The Fed’s Two Big Levers: Interest Rates and Quantitative Easing

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The Federal Reserve has two main levers for spurring or restraining spending, and both reach households through loan rates, savings returns, jobs and prices. The first is the federal funds rate, which banks charge one another for overnight loans. The second, adopted after that rate reached about zero in December 2008, is buying longer-term securities, known as quantitative easing (QE).

Neither lever works by command. A bond purchase adds money to a bank’s account at the Fed, but that does not automatically produce a new loan. The Fed’s influence comes from changing the incentives to lend and invest, which makes the response of banks and markets as important as the announcement itself.

Who decides, and what the Fed is trying to achieve

Congress gave the Federal Reserve monetary-policy goals of maximum employment, stable prices and moderate long-term interest rates. Employment and price stability are commonly called its dual mandate.

The decisions belong to the Federal Open Market Committee (FOMC): the seven members of the Fed’s Board of Governors, the president of the Federal Reserve Bank of New York and four other Reserve Bank presidents, who serve one-year terms in rotation. The committee normally holds eight scheduled meetings a year and can meet at other times when needed. Congress gave the Fed a significant degree of independence in conducting monetary policy, along with mechanisms to keep it transparent and accountable to Congress and the public.

The committee seeks inflation of 2 percent over the longer run, measured by the annual change in the price index for personal consumption expenditures. It doesn’t set a fixed numerical employment target, because the labor market’s sustainable capacity changes with factors outside monetary policy.

When overall demand is too weak relative to the economy’s capacity, unemployment tends to rise and inflation tends to fall. When demand is too strong, inflation can rise, and higher interest rates can restrain economic activity. The committee says monetary policy affects activity, employment and prices with a lag. A decision therefore has to look ahead, rather than simply respond to the last reported number.

How an overnight rate reaches borrowers and savers

The federal funds rate is the interest rate at which deposit-taking institutions, such as banks, lend balances held at the Fed to one another overnight. When the Fed raises or cuts rates, the FOMC is changing the target range for that rate.

To help implement the decision, the Board of Governors sets interest on reserve balances (IORB), the return banks earn on deposits held at the Fed. Banks generally have little reason to lend to a private counterparty for less than they can earn at the central bank. Raising that return puts upward pressure on short-term rates; lowering it works in the other direction. That is how the payment helps move the federal funds rate into the target range the committee sets.

A supplementary tool is an overnight reverse repurchase agreement: the Fed sells a security while agreeing to buy it back the next day. For the institutions eligible to use it, the rate on this facility plays a role similar to interest on reserves: in general, they should be unwilling to invest overnight elsewhere at a lower rate. The transaction does not change the size of the Fed’s securities portfolio.

The Fed also lends directly through the discount window, where Reserve Banks lend to eligible institutions. Its main program, called primary credit, is a ready source of cash for institutions in generally sound financial condition that have signed up and pledged collateral. When market rates exceed the primary credit rate, banks can borrow at the discount window and lend to others, helping implement monetary policy and support credit to households and businesses.

Changes in the federal funds rate quickly affect loans with interest rates that can adjust, including many personal and commercial credit lines. Lower quoted interest rates generally mean lower returns on savings accounts as well as lower costs for car loans and mortgages. But a Fed decision alone does not determine the rates on longer-term loans, which reflect expectations about policy and economic conditions across the life of the loan.

Why the Fed buys longer-term securities

After the federal funds rate reached roughly zero in December 2008, leaving little room for further cuts, the Fed purchased securities with longer periods until repayment to provide further easing. The purchases covered Treasury securities, agency debt and agency mortgage-backed securities (MBS). Agency debt is debt issued by government-sponsored enterprises such as Fannie Mae, Freddie Mac and the Federal Home Loan Banks; agency MBS are mortgage securities guaranteed by Fannie Mae, Freddie Mac or the government agency Ginnie Mae. Mortgage-backed securities use pools of mortgages as collateral.

Purchases can raise the prices of the securities bought and lower their yields, or investment returns. Investors replacing securities sold to the Fed with other assets can lift those assets’ prices and reduce their yields as well. This effect, known as the portfolio-balance channel, depends on different assets not being fully interchangeable for investors. Purchases can also signal an intention to keep short-term rates low for an extended period.

For Treasury purchases, the Fed buys securities already held by the public through a competitive bidding process, rather than buying newly issued securities directly from the Treasury. The existing holder gets paid, but gives up the security in return. The Fed says such purchases are not a means of financing the federal deficit.

Where the money comes from, and where it goes

The Fed pays for its net securities purchases by creating commercial bank reserves, balances that banks hold in accounts at the Fed. A purchase from a nonbank seller also involves the seller’s commercial bank: the bank receives reserves and credits the seller’s deposit account. The seller has exchanged a security for a deposit; the bank’s reserve balance and the seller’s deposit balance have both increased.

Creating reserves does not set off an automatic chain in which banks multiply those balances into a fixed amount of lending. A 2010 staff working paper by Seth B. Carpenter and Selva Demiralp in the Fed’s Finance and Economics Discussion Series rejects that textbook account, the money multiplier, as a useful way to understand how the Fed’s securities transactions affect money and bank lending. More reserves show that a purchase settled, not that a new business loan was made.

Evidence from Britain points to one thing that can hold lending back: a 2014 Bank of England paper on British banks suggested that low levels of bank capital weakened QE’s effects on lending. Bank capital is the financial cushion available to absorb losses. The authors, Michael Joyce and Marco Spaltro, suggested that the Bank of England’s first round of QE purchases, during 2009-10, may have led to a small but statistically significant increase in bank lending growth. That is evidence about British banks, not a measurement of the effect on American banks.

What the financial crisis and pandemic purchases showed

On December 16, 2008, the FOMC established a federal funds target range of 0 to 1/4 percent. That statement also said the Fed would purchase large quantities of agency debt and mortgage-backed securities to support mortgage and housing markets, a plan it had announced on November 25, 2008. On March 18, 2009, the committee expanded the program to total purchases of $1.25 trillion in mortgage-backed securities, $200 billion in agency debt and $300 billion in longer-term Treasury securities. Those purchase totals measure securities acquired, not the amount households and businesses borrowed.

A March 2010 New York Fed paper by Joseph Gagnon, Matthew Raskin, Julie Remache and Brian Sack reported evidence of meaningful, persistent reductions in longer-term interest rates. The reductions extended to securities outside the purchase program. That is what the portfolio-balance channel would predict: investors respond across markets, not only in the securities the Fed buys.

Measuring the broader economic effect is harder because the economy without the Fed’s purchases cannot be observed directly. Evidence that yields fell is not a count of the jobs QE created.

The pandemic purchases also addressed market functioning: effective March 23, 2020, the FOMC directed purchases in the amounts needed to support smooth Treasury and agency MBS markets. The same directive kept the federal funds target range at 0 to 1/4 percent. Buying securities to steady a disrupted market and buying them to lower longer-term borrowing costs use the same tool for different purposes.

The costs do not fall on everyone in the same way

Very low financing costs can encourage excessive borrowing and lead investors to accept too little compensation for risk. And when demand grows too strong relative to production capacity, inflation can rise.

The benefits are uneven as well. Forward guidance tells the public about the likely future course of monetary policy. In a New York Fed model study revised in October 2024, Donggyu Lee found that unconventional monetary policies, including QE and forward guidance, boosted economic activity and benefited all households. They reduced inequality within the bottom 90 percent by lowering unemployment. But the model also found a wider income gap between the top 10 percent and everyone else through higher profits and equity prices. That result is a model-based finding about policy after the Great Recession, not a universal verdict on every purchase program.

There is a cost on the central bank’s own books, too: higher policy rates can increase interest expense on reserves, offsetting the income earned from securities. The Reserve Banks send their earnings to the Treasury, but when income cannot cover expenses, those payments stop and the Fed records a deferred asset. That entry records earnings the Reserve Banks must retain in the future to cover the loss before payments to the Treasury resume. The Fed says negative net income and that accounting entry do not prevent it from conducting monetary policy or meeting financial obligations. The Treasury goes without those payments in the meantime, even though the Fed’s ability to set policy is intact.

Ending purchases is different from shrinking holdings

In October 2014, the Fed concluded its asset-purchase program while continuing to reinvest principal from maturing securities in replacement securities. Principal is the amount lent; a maturing Treasury security is coming due for repayment. Stopping new purchases therefore did not mean selling the portfolio.

To shrink its holdings, the Fed lets securities be repaid without fully reinvesting the principal, a process called balance-sheet runoff. This shrinking process is also called quantitative tightening (QT). Under plans released in May 2022, the FOMC reinvested principal payments to the extent they exceeded monthly caps, which limited how much holdings could shrink each month. Its January 2022 principles identified changes in the federal funds target range as its primary means of adjusting monetary policy. Rate changes and runoff act on different measures: one changes an overnight price, while the other changes the amount of securities still held. A rate that holds steady can still accompany new instructions for the securities portfolio, so ‘no rate change’ need not mean ‘no policy action’.

The FOMC set December 1, 2025 as the end date for the runoff that began in June 2022. Later instructions differ: the Fed’s Implementation Note, effective September 17, 2026, calls for rolling over, or reinvesting at auction, all principal from Treasury holdings and reinvesting agency-security principal into Treasury bills. It also allows purchases of Treasury bills and, if needed, other Treasury securities with three years or less remaining maturity to keep the level of bank reserves ample. That stated purpose matters when reading a headline about Fed purchases: the note ties them to the level of reserves, while the crisis programs were described as efforts to lower longer-term borrowing costs and support markets.

For the actual decision, consult the Fed’s meeting calendar, which links policy statements and minutes. Read the implementation note as well for the instructions governing purchases and reinvestment.