If the Fed moves more and more towards explicit inflation targeting and transparency as I have discussed in several recent posts here, here, here, here, and here there is another change that might be coming as well (someday). The Fed may abandon open market operations.
Controlling the federal funds rate does not require the use of open market operations or any reference at all to a monetary aggregate. This is desirable since monetary aggregates are becoming increasingly difficult to define due to the ease of converting financial and other assets to cash. Because of this, it is difficult to know which monetary aggregate to target when attempting to control the overnight borrowing rate between banks (i.e., the federal funds rate). The procedure described below overcomes this difficulty.
Currently, policy works by using open market operations to obtain the desired federal funds rate target. Each morning, the desired change in the federal funds rate is determined by the Fed and then the open market operation needed to move as close as possible to the target is implemented.
However, the discount window is all that is needed to control the overnight rate, open market operations are unnecessary. In fact, recent changes in the Fed’s operating procedure where the discount rate caps the federal fund rate have already put part of this procedure into place (currently the discount rate is equal to the target federal funds rate plus 1%. Thus, the federal funds rate caps the discount rate and allows the discount window to serve its traditional lender of last resort role without the need to explicitly limit how many times a bank may visit the window, i.e. there is no longer a need for "moral suasion").
Here’s how to control the federal funds rate without open market operations. The Fed simply sets the discount rate it charges for borrowing reserves at the target rate plus a small amount s, i.e. r + s (as it already does). Simultaneously, the Fed stands ready to pay r - s on deposits held at the Fed (it does not yet do this). Under this procedure, the federal funds rate will be bounded within the range r plus or minus s. Thus, there is no need to reference a monetary aggregate at all in order to bound movements in the overnight borrowing rate between banks.