Last week, the Federal Open Market Committee (FOMC) lowered its target for the federal funds rate by half a percentage point to 1 percent. What most people do not realize is that this target is no longer the operative instrument of U.S. monetary policy, and that the real work is being done through the massive creation of bank reserves.

The main liability on the Federal Reserve’s balance sheet is now fiat money, which cannot be redeemed by the private sector. A central bank can create fiat money at will. It is not a coincidence that the country which invented paper money almost a millennium ago—China—also experienced the world’s first hyperinflation not long thereafter.

The federal funds rate target is now irrelevant.

But a central bank can also constrain itself. For the past 25 years, the Fed’s self-constraint of choice has been a target for the overnight federal funds rate, or the price banks charge among themselves in the trade of reserves. A rate target limited the amount of reserves that could be supplied. If the Fed pumped too many reserves into the market, the fed funds rate would soften relative to its target.

The legislation that established Treasury’s Troubled Asset Recovery Program also introduced a game-changer for U.S. monetary policy. The Fed can now pay interest on reserves. Even if the Fed supplies more reserves than are consistent with the FOMC rate target, the funds rate can go no lower than the deposit rate paid on reserves. This is because banks will deposit reserves back at the Fed at the deposit rate rather than lend those reserves in the money market at a lower rate. Thus, the Fed can acquire massive amounts of assets, pay for them with reserves, and see the funds rate go no lower than the deposit rate.

That is exactly what has happened over the past month. Outstanding reserves have ballooned to finance the expansion of the Fed’s special facilities, and the funds rate has traded closer to the deposit rate than it has to the FOMC target. The Fed is hoping that its massive accumulation of assets and creation of reserves will buoy financial markets.

In other words, the fed funds rate target is now irrelevant. The Fed governors set the rate that matters—the deposit rate—and they also set the discount window borrowing rate (the upper limit for funds rate trading). True, the governors say they are setting the deposit and discount rates as fixed spreads to the funds rate target. But they have changed those spreads when they wanted to.

The hope is that this experiment will stabilize asset prices, reduce credit spreads, and boost the economy.

No group of Fed policymakers currently determines the amount of reserves outstanding. That is because most reserves are provided through open facilities such as swap lines (for foreign central banks), discount windows (for commercial and investment banks), and the commercial paper and money market fund programs. For now, outstanding reserves depend on the day-to-day activities of these facilities.

A better method would be for the Fed governors to decide on the deposit rate in joint collaboration with the FOMC. In its public statements, the FOMC could give some guidance as to the expected growth of reserves. This would direct public attention to the operative Fed policy rate.

Looking at the bigger picture, America has embarked on one of the great experiments in the history of monetary economics. We are testing the notion that the size of a central bank’s balance sheet matters more to the economy than the overnight interest rate that balance sheet produces in money markets. The hope is that this experiment will stabilize asset prices, reduce credit spreads, and boost the economy.

It may work out that way. But for now, the Fed must do a better job of explaining its radical new policy model.

Vincent R. Reinhart, a resident scholar at the American Enterprise Institute, was formerly director of the Federal Reserve Board’s Division of Monetary Affairs and chief economist of the Federal Open Market Committee.

Image Credit: Darren Wamboldt/Bergman Group.