing money across the economy. When the Fed wants to slow inflation, it uses these tools to push rates up. When it wants to encourage hiring and spending, it uses them to push rates down. A fifth practice, large-scale asset purchases, comes into play when the standard rate tools have already been cut as far as they can go.
Open Market Operations
Open market operations are the tool the Fed uses most often. The New York Fed buys or sells government securities — mostly Treasury bonds and notes — in the open market.1eCFR. 12 CFR Part 270 – Open Market Operations of Federal Reserve Banks When the Fed buys securities from banks, it credits those banks’ reserve accounts with new money. More reserves means more cash available to lend, which pushes rates down. When the Fed sells, banks pay out of their reserves, less money is available for lending, and rates rise.
The authority for these transactions comes from the Federal Reserve Act. Section 263 created the Federal Open Market Committee and gave it exclusive control over the “time, character, and volume” of purchases and sales.2Office of the Law Revision Counsel. 12 U.S. Code 263 – Federal Open Market Committee; Creation; Membership Section 355 separately authorizes each Reserve Bank to buy and sell Treasury obligations and certain agency securities in the open market.3Office of the Law Revision Counsel. 12 USC 355 – Purchase and Sale of Obligations; Open Market Operations No individual Reserve Bank can decide on its own to conduct these trades; everything runs through FOMC directives.
The result shows up in the federal funds rate, the interest rate banks charge each other for overnight loans. As of January 2026, the FOMC’s target range for this rate is 3.50% to 3.75%.4Federal Reserve Board. Federal Reserve Issues FOMC Statement Open market operations keep the actual traded rate inside that band by ensuring the banking system holds enough reserves for the Fed’s other rate tools to do the steering.
The Discount Rate
The discount rate is the interest rate the Fed charges when commercial banks borrow directly from it. That lending happens at the discount window, a standing facility that gives banks a reliable backstop when they face a temporary cash shortage. Every loan must be backed by collateral — Treasury securities, agency debt, mortgage-backed securities, and certain other assets — pledged to the satisfaction of the lending Reserve Bank.5Board of Governors of the Federal Reserve System. Policy Tools – Discount Window
The window offers three tiers of credit:
- Primary credit goes to banks in generally sound financial condition, with no restrictions on how they use the funds. This is the main program, and its rate sits at the top of the federal funds target range — 3.75% as of early 2026.6Federal Reserve. Discount Window Lending
- Secondary credit is available to banks that don’t qualify for primary credit. The rate is higher, and Reserve Banks typically apply steeper haircuts to pledged collateral.
- Seasonal credit is designed for smaller banks with seasonal deposit and loan swings, such as agricultural lenders. The rate floats with market conditions, and institutions with deposits over $500 million generally don’t qualify.
Because the primary credit rate sits at the top of the federal funds target range, it effectively caps short-term borrowing costs. No bank pays 3.75% at the discount window when it can borrow from another bank at a lower rate in the fed funds market. That pricing is deliberate: the Fed wants banks to manage cash through the private market first and treat the discount window as a safety valve.
Interest on Reserve Balances
This is the tool that does most of the steering in the current framework. Under the Financial Services Regulatory Relief Act of 2006, Congress authorized the Fed to pay interest on the money banks keep in their reserve accounts.7Federal Reserve. Financial Services Regulatory Relief Act of 2006 – Section: Monetary Policy Provisions The authority was originally slated to begin in 2011 but was accelerated to 2008 during the financial crisis.8Federal Reserve History. Interest on Reserves The rate paid on those balances, called the interest on reserve balances rate or IORB, currently stands at 3.65%.9Federal Reserve Board. Interest on Reserve Balances
The logic is simple. If a bank can earn 3.65% risk-free at the Fed, it won’t lend that money to anyone else for less. IORB creates a floor beneath short-term rates across the whole financial system. When the FOMC wants to raise borrowing costs, it raises the IORB rate, and banks pass the increase through to mortgages, car loans, and business credit lines. No large-scale bond sales are needed. Just a number change.
The Overnight Reverse Repurchase Facility
IORB only works on banks. Plenty of large financial players — money market funds, government-sponsored enterprises, certain broker-dealers — don’t hold reserve accounts and can’t earn IORB. Without a comparable option, those firms might accept rates below the IORB floor, dragging the federal funds rate down with them. The Overnight Reverse Repurchase Agreement facility, or ON RRP, solves that problem. It lets non-bank institutions effectively lend cash to the Fed overnight in exchange for Treasury securities, earning a guaranteed return, currently 3.50%.10FEDERAL RESERVE BANK of NEW YORK. Repo and Reverse Repo Agreements
Together, IORB and the ON RRP rate form a corridor that keeps the federal funds rate inside the FOMC’s target range. IORB anchors the top of the corridor for banks; ON RRP catches everyone else at the bottom.
Reserve Requirements
Reserve requirements used to be a much bigger deal. For decades, the Fed required banks to hold a fixed percentage of their deposits either as vault cash or on deposit at a Reserve Bank. Under 12 U.S.C. § 461, the Fed can set this ratio anywhere from zero to 14% on transaction account balances above a certain threshold.11Office of the Law Revision Counsel. 12 USC 461 – Reserve Requirements A higher ratio meant banks could lend less of each dollar deposited, which slowed money creation; a lower ratio freed up more cash for lending.
In March 2020, the Fed dropped the reserve requirement to zero across all deposit categories, and it remains there today.12eCFR. 12 CFR Part 204 – Reserve Requirements of Depository Institutions (Regulation D) Every tier in the current Regulation D table shows 0%: transaction accounts, nonpersonal time deposits, and Eurocurrency liabilities alike. Banks still hold enormous reserve balances voluntarily, partly because IORB gives them a reason to, but they are no longer legally required to do so. The statutory framework hasn’t been repealed, so the Fed could reimpose requirements if conditions changed.
Quantitative Easing and Quantitative Tightening
Sometimes the standard tools aren’t enough. When the federal funds rate has already been cut to near zero and the economy still needs stimulus, the Fed turns to quantitative easing, or QE: buying large quantities of longer-term Treasury securities and mortgage-backed securities to push down long-term interest rates directly.13Board of Governors of the Federal Reserve System. Quantitative Easing and the “New Normal” in Monetary Policy It’s open market operations at a much larger scale, aimed at the far end of the yield curve rather than overnight rates. The Fed used QE extensively after the 2008 financial crisis and again during the COVID-19 pandemic, expanding its balance sheet to roughly $9 trillion by mid-2022.
Quantitative tightening, or QT, is the reverse. The Fed lets maturing securities roll off the balance sheet without replacing them, gradually draining liquidity. That process ran from June 2022 through December 1, 2025, when the balance sheet settled at roughly $6.5 trillion, or about 21% of GDP.14Board of Governors of the Federal Reserve System. The Central Bank Balance-Sheet Trilemma QE and QT aren’t separate tools so much as extensions of the open market operations authority, used at a different scale when ordinary rate moves hit their limits.
How the Tools Work Together
Each tool looks independent, but they form an interlocking system built to keep the federal funds rate inside the FOMC’s target range. In the current framework:
- IORB at 3.65% is the primary anchor. Banks won’t lend reserves for less than they can earn risk-free at the Fed, so this rate pulls the federal funds rate toward the upper portion of the target range.
- ON RRP at 3.50% is a sub-floor for non-bank players. Money market funds and similar institutions park cash here rather than accept a lower rate elsewhere, preventing the federal funds rate from drifting below the bottom of the range.
- The primary credit rate at 3.75% is the ceiling. No bank borrows from another bank at more than the discount window would charge, capping the upside on overnight lending costs.
- Open market operations keep the overall level of reserves large enough for the administered rates above to work. Without ample reserves, the floor-and-ceiling mechanism breaks down.
Reserve requirements, currently at zero, don’t play an active role. But the fact that banks hold huge voluntary reserves — earning IORB — is precisely what makes the system function. The shift from a scarce-reserves model, where reserve requirements were the binding constraint, to an ample-reserves model, where interest rates do the steering, is the defining change in how the Fed has operated over the past fifteen years. Every rate decision the FOMC announces flows through this architecture before it reaches the mortgage rate on your kitchen table.