When the economy starts to wilt, as it has over the past year, the Federal Reserve, the U.S. central bank or "The Fed", takes center stage.

The Fed has a number of policy tools that it uses to help goose growth. It also has ways to curtail growth. In other words, the Fed has a lot of economic power.

Before delving into the Fed’s various tools, it’s important to note that policymakers have two main levers of economic power. The Fed’s power, usually focused on interest rates, or the cost of money, is called monetary policy. The power to tax and spend, the purview of the government, is called fiscal policy.

In this story, I’ll focus on the monetary policy, the Fed’s toolbox. And, as this current economic crisis has demonstrated, the Fed’s toolbox is not all powerful.

Interest Rate Setting

The Fed’s chief weapon is short-term interest rates. This is the rate that banks charge one another for overnight lending, a common business practice. The Fed can set this rate, commonly called the Fed Funds rate, based on its actions in the marketplace as either a lender or a borrower. The Fed also sets a rate at its so-called discount window by interacting directly with banks. This rate is usually very close or the same as the Fed Funds rate, but it is the Fed Funds rate that more closely watched.

The Fed has two mandates, under the law: keep inflation in check and strive for full employment in the economy. These two goals are sometimes in conflict, primarily because most economists believe true full employment is inflationary. If everyone has a job, labor’s wage bargaining power is large.

Pushing on a String

In a typical economic cycle, when growth slows, the Fed will reduce the Fed Funds rate, making it cheaper for banks to borrow and lend. This helps drive economic activity. When the economy is growing fast, the Fed will raise the Fed Funds rate to make it more expensive for banks to borrow and lend, thereby curtailing growth and reducing the risk of inflation that tends to accompany fast growth.

In the current crisis, the Fed’s traditional tools have not yet taken hold. The Fed Funds rate, which is a short-term rate (overnight lending isn’t a long-term relationship) has been cut essentially to zero - a record low. Even at that level, banks remain too scarred by the financial crisis to lend very much money.

Economists call this conundrum “pushing on a string.” The Fed has lowered rates as far as it is able, but even that effort hasn’t helped the economy start growing again.

Quantitative Easing

So, the Fed has decided to get ever more creative in its policy to try and jump-start lending and growth. It has stepped into the marketplace to purchase longer-term Treasury bonds. This drives the price of Treasurys higher, pushing the yield lower. Yield which moves in the opposite direction of price and is a proxy for long-term interest rates.

The notion is that this move to reduce longer-term interest rates will help mortgage refinancings, putting money in consumers’ pockets, and help companies reduce their own long-term financing costs, saving them money as well.

The Fed's actions of buying bonds is called “quantitative easing,” a policy tool usually implemented when interest rates are at or near zero. Since the Fed can’t make money any less expensive to use, it uses quantitative easing to essentially create more money. This money flows into the system and, in theory, helps make bank lending easier.

Balance Sheet Expansion

Lastly, the Fed has also made use of its own balance sheet to lend money to financial institutions, sometimes accepting questionable assets as collateral against the loan. This has made it easier for banks to borrow money to rebuild their balance sheets. In addition, the Fed has reclassified many non-bank companies, such as Goldman Sachs and other investment banks, as “banks,” thereby giving them access to various Fed lending programs.

Fed Chief Ben Bernanke, while an academic made, studying the Great Depression his specialty. He believes that the Fed must use every available tool – as well as create some new ones – in order to stave a rerun of the Great Depression. Based on everything the Fed has done, he certainly has followed his own recipe.

Will it work? Eventually. But undwinding the massive Fed involvement in the economy and returning to a world when the Fed merely set short-term interest rates will take a long, long time.

-- FiLife Editor-at-Large Dave Kansas is the author of The Wall Street Journal Guide to the End of Wall Street as We Know It: What You Need to Know About the Greatest Financial Crisis of Our Time--and How to Survive It