The Fed’s first line of defense is open market operations. The Fed can lower interest rates by buying debt securities on the open market in return for newly created bank credit. Flush with new reserves, the banks that the Fed buys from are able to loan money to each other at a lower fed funds rate, which is the rate that banks lend to each other overnight. The Fed hopes that a drop in interest rates spreads throughout the financial system, reducing rates charged to businesses and individuals.

When this works, the lower rates make it cheaper for companies to borrow, allowing them to continue going into more debt rather than defaulting or being forced to lay off staff. This helps keep employees in their current jobs and suppress the rise in unemployment when a recession hits. Lower interest rates also enable consumers to make more purchases on credit, keeping consumer prices high and likewise extend themselves further into debt rather than live within their means.

The Federal Reserve may choose to simply continue open market operations, buying bonds and other assets to flood the banking system with new credit. This is known as quantitative easing (QE), the direct purchase of assets by the Federal Reserve to inject more money into the economy and expand the money supply. 

The Fed has used quantitative easing on several occasions since 2008, including in March of 2020, when the central bank launched an initial $700 billion QE plan aimed at propping up the debts of the financial system on top of most of the nearly $4 trillion in quantitative easing it created during the Great Recession which it has yet to unwind. It is not clear where the upper limit is on the Fed’s ability to continue flooding trillions of new dollars into the system to protect the banks.  

The fed funds rate is the most well-known of the Fed’s tools. It’s also part of its open market operations. It’s the interest rate banks charge for overnight loans they make to each other. It has the same effect as changing the Reserve requirement, and is much easier for the Fed to modify.

The Fed also changes the discount rate. That’s the interest rate the Fed charges to allow banks to borrow funds from the Fed’s discount window. Historically, this type of lending was carried out as an emergency bailout loan of last resort for banks out of other options, and came with a hefty interest rate to protect the interests of taxpayers given the risky nature of the loans.

However, in recent decades the practice of discount lending by the Fed has shifted toward making these risky loans at much lower interest rates in order to favor the interests of the financial sector as much as possible. It has also rolled out a host of new lending facilities similar to discount lending, targeted at supporting specific sectors of the economy or the prices of specific asset classes.

As of March 2020, the Fed dropped its discount rate to a record low 0.25% to give extraordinarily favorable terms to the riskiest of borrowers. It may not be possible to lower this rate any further as the economy slips deeper into economic malaise. 

The reserve requirement was the amount banks were required to keep in reserve at the end of each day. Increasing this reserve kept money out of circulation. Changing the fed funds rate has the same impact as adjusting the reserve requirement. The Fed eliminated the reserve requirement, effective March 26, 2020.

Former Chairman Ben Bernanke said the Fed’s most important tool is managing public expectations of inflation. Once people anticipate future price increases, they create a self-fulfilling prophecy. They plan for future prices increases by buying more now, thus driving up inflation even more.

On August 27, 2020, the FOMC announced it would allow a target inflation rate of more than 2% if that will help ensure maximum employment. It still seeks a 2% inflation over time but is willing to allow higher rates if inflation has been low for a while.

Bernanke said the mistake the Fed made in controlling inflation in the 1970s was its go-stop monetary policy. It raised rates to combat inflation, then lowered them to avoid recession. That volatility convinced businesses to keep their prices high.

Fed Chairman Paul Volcker raised rates to end the instability. He kept them there despite the 1981 recession. That finally controlled inflation because people knew prices had stopped rising. The past fed funds fate tells you how the Fed managed the expectations of inflation.

The next Chairman, Alan Greenspan, followed Volcker’s example. During the 2001 recession, the Fed lowered interest rates to end the recession. By mid-2004, it slowly but deliberately raised rates to avoid inflation. Greenspan told investors exactly what he planned to do, thus avoiding another recession. He reassured market investors, who kept investing and spending despite higher interest rates.