The Federal Reserve is considering a new tool to manage interest rates in an improving economy, and the policy could result in broader control in the monetary system of the United States.

While acknowledging that the Fed funds rate has been an effective tool for monetary policy, the Fed may have a desire to switch to a different regime, one that would involve the Fed maintaining a permanent balance sheet.

Maybe the balance sheet is not $4.5 trillion [see graph], but maybe it would be $2 trillion or $3 trillion. With that balance sheet, they would conduct open market operations, as they do today. But with their large portfolio, they would try to set a floor rate for interest rates in the short end of the yield curve. This floor rate would, in turn, via different channels in the markets, such as money market funds or bank deposits, work to set monetary policy.

Quantitative easing: A closer look

Explore more QE1 QE2 Operation Twist QE3 Tapering

A series of bond purchase programs have expanded the Fed’s balance sheet while holding down interest rates.

Since early December, the Federal Reserve has been injecting $85 billion per month of newly created money into the financial system, buying mortgage-backed securities and longer-term Treasuries. November 2008 - March 2010: $1.25 trillion of agency mortgage-backed securities (MBS), representing about 25% of the outstanding market. October 2010 - June 2011: $600 billion in U.S. Treasuries, adding to the approximately $300 billion already on the government's books. October 2011 - December 2012: This program was designed to push down longer-term interest rates by using the proceeds from the Fed's maturing holdings to purchase longer-dated date. September 2012 - present: Targeted purchases of agency MBS of up to $40 billion per month. January 2014 - present: The Fed began reducing the amount of bonds it buys each month, citing improvement in the outlook for the labor market.

From our perspective, there’s a reasonable chance that this [approach] is going to be highly successful.

The Fed has been testing a facility, a reverse repurchase facility, that allows them to perform open market operations with the system. They want to see how functional this tool might be, whether they can make the liquidity in the system move with their large balance sheet.

To date, the tests have been fairly successful. Although limited in size, the tests have gone smoothly.

If you look through Fed research, and you listen to the Fed talking points, they do intend to hold a fairly large balance sheet for the foreseeable future, and their monetary operations will be conducted less through the Fed funds channel, and more through their open market operations with the market. The open market operations would be conducted through a reverse repurchase system that they establish: The Fed would sell assets to the private sector and simultaneously buy them back at a future date. The transaction temporarily removes cash from the system.

The Fed envisions this capability as its new Fed funds tool. The difference between the Fed funds and this new tool is that the Fed funds can only operate through the bank channel. With the new tool, the Fed can operate through money market mutual funds or operate through the GSEs (government-sponsored enterprises), or operate through the banks. The Fed could get broader control over the entire system.