The monetary channel was broken on the downside, and will remain broken on the upside pressure in rates. Long rates will not move to the extent the Fed thinks they will, which is precisely what happened the last time the Fed began a similar upward march.
Although the federal funds rate is likely to remain exceptionally low for an extended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures. Notwithstanding the substantial increase in the size of its balance sheet associated with its purchases of Treasury and agency securities, we are confident that we have the tools we need to firm the stance of monetary policy at the appropriate time.2
Most importantly, in October 2008 the Congress gave statutory authority to the Federal Reserve to pay interest on banks' holdings of reserve balances at Federal Reserve Banks. By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.
The Federal Reserve has also been developing a number of additional tools to reduce the large quantity of reserves held by the banking system, which will improve the Federal Reserve's control of financial conditions by leading to a tighter relationship between the interest rate paid on reserves and other short-term interest rates. Notably, our operational capacity for conducting reverse repurchase agreements, a tool that the Federal Reserve has historically used to absorb reserves from the banking system, is being expanded so that such transactions can be used to absorb large quantities of reserves. The Federal Reserve is also currently refining plans for a term deposit facility that could convert a portion of depository institutions' holdings of reserve balances into deposits that are less liquid and could not be used to meet reserve requirements. In addition, the FOMC has the option of redeeming or selling securities as a means of reducing outstanding bank reserves and applying monetary restraint. Of course, the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments. I provided more discussion of these options and possible sequencing in a recent testimony.