Part 2: Monetary Policy

Monetary Policy Report submitted to the Congress on July 9, 2021, pursuant to section 2B of the Federal Reserve Act

The Federal Open Market Committee maintained the federal funds rate near zero as it seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run...

As part of its actions to ensure that monetary policy will continue to deliver powerful support to the economy until the recovery is complete, the Federal Open Market Committee (FOMC) has maintained the target range for the federal funds rate at 0 to 1/4 percent (figure 49). The Committee has indicated that it expects it will be appropriate to maintain the target range for the federal funds rate at 0 to 1/4 percent until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time. With inflation having run persistently below the Committee's longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved.

. . . and the Committee increased the holdings of Treasury securities and agency mortgage-backed securities in the System Open Market Account

In addition, the Federal Reserve has continued to expand its holdings of Treasury securities by $80 billion per month and its holdings of agency mortgage-backed securities (MBS) by $40 billion per month. These asset purchases help foster smooth market functioning and accommodative financial conditions, thereby supporting the flow of credit to households and businesses. The Committee's current guidance regarding asset purchases indicates that increases in the holdings of Treasury securities and agency MBS in the System Open Market Account will continue at least at this pace until substantial further progress has been made toward its maximum-employment and price-stability goals since the Committee adopted its asset purchase guidance last December. In addition, the minutes of the June 2021 FOMC meeting noted the importance that policymakers attach to clear communications about the Committee's assessment of progress toward its longer-run goals and to providing these communications well in advance of the time when progress can be judged substantial enough to warrant a change in the pace of asset purchases.9 In coming meetings, the FOMC will continue to assess the economy's progress toward the Committee's goals.

The FOMC is committed to using its full range of tools to promote maximum employment and price stability

Progress on vaccinations will likely continue to reduce the effects of the public health crisis on the economy, but risks to the economic outlook remain. The Federal Reserve is committed to using its full range of tools to support the U.S. economy in this challenging time, thereby promoting its maximum-employment and price-stability goals. The Committee will continue to monitor the implications of incoming information for the economic outlook and is prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals. The Committee's assessments will continue to take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments.

In addition to considering a wide range of economic and financial data and information gathered from business contacts and other informed parties around the country, policymakers routinely consult prescriptions for the policy interest rate provided by various monetary policy rules. These rule prescriptions can provide useful benchmarks for the FOMC. Simple rules cannot capture the complexities of monetary policy, and many practical considerations make it undesirable for the FOMC to adhere strictly to the prescriptions of any specific rule. However, some principles associated with good monetary policy can be illustrated by these policy rules (see the box "Monetary Policy Rules, the Effective Lower Bound, and the Economic Recovery"). The FOMC's framework for conducting monetary policy involves a systematic approach in keeping with key principles of good monetary policy but allows for more flexibility than is implied by simple policy rules.

The size of the Federal Reserve's balance sheet continued to grow, reflecting purchases of U.S. Treasury securities and agency mortgage-backed securities

The Federal Reserve's balance sheet has grown to $8.1 trillion from $7.4 trillion at the end of January, reflecting continued asset purchases to help foster smooth market functioning and accommodative financial conditions, thereby supporting the flow of credit to households and businesses (figure 50). The Federal Reserve has continued rolling over at auction all principal payments from its holdings of Treasury securities. Principal payments received from agency MBS and agency debt continue to be reinvested into agency MBS. After the March FOMC meeting, in light of the sustained smooth functioning of markets for agency commercial mortgage-backed securities (CMBS), the Federal Reserve ended regular purchases of agency CMBS.

The increase in aggregate asset holdings on the Federal Reserve's balance sheet arising from Treasury security and agency MBS purchases has been offset in part by declines in several other asset categories. Outstanding balances at many of the Federal Reserve's emergency liquidity and credit facilities have declined since the end of January, and most facilities have now expired.10 In June, the Federal Reserve Board announced plans to begin winding down the portfolio of the Secondary Market Corporate Credit Facility (SMCCF). The SMCCF proved very important in restoring market functioning last year, supporting the availability of credit for large employers, and bolstering employment through the COVID-19 pandemic. The winding down of the SMCCF portfolio has been gradual and orderly and has not produced any adverse effect on market functioning. Draws on central bank liquidity swap lines have decreased further to near zero, and usage of repurchase operations has remained at zero since February. In contrast, the Paycheck Protection Program Liquidity Facility has expanded to around $80 billion since the end of January.

Reserves have increased significantly to around $4 trillion, mostly because of asset purchases and the large drawdown in the Treasury General Account from around $1.6 trillion in January to about $850 billion in June. However, reserves have been relatively stable more recently given a substantial increase in the use of the overnight reverse repurchase agreement facility. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets.")

Monetary Policy Rules, the Effective Lower Bound, and the Economic Recovery

Simple interest rate rules relate a policy interest rate, such as the federal funds rate, to a small number of other economic variables—typically including the deviation of inflation from its target value and a measure of resource slack in the economy. Policymakers consult prescriptions of the policy interest rate derived from a variety of policy rules for guidance, without mechanically following the prescriptions of any particular rule. This discussion examines the prescriptions of a number of interest rate rules. One simplification these rules typically adopt is ignoring the effective lower bound (ELB) on interest rates, and many of the rules have prescribed negative values for the federal funds rate since the onset of the pandemic-driven recession.

Most rules analyzed in the research literature respond to deviations—both positive and negative—of resource utilization from its trend level because they were informed by historical periods and economic models in which high resource utilization is accompanied by inflation pressure. By contrast, the Federal Open Market Committee's (FOMC) Statement on Longer-Run Goals and Monetary Policy Strategy indicates that policymakers would not respond to high employment unless it was accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of the Committee's goals.1 Accordingly, this discussion examines—in addition to the prescriptions of a number of commonly studied monetary policy rules—the prescriptions of a modified simple rule that, all else being equal, does not mechanically call for policy rate increases as unemployment drops below its estimated longer-run level.2

Policy Rules: Some Key Design Principles and Limitations

In many stylized models of the economy, desirable economic outcomes can be achieved by following a monetary policy rule that incorporates key principles of good monetary policy. One such principle is that monetary policy should respond in a predictable way to changes in economic conditions, thus fostering public understanding of policymakers' goals and strategy. A second principle is that, to stabilize inflation, the policy rate should be adjusted over time in response to persistent increases or decreases in inflation to an extent sufficient to ensure a return of inflation to the central bank's longer-run objective.

Simple monetary policy rules also have important limitations. As noted earlier, simple rules do not typically recognize that the ELB limits the extent to which the policy rate can be lowered to support the economy, which may impart a downward bias to both employment and inflation. To mitigate the challenges posed by the ELB and anchor longer-term inflation expectations at 2 percent, the Committee indicates in its statement that it "seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time."3 None of the simple rules analyzed in this discussion include any mechanism to offset the downward bias in inflation imposed by the ELB. As such, they do not reflect these important aspects of the FOMC's monetary policy strategy.

Another limitation is that simple rules respond to only a small set of economic variables and thus necessarily abstract from many of the considerations that the FOMC takes into account. For example, a simple rule might respond to movements in a specific labor market indicator, such as the overall unemployment rate. However, no single labor market indicator can precisely capture the size of the shortfall from maximum employment or identify when a strong labor market can be sustained without putting undue upward pressure on inflation; many labor market indicators must be assessed.4 Similarly, simple policy rules that systematically call for increases in the policy rate as slack in the labor market diminishes might fail to recognize the benefits of sustaining a strong labor market.5

Finally, simple rules for the policy rate do not explicitly recognize that the monetary policy toolkit includes other tools—notably, large-scale asset purchases and forward guidance, which are especially relevant when the policy rate is constrained by the ELB. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets.")

Policy Rules: Descriptions

Economists have analyzed many monetary policy rules, including the well-known Taylor (1993) rule, the "balanced approach" rule, the "adjusted Taylor (1993)" rule, and the "first difference" rule.6 In addition to these rules, figure A shows a "balanced approach (shortfalls)" rule, which represents one simple way to illustrate the Committee's focus on shortfalls from maximum employment. All of the policy rules analyzed in this discussion embody the key principles of good monetary policy previously noted as well as the important limitations.

All five rules feature the unemployment rate gap, measured as the difference between an estimate of the rate of unemployment in the longer run ($$ u_t^{LR}$$) and the current unemployment rate; the first-difference rule includes the change in the unemployment rate gap rather than its level.7 All of the rules abstract from the uncertainty that surrounds estimates of the unemployment rate gap. In addition, all of the rules include the difference between inflation and the FOMC's longer-run objective of 2 percent.8 All but the first-difference rule include an estimate of the neutral real interest rate in the longer run ($$ r_t^{LR}$$).9

By construction, the balanced-approach (shortfalls) rule prescribes identical policy rates to those prescribed by the balanced-approach rule at times when the unemployment rate is above its estimated longer-run level. However, when the unemployment rate is below that level, the balanced-approach (shortfalls) rule is more accommodative than the balanced-approach rule because it does not call for the policy rate to rise as the unemployment rate drops further.

Unlike the other simple rules featured here, the adjusted Taylor (1993) rule recognizes that the federal funds rate cannot be reduced materially below the ELB. To make up for the cumulative shortfall in accommodation following a recession during which the federal funds rate has fallen to its ELB, the adjusted Taylor (1993) rule prescribes delaying the return of the policy rate to the (positive) levels prescribed by the standard Taylor (1993) rule until after the economy begins to recover.

Policy Rules: Prescriptions

Figure B shows historical prescriptions for the federal funds rate from the five rules. For each period, the figure reports the policy rates prescribed by the rules, taking as given the prevailing economic conditions and estimates of $$ u_t^{LR}$$ and $$ r_t^{LR}$$ at the time. The four rules whose formulas do not impose a lower bound on the value of the federal funds rate imply prescriptions of strongly negative policy rates in response to the pandemic-driven recession, well below their respective troughs in the 2008–09 recession. The prescriptions of the balanced-approach and balanced-approach (shortfalls) rules are the most negative because these rules call for relatively large responses to resource slack. The negative prescriptions of the four rules show the extent to which policymakers' ability to support the economy through reductions in the federal funds rate has been constrained by the ELB during the pandemic-driven recession—a constraint that underlines the importance of the FOMC's other policy actions at the time, including forward guidance about the federal funds rate and large-scale asset purchases.

Regarding the recovery from the 2008–09 recession, all of the simple rules shown here prescribed departure from the ELB well before the FOMC determined that it was appropriate to raise the federal funds rate. The FOMC judged, on the basis of a wide range of information available at the time, that it was appropriate to maintain a more accommodative path of the federal funds rate than prescribed by these rules. Similarly, in the aftermath of the pandemic-driven recession, the FOMC has been drawing from a broad range of indicators, analyses, and judgments in making its determinations concerning the appropriate stance for monetary policy, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments. Under the FOMC's flexible form of average inflation targeting, departure from the ELB might be delayed relative to the simple rules by the desire to see inflation run moderately above 2 percent for some time. While the simple rules are concerned with period-by-period inflation, the Committee aims for a sustained return of inflation to the 2 percent objective.

1. For a discussion of changes made to the statement, see the box "The FOMC's Revised Statement on Longer-Run Goals and Monetary Policy Strategy" in Board of Governors of the Federal Reserve System (2021), Monetary Policy Report (Washington: Board of Governors, February), pp. 40–41, https://www.federalreserve.gov/monetarypolicy/files/20210219_mprfullreport.pdf. Return to text

2. Other key features of the Committee's monetary policy strategy outlined in its statement, including the aim of having inflation average 2 percent over time to ensure that longer-term inflation expectations remain well anchored, are not incorporated in the simple rules analyzed in this discussion. For a description of the revised statement, see Jerome H. Powell (2020), "New Economic Challenges and the Fed's Monetary Policy Review," speech delivered at "Navigating the Decade Ahead: Implications for Monetary Policy," an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, held in Jackson Hole, Wyo. (via webcast), August 27, https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm. Return to text

3. The statement recognizes the ELB as an important consideration in the conduct of monetary policy by indicating that "the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past." In part because of the proximity of interest rates to the ELB, the Committee judges that downward risks to employment and inflation have increased. The Committee is prepared to use its full range of tools to achieve its maximum-employment and price-stability goals. Return to text

4. See Lael Brainard (2021), "How Should We Think about Full Employment in the Federal Reserve's Dual Mandate?" speech delivered at the Ec10, Principles of Economics, Lecture, Faculty of Arts and Sciences, Harvard University, Cambridge, Mass. (via webcast), February 24, https://www.federalreserve.gov/newsevents/speech/brainard20210224a.htm. Return to text

5. For examples of the benefits associated with strong labor market conditions, see Fed Listens: Perspectives from the Public, which summarizes the feedback received from the community as part of the FOMC's 2019–20 review of its monetary policy strategy, tools, and communication practices and is available on the Board's website at https://www.federalreserve.gov/publications/files/fedlistens-report-20200612.pdf. Return to text

6. The Taylor (1993) rule was suggested in John B. Taylor (1993), "Discretion versus Policy Rules in Practice," Carnegie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 195–214. The balanced-approach rule was analyzed in John B. Taylor (1999), "A Historical Analysis of Monetary Policy Rules," in John B. Taylor, ed., Monetary Policy Rules (Chicago: University of Chicago Press), pp. 319–41. The adjusted Taylor(1993) rule was studied in David Reifschneider and John C. Williams (2000), "Three Lessons for Monetary Policy in a Low-Inflation Era," Journal of Money, Credit and Banking, vol. 32 (November), pp. 936–66. The first-difference rule is based on a rule suggested by Athanasios Orphanides (2003), "Historical Monetary Policy Analysis and the Taylor Rule," Journal of Monetary Economics, vol. 50 (July), pp. 983–1022. A review of policy rules is in John B. Taylor and John C. Williams (2011), "Simple and Robust Rules for Monetary Policy," in Benjamin M. Friedman and Michael Woodford, eds., Handbook of Monetary Economics, vol.3B (Amsterdam: North-Holland), pp. 829–59. The same volume of the Handbook of Monetary Economics also discusses approaches other than policy rules for deriving policy rate prescriptions. Return to text

7. The original Taylor (1993) rule represented slack in resource utilization using an output gap (the difference between the current level of real gross domestic product (GDP) and the level that GDP would be if the economy were operating at maximum employment, measured in percent of the latter). The rules in figure A represent slack in resource utilization using the unemployment gap instead, because that gap better captures the FOMC's statutory goal to promote maximum employment. Movements in these alternative measures of resource utilization are highly correlated. For more information, see the note below figure A. Return to text

8. None of these rules take into account historical inflation performance. As such, these rules do not incorporate the aim of achieving inflation that averages 2 percent over time as described in the FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy. In particular, that statement indicates that "the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time." Return to text

9. The neutral real interest rate in the longer run ($$ r_t^{LR}$$) is the level of the real federal funds rate that is expected to be consistent, in the longer run, with maximum employment and stable inflation. Like $$ u_t^{LR}$$, $$ r_t^{LR}$$ is determined largely by nonmonetary factors. The first-difference rule shown in figure A does not involve an estimate of $$ r_t^{LR}$$. However, this rule has its own shortcomings. For example, research suggests that this sort of rule often results in greater volatility in employment and inflation relative to what would be obtained under the Taylor (1993) and balanced-approach rules. Return to text

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Developments in the Federal Reserve's Balance Sheet and Money Markets

The Federal Reserve's asset purchases since March 2020 have resulted in a large and rapid expansion of the Federal Reserve's balance sheet. Federal Reserve assets totaled $4.2 trillion before the pandemic in January 2020 and have since grown to $8.1 trillion (figure A). As net asset purchases proceed at a pace of $120 billion per month, the Federal Reserve's total liabilities increase correspondingly.1 Alongside this growth in aggregate liabilities arising from asset purchases, there have also been large compositional shifts between liabilities this year due to factors that are not directly related to monetary policy decisions (figure B). This discussion reviews recent developments in the Federal Reserve's balance sheet and associated changes in money market conditions.

B. Federal Reserve liabilities

*Note: On July 14, 2021, the “Federal Reserve notes” and “Other liabilities and capital” data were corrected to place Federal Reserve bank holdings of Federal Reserve notes in the latter category.

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Reserve balances are the largest liability on the Federal Reserve's balance sheet. Federal Reserve asset purchases are settled by adding reserves to the banking system; thus, the magnitude of asset purchases since the onset of the pandemic has brought reserves to record levels.2 Reserves grew substantially earlier this year, from $3.1 trillion in early January to $3.9 trillion by early April. The level of reserves was, however, mostly stable from April to June 2021, reflecting growth in other liabilities such as the overnight reverse repurchase agreement (ON RRP) facility.

In light of the Federal Reserve's role as fiscal agent for the federal government, the U.S. Treasury holds balances in the Treasury General Account (TGA), which is another liability on the Federal Reserve's balance sheet. Changes in the TGA affect other Federal Reserve liabilities such as reserves and may have implications for money market conditions. A reduction in the TGA increases the level of reserves, other things being equal, as the Treasury makes payments to individuals and businesses, which may increase private deposits in the banking system. An important recent development in this regard has been the substantial drawdown of the TGA over the first half of 2021. With the enactment of pandemic-related fiscal stimulus measures through multiple rounds of federal legislation in 2020 and 2021, the Treasury's balance in the TGA increased to unprecedentedly high levels. As shown in figure C, as the bulk of the most recent fiscal stimulus payments and tax refunds came to an end, the Treasury lowered its outstanding balance in the TGA from about $1.6 trillion at the end of January 2020 to about $850 billion by the end of June 2021. As the Treasury sought to reduce its TGA balance, the Treasury also lowered its net issuance of Treasury bills substantially in 2021.

C. Balance sheet comparison*

(Billions of dollars)

  6/30/2021 1/27/2021 Change
Assets
Total securities
Treasury securities 5,183 4,766 417
Agency debt and MBS 2,322 2,072 250
Net unamortized premiums 351 345 6
Repurchase agreements 0 1 -1
Loans and lending facilities
PPPLF 91 47 44
Other loans and lending facilities 72 91 -19
Central bank liquidity swaps 1 10 -9
Other assets 58 74 -16
Total assets 8,079 7,405 674
Liabilities and capital
Federal Reserve notes 2,134 2,049 85
Reserves held by depository institutions 3,512 3,229 283
Reverse repurchase agreements
Foreign official and international accounts 269 209 60
Others 992 1 991
U.S. Treasury General Account 852 1,613 -761
Other deposits 230 203 27
Other liabilities and capital 90 101 -11
Total liabilities and capital 8,079 7,405 674

Note: MBS is mortgage-backed securities. PPPLF is Paycheck Protection Program Liquidity Facility.

Source: Federal Reserve Board, Statistical Release H.4.1, "Factors Affecting Reserve Balances."

*Note: On July 14, 2021, the “Federal Reserve notes” and “Other liabilities and capital” data were corrected to place Federal Reserve bank holdings of Federal Reserve notes in the latter category.

The developments with reserves, the TGA, and Treasury bill issuance have affected money markets in 2021. The recent large increases in reserves, resulting from both asset purchases and reductions in the TGA, have put broad but modest downward pressure on short-term interest rates over recent months. Additionally, the net declines in Treasury bill supply have put downward pressure on bill yields, which similarly affected rates on close substitutes to bills such as repurchase agreements (repos) collateralized by Treasury securities.3

In this environment of ample liquidity and downward pressure on money market rates, the Federal Reserve's ON RRP facility has seen a historically large increase in usage since April 2021, primarily driven by greater participation from government money market funds. Take-up at the ON RRP facility reached record levels—nearly $1 trillion by the end of June 2021. In light of the potential for expanded use of the facility and given growth in money market fund assets under management in recent years, the Federal Open Market Committee (FOMC) raised the per-counterparty cap on ON RRP participation to $80 billion per day from $30 billion at the March 2021 FOMC meeting. With the increase in usage, the ON RRP facility continued to serve its intended purpose of helping to provide a floor under short-term interest rates.4

The recent spike in facility usage reflected government money market funds turning to the facility because of their large inflows. Certain banks reportedly sought to limit further growth of their reserve holdings and of certain deposit liabilities. This phenomenon has reportedly been important in recent months in driving additional inflows into money market funds in lieu of bank deposits. Additionally, money market funds faced a relative lack of eligible short-term investments amid declining Treasury bill supply and reduced demand for repo funding on the part of borrowers. In this situation, the ON RRP has provided money market funds with an additional investment option for these inflows despite its offering rate being at 0 percent through mid-June.

Other deposits, another liability on the Federal Reserve's balance sheet, include deposits from government-sponsored enterprises (GSEs) and designated financial market utilities. These deposits roughly doubled since the beginning of 2021 to $408 billion by mid-June, reflecting in part the same money market conditions that drove higher ON RRP take-up.

Following the June 2021 FOMC meeting, the Federal Reserve made a technical adjustment to its administered rates: interest on excess reserves and the ON RRP offering rate. Both rates were increased 5 basis points in order to keep the federal funds rate well within the FOMC's target range and to support smooth functioning of short-term funding markets. ON RRP take-up rose substantially over subsequent days. This increase reflected shifts to the ON RRP from GSEs' deposits at the Federal Reserve that do not earn interest as well as additional participation from money market funds. Following the technical adjustment, short-term market interest rates adjusted slightly higher, largely in step with the increase in administered rates. The effective federal funds rate rose to 10 basis points, while the Secured Overnight Financing Rate increased to 5 basis points.

1. For general explanations of several liabilities on the Federal Reserve's balance sheet, see the box "The Role of Liabilities in Determining the Size of the Federal Reserve's Balance Sheet" in Board of Governors of the Federal Reserve System (2019), Monetary Policy Report (Washington: Board of Governors, February), pp. 41–43, https://www.federalreserve.gov/monetarypolicy/files/20190222_mprfullreport.pdf. Return to text

2. Reserves consist of deposits held at Federal Reserve Banks by depository institutions, such as commercial banks, savings banks, credit unions, thrift institutions, and U.S. branches and agencies of foreign banks. Reserve balances allow depository institutions to facilitate daily payment flows, both in ordinary times and in stress scenarios, without borrowing funds or selling assets. Return to text

3. For further information on recent money market developments, see the Financial Developments section in Part 1 of this report. Return to text

4. The ON RRP facility helps keep the effective federal funds rate from falling below the target range set by the FOMC, as institutions with access to the ON RRP should be unwilling to lend funds below the ON RRP's pre-announced offering rate. The ON RRP facility is primarily used by nonbank counterparties such as money market funds. The rate offered through the ON RRP facility complements the interest on excess reserves rate in supporting effective monetary policy implementation. The Federal Reserve provides a similar service to foreign official and international accounts (primarily foreign central banks), though these balances have not seen notable growth in recent months. Return to text

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Footnotes

 9. The minutes for the June 2021 FOMC meeting are available on the Board's website at https://www.federalreserve.gov/monetarypolicy/fomccalendars.htmReturn to text

 10. A list of credit and liquidity facilities established by the Federal Reserve in response to COVID-19 is available on the Board's website at https://www.federalreserve.gov/funding-credit-liquidity-and-loan-facilities.htmReturn to text

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Last Update: July 14, 2021