Central bank policy is a set of tools to manage the money supply and steer short-term interest rates towards the central bank’s goal. The key instrument is the central bank’s target for its main interest rate, which aims to influence market interest rates and, thus, the money supply, demand and inflation. Other instruments include the buying or selling of securities (open market operations), rules that stipulate how much money commercial banks can keep on hand or cannot loan out, and deposit requirements and requirements for collateral that financial institutions must pledge.
In times of crisis, the Fed has augmented its toolkit by expanding its balance sheet through quantitative easing (QE). This has included purchasing Treasuries from banks to increase their reserves and make it easier for them to lend to consumers or businesses. It also bought mortgage-backed securities to sustain housing finance and commercial paper to boost lending to companies.
The biggest challenge for central banks is to achieve their goals without causing too much inflation. Expansion of the money supply may stimulate the economy, but if prices rise too quickly it could lead to generalized inflation that undermines growth and employment rates. To avoid this, central banks often temporarily depart from their long-run price stability goal and cut their policy rate in a recessionary environment. However, this strategy works only if people believe that the central bank will return to its price stability objective soon. This requires credibility, which is achieved through clear communication and actions that back up the central bank’s words.