The Federal Reserve controls the money supply by adjusting how many dollars sit in the banking system and how expensive it is to borrow them. It does this through five main tools: buying and selling government securities on the open market, setting the interest rate it pays banks on their reserves, steering the federal funds rate within a target range, lending directly to banks through the discount window, and telling the public where it expects rates to go next. As of early 2026, the federal funds target range sits at 3.5 to 3.75 percent, and every move in that range travels outward into mortgage rates, credit cards, and business loans.1Federal Reserve. FOMC Minutes January 27-28, 2026
Why the Fed Adjusts the Money Supply at All
Federal law gives the Fed two jobs at once: maximum employment and stable prices.2Office of the Law Revision Counsel. 12 U.S. Code 225a – Maintenance of Long Run Growth of Monetary and Credit Aggregates These pull against each other. More money in the system tends to boost hiring but risks pushing prices up. Less money tames inflation but can slow the job market. Every tool below is a way to lean one direction or the other.
The Fed defines stable prices as 2 percent annual inflation, measured by the Personal Consumption Expenditures Price Index.3Federal Reserve. Why Does the Federal Reserve Aim for Inflation of 2 Percent Over the Longer Run Above that, the Fed tightens. Below it, or when unemployment climbs, the Fed loosens.
Open Market Operations
Buying and selling government securities is the Fed’s most routine method for moving the money supply.4eCFR. 12 CFR Part 270 – Open Market Operations of Federal Reserve Banks When the Fed buys Treasury bonds from banks, it pays by crediting those banks’ reserve accounts with newly created electronic dollars. Banks then have more cash to lend, which pushes rates down and expands credit. Selling bonds reverses the flow. Banks pay from their existing reserves, those reserves vanish from the system, and less money is available for lending.
The Federal Open Market Committee directs these trades, and a single regional Reserve Bank executes them on behalf of the whole system.4eCFR. 12 CFR Part 270 – Open Market Operations of Federal Reserve Banks The trades happen daily, which is why open market operations are the flexible, workhorse tool. No new law is needed. The Committee issues a directive at its policy meetings, and the trading desk carries it out.
Quantitative Easing and Quantitative Tightening
Standard open market operations move money in modest amounts. Quantitative easing is the same mechanism, scaled up dramatically. Starting in March 2020, the Fed began buying enormous quantities of Treasury bonds and mortgage-backed securities to push down long-term rates that ordinary policy could not reach. Each purchase added new reserves to the banking system, and by the time the program ended, the Fed’s balance sheet had grown into the trillions.
Quantitative tightening reverses the process. Beginning in June 2022, the Fed let maturing bonds roll off its balance sheet without replacement, quietly draining reserves. The mechanics are simple: when a bond matures and the Fed does not reinvest the proceeds, those dollars stop existing as bank reserves. The Fed ended this balance sheet reduction on December 1, 2025, with total assets settling at roughly $6.5 trillion.5Federal Reserve. The Central Bank Balance-Sheet Trilemma
Easing was meant to make long-term borrowing cheap and encourage spending. Tightening flipped the goal to soaking up the excess liquidity that was feeding inflation. The size of these programs dwarfs day-to-day open market operations, and balance sheet management has become a permanent feature of how the Fed runs policy.
The Federal Funds Rate and the Discount Window
The federal funds rate is what banks charge each other for overnight loans of reserves. The Fed does not set it directly. Instead, the FOMC announces a target range and uses its other tools to keep the market rate inside that band.6FRED | St. Louis Fed. Federal Funds Effective Rate A lower target makes borrowing cheaper throughout the economy. A higher target cools spending and slows the growth of new money.
The discount window is the Fed’s direct lending facility. A bank that needs cash quickly can borrow straight from its regional Reserve Bank by pledging collateral rather than going to another bank.7Federal Reserve Board. Discount Window There are three tiers of discount window credit, each with its own rate. Primary credit, for financially healthy banks, currently stands at 3.75 percent.8Federal Reserve Board. H.15 – Selected Interest Rates (Daily) Secondary credit, for banks that do not qualify for the primary program, carries a higher rate.9Federal Reserve. Discount Window Lending Setting the primary rate at the top of the federal funds target gives banks a reason to borrow from each other first and treat the discount window as a backstop.
Changes to the federal funds target send the loudest signal. A cut says the economy needs cheaper credit. A hike says growth or inflation is running too hot. Markets often reprice everything from corporate bonds to savings yields within minutes of an announcement.
Interest on Reserve Balances and the Rate Floor
Congress authorized the Fed to pay interest on bank reserves in 2006, and the authority took effect in October 2008 during the financial crisis.10Federal Reserve. Interest on Reserve Balances That rate, known as the IORB, is now the primary tool for keeping short-term rates inside the target range.11Federal Reserve Board. Interest on Reserve Balances (IORB) Frequently Asked Questions The logic is simple. If the Fed pays banks 3.65 percent to leave money in their reserve accounts, no bank has a reason to lend to another bank for less than 3.65 percent.12FRED | St. Louis Fed. Interest Rate on Reserve Balances (IORB Rate) That creates a floor under the overnight lending market.
When the Fed wants to tighten, it raises the IORB, making it more attractive to sit on reserves than to lend them. Less lending means less new money entering circulation. When it wants to loosen, it lowers the IORB, pushing banks to hunt for better returns by lending. The tool works through incentives, which is what makes it effective in an era when banks hold ample reserves.
Banks are not the only players in overnight markets. Money market funds and government-sponsored enterprises cannot earn IORB because they do not hold reserve accounts. Without a matching tool, overnight rates from these firms could drop below the IORB floor. The overnight reverse repurchase agreement facility fixes that. The ON RRP lets non-bank entities effectively park cash at the Fed overnight for a guaranteed return, currently 3.50 percent.13FRED | St. Louis Fed. Overnight Reverse Repurchase Agreements: Offering Rate Together, the two rates keep the entire overnight market inside the Fed’s target range.14Federal Reserve Bank of New York. Repo and Reverse Repo Agreements
Reserve Requirements
For decades, reserve requirements were one of the Fed’s bluntest tools. Under Regulation D, the Fed could dictate what fraction of customer deposits banks had to hold back rather than lend.15eCFR. 12 CFR Part 204 – Reserve Requirements of Depository Institutions (Regulation D) Take in $100, hold $10, lend $90. The $90 gets deposited elsewhere, that bank lends most of it out, and the original deposit multiplies through the system.
In March 2020, the Fed set reserve requirement ratios to zero across the board.15eCFR. 12 CFR Part 204 – Reserve Requirements of Depository Institutions (Regulation D) Banks are no longer legally required to hold any particular fraction of deposits in reserve. That does not mean they stopped holding reserves. They still keep large balances because the IORB pays them to, and because modern liquidity rules impose their own constraints.16Federal Register. Liquidity Coverage Ratio: Liquidity Risk Measurement Standards The old reserve requirement lever is dormant, but the statutory authority to reimpose it remains intact.17Office of the Law Revision Counsel. 12 USC 461 – Reserve Requirements
Forward Guidance
Not every tool involves moving money. The Fed also shapes the economy by talking about what it plans to do. Businesses and investors make decisions today based on where they think rates are heading tomorrow, so a credible signal from the Fed changes behavior before anything actually changes on the balance sheet.18Federal Reserve. What Is Forward Guidance and How Is It Used in Federal Reserve Monetary Policy If the Fed signals rates will stay low for a long stretch, banks loosen lending standards, businesses invest, and bond markets price in cheaper long-term borrowing.
The FOMC began weaving this language into its post-meeting statements in the early 2000s and leaned on it heavily after 2008, when the federal funds rate was already near zero and could not be cut further.18Federal Reserve. What Is Forward Guidance and How Is It Used in Federal Reserve Monetary Policy Used carefully, it extends the Fed’s reach well beyond the tools that physically move reserves.
How Fed Policy Reaches Your Wallet
The federal funds rate gets the headlines, but its link to the rates you actually pay is less direct than most people think.
Credit card APRs track the federal funds rate closely, because most variable-rate cards are pegged to the prime rate, which moves nearly in lockstep with the Fed’s target. When the Fed raises, your balance gets more expensive within a billing cycle or two. When the Fed cuts, card issuers are slower to pass along the savings.
Mortgage rates follow a different path. The 30-year fixed is tied more closely to the yield on 10-year Treasury bonds than to the federal funds rate. That is why a Fed cut does not always mean a cheaper mortgage. If investors expect inflation to pick up, long-term Treasury yields can rise even while the Fed is cutting short-term rates. Auto loans and home equity lines sit between the two, moving with both the Fed’s target and broader market conditions.
Savings rates respond, but with a familiar lag. Banks raise loan rates faster than they raise deposit rates. When the Fed tightens, savers eventually see better yields on CDs and high-yield savings accounts, but the increase trails the hikes by months. The IORB matters here too. When the Fed pays banks 3.65 percent to hold reserves, banks have less reason to compete hard for your deposits unless they need the funding. Fed policy shapes both the cost of borrowing and the reward for saving, but the transmission is neither instant nor uniform across every product you use.