What Are Open Market Operations?

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Open market operations are the buying and selling of government securities as a means to expand or contract the banking system's money supply. These securities are bought and sold in the open market as a means to inject additional money into the nation's banking system to encourage economic growth. They are also used to sell securities and take money out of the nation's money supply to cause an economic contraction.

TL;DR (Too Long; Didn't Read)

Put very simply; open market operations are defined as buying and selling securities in the open market by the nation's Central Bank. This is a key tool the Federal Reserve uses to implement monetary policy.

Defining Open Market Operations

The Federal Reserve Bank, also called the Central Bank, or Fed conducts open market operations (OMO), which involve the purchase and sale of securities in the open market as a tool to implement expansionary or contractionary monetary policy. The Federal Reserve uses this buying and selling activity as one of three key tools to influence or change interest rates.

The Federal Open Market Committee (FOMC) specifies certain short-term objectives for the Central Bank to carry out through its OMO. The Federal Reserve Bank of New York has a trading desk that takes care of the actual open market buy and sell transactions.

These transactions involve a limited set of securities, mostly treasury bills, notes and bonds, and each year, the Federal Reserve Bank of New York publishes an annual report containing details of the transactions involved in its OMO activity for that year.

The Fed conducts different types of OMOs, using some transactions to address transitory issues in the market, and other transactions to implement permanent change. You can find details of the Federal Reserve Bank of New York's permanent and temporary OMOs on its website.

The Federal Open Market Committee

The Federal Open Market Committee or FOMC is the body that decides on the objectives for open market operations in the short-term. The FOMC also serves as the Federal Reserve's monetary policy-making body.

It meets eight times each year, or about every six weeks. Unscheduled meetings to review new financial or economic developments may also take place as needed. After each regular meeting, the FOMC issues a policy statement which describes the decision made regarding the economy and any new policy set by the committee, and the Chair of the FOMC briefs the press about these updates four times each year.

The press briefing typically offers additional information and details related to the FOMC's latest policies, and also provides an updated view of its current projections for the economy.

The main goal of the FOMC and the OMOs it requests is to carry out two important tasks of macroeconomic policy. These two tasks consist of achieving maximum employment for the nation and maintaining stable levels of pricing for consumers.

The FOMC strives to achieve these outcomes by specifying OMO activities that will affect short-term interest rates, based on the response it deems appropriate to address its current view of the economy's condition, including any changes to its economic outlook.

Since the tumultuous market conditions of 2008, the FOMC has also begun to address long-term interest rates by issuing an order for the Fed to buy large amounts of Treasury securities and securities guaranteed by federal agencies, as a way to reduce interest rates in the longer-term and lend more support to recovery efforts in the economy.

The Mechanics of Open Market Operations

What are the Fed's open market operations? How do they work? The Fed, or Central Bank, buys and sells debt instruments issued by the government. These are known as Treasury notes, bills and bonds. The goal is to affect the money supply by circulating more money into the economy or taking money out of the economy to decrease the supply.

The desired outcome is to influence interest rates and move them either higher or lower, depending on what is needed in the current economic environment. When the Fed decides to buy securities, it puts money into the economy which results in expansion because banks now have more money to lend, helping consumers spend more.

When the Fed sells government debt, banks and investors give up their money in exchange for these securities, which removes money from the economy and is an example of a contractionary monetary policy.

When the Fed buys securities, it pays for them using its own money out of its account. This is significant because the Fed is the only body that has the authority to bring money in and out of existence. This entity creates money, although it's typically in digital form rather than actual bills and coins.

Sellers take the Fed's money and put it into their private bank accounts. Then the banks use that money to increase their reserve accounts, and this gives them the capacity to offer more loans to their customers. This increases the money supply, and interest rates fall lower, at least in the short-term.

On the other side, when the Fed wants to reduce the amount of money in circulation, it works in reverse. The Fed sells government securities from its account, and buyers use money from their private bank accounts to purchase these securities.

The private banks clear the checks and send the proceeds to the Fed. The private Banks now have less money in their customer deposit accounts and less money in their Federal Reserve accounts. This reduces the private banks' ability to offer loans, and fewer loans mean less money in the economy, resulting in higher interest rates, at least for the short-term.

An Overview of Monetary Policy

Monetary policy refers to the mechanism the Fed uses to influence how much money and credit is available in the nation's economy. Changes in the availability of credit and money lead to changes in interest rates.

Interest rates, also known as the cost of credit, encourage savings and investing when they are high. However, when interest is high, it discourages spending.

Low-interest rates, on the other hand, discourage saving and investing, while encouraging spending. For example, consumers will enjoy cheaper credit and cheaper loans. When the amount of available money and credit increases too quickly, the general levels of prices also increase which leads to inflation. The Fed uses monetary policy to moderate interest rates, keeping them from being either too high or too low.

Aside from OMOs, the Fed also uses two other tools to regulate the economy's interest rates. These tools are bank reserves requirements and the discount rate. Bank reserve requirements represent an amount, set as a certain percentage of customer deposits, that private banks must keep as a form of security, either in their vaults or on deposit at the Fed. Additionally, the Fed loans funds on a short-term basis to banks and charges them interest for doing so. This interest rate is known as the discount rate.

Expansionary Monetary Policy

An expansionary monetary policy is a policy enacted by the Fed to increase the economy's supply of money.

When the money supply increases, this creates more spending which boosts the economy. The Fed keeps interest rates low, which encourages businesses and individuals to borrow more money for various economic projects.

The Fed may lower the interest rate paid on Treasury bonds through a process known as quantitative easing. This makes funds cheaper for banks, who can then lend more money to consumers. Expansionary monetary policy carries the risk of inflation if the Fed increases the money supply too quickly, which leads to higher prices of goods and services for consumers.

Contractionary Monetary Policy

A contractionary monetary policy is the opposite of expansionary policy. The Fed implements these types of actions when economic growth is taking place at a rate that's moving too fast, causing inflation. Contractionary monetary policy can be used to exert some control and slow down the economy to bring more stability to prices.

For example, in a strong economy when the unemployment rate falls too low, and companies cannot find workers, this creates what economists call an inflationary gap. Typical tools used to reduce the gap include OMOs, reduced government spending in other areas and tax increases.

When the government decreases its spending, it decreases its demand for goods and services which lowers the nation's overall demand curve. Tax increases reduce demand and slow down the economy because consumers will be left with less money to spend and invest, which also reduces the nation's overall, aggregate demand. These reductions in demand lead to a contraction of the economy.

The Discount Rate

The discount rate is defined as the interest rate that certain banks pay to borrow money from the Fed. The discount rate is updated every 14 days. The Fed can control the supply of available money by changing the discount rate, and this exerts an influence on inflation, and on interest rates overall.

Raising the discount rate means that banks must pay more to borrow money from the Fed. For example, if a bank's reserves fall below the Fed's required level, it must borrow money to cover the shortage. However, this process is not optimal, and banks prefer to borrow money from each other for short-term needs.

The Federal Reserve Banks in various regions of the nation establish the discount rates. Three different discount rates exist; the primary credit, secondary credit and seasonal credit rates, with each having a different interest rate.

The primary rate applies to short-term loans, usually taken only overnight, to banks in generally good financial condition. Banks that cannot meet the eligibility for primary credit at the primary discount rate can apply for secondary credit to borrow money for any short-term needs, or to help in the event of any type of severe financial issue. Regional Federal Reserve Banks offer seasonal credit to small banks that experience funding fluctuation each year, such as banking institutions located in seasonal resort communities or agricultural communities.

The primary credit discount rate is usually just above the short-term market interest rate, and the secondary rate is set higher than the primary credit rate. The seasonal discount rate is determined by taking an average of certain market rates. All regional federal reserve banks generally maintain the same discount rates for each of the three programs.

Bank Reserve Requirements

Banking institutions must hold a certain amount of money in reserve to protect against the liability of their deposits. In other words, the bank must have enough cash on hand to cover a certain specified amount of customer withdrawals, set as a percentage of the total amount of funds it has on deposit. When banks have this safeguard in place, the Fed allows them to make loans to customers based on a percentage of the cash they have in hand.

The Fed uses bank reserves as a monetary policy tool, along with the discount rate and open market operations. For example, when the Fed reduces the reserve requirement for banks, this frees up money and contributes to an expansionary monetary policy. Conversely, when the Fed raises the reserve requirement, this action cuts down on liquidity, or available cash, and cools down a fast-moving economy. This is contractionary monetary policy.

The Federal Reserve's Board of Governors is the only entity that has the power to change bank reserve requirements. Banks must keep their reserves in cash inside of their vault, or deposited with their regional Federal Reserve Bank. If a bank has an excess of money in reserve, it will receive an interest payment on those funds from the Fed.

References

About the Author

Cynthia Gaffney has spent over 20 years in finance with experience in valuation, corporate financial planning, mergers & acquisitions consulting and small business ownership. She has worked as a financial writer and editor for several online finance and small business publications since 2011, including AZCentral.com's Small Business section, The Balance.com, Chron.com's Small Business section, and LegalBeagle.com. A Southern California native, Cynthia received her Bachelor of Science degree in finance and business economics from USC.