Understanding the Federal Reserve, Part Five: Open Market Operations

David Frost // Blog

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March 10  

This is part five of a series on the Federal Reserve, specifically about open market operations. Click here for part one. Click here for part two on the history. Click here for part three on the Fed’s structure. Click here for part four on interest rates.

One of the primary ways the Federal Reserve affects change in the U.S. economy is through open market operations. These operations are aimed at injecting or deducting money into or out of the financial system. Open market operations can target expansionary or contractionary monetary policies, and they can be categorized as temporary and permanent.

What are open market operations?

Open market operations include buying and selling U.S. Treasuries on the open market with the ultimate goal of regulating the monetary supply. They are called “open market operations” because the Fed isn’t deciding on its own which dealers it will do business with. Rather, securities dealer compete for the Fed’s business based on pricing within the market for Treasury securities.

By buying and selling Treasuries, the Fed also indirectly adjusts interest rates by increasing or decreasing the amount of money that’s available. The more money that’s on deposit in the nation’s banks, the more money is available for loans to consumers and businesses.

When there is more money available, interest rates decline, which means it becomes less expensive to borrow. On the other hand, the less money that’s available, the higher interest rates will go because it is more expensive to borrow money when there’s less available.  

Permanent and temporary open market operations

All open market operations are carried out by the Federal Reserve’s Trading Desk on order of the Federal Open Market Committee. Operations can be categorized as permanent or temporary. 

Permanent open market operations are straight purchases or sales of securities for the System Open Market Account, which is the Fed’s portfolio. Permanent open market operations have traditionally been used to accommodate longer-term factors for expanding the Fed’s balance sheet. Permanent operations can also be used to implement the FOMC’s policies for reinvesting principal payments on its debt holdings and mortgage-backed securities and rolling over maturity Treasuries at auction.

Temporary operations are generally used to correct reserve levels which are seen as only transitory problems. Such operations may include repurchase agreements, which are basically a buy order for a security with an agreement to resell it in the future. It’s sort of like a collateralized loan made by the Federal Reserve. These operations may also include reverse purchase agreements, which are the sale of a security with an agreement to buy back the security at some point.   

The Federal Open Market Committee

The FOMC is the part of the Fed that handles all the open market operations. The FOMC is tasked with setting a target for the federal funds rate and then taking various steps within the open market to shepherd the federal funds rate in the direction it wants the rate to go. The federal funds rate is the interest rate at which financial institutions lend money to each other overnight.

The FOMC consists of the Fed’s Board of Governors and the presidents of the five regional Federal Reserve banks. The group meets eight times per year to set or change interest rates and decide whether to decrease or increase the amount of money that’s available in the economy. The FOMC uses Treasury bills, bonds and notes in open market operations.

The Fed uses two different terms to describe its monetary policies as they relate to open market operations. Policies can be either expansionary or contractionary.

Expansionary and contractionary monetary policy

Expansionary monetary policies involve buying Treasury securities through dealers in the open market. When the Fed buys Treasuries, it deposits money to pay for them into the accounts of those who sold them. The deposits are then part of the funds those dealers have on hold at the Federal Reserve. 

By increasing the amount of funds banks or dealers have on hold, the Fed makes more money available to them. Since banks have more money to lend, they lower interest rates, making it cheaper and easier to borrow money. All interest rates are affected by open market operations to varying extents. 

Contractionary monetary policies involve selling government securities. When banks and dealers buy Treasuries from the Fed, money is withdrawn from their reserve accounts, thus decreasing the amount of money they have on hold. Banks don’t have as much money to lend in this case, and when they have less money, they raise interest rates because there isn’t as much money to go around. It becomes more difficult to borrow because the money supply becomes less.

The Fed uses both expansionary and contractionary moves to reach its targeted federal funds rate. When the federal funds rate moves, other interest rates move as well because they are influenced by the federal funds rate.

Other open market operations

Every open market move the Fed makes impacts its balance sheet. The balance sheet includes securities held by the central bank, commitments to buy and sell securities and repurchase agreements for securities.

The Fed began a period of normalization of its monetary policy in 2015 after the financial crisis measures were ending. During the normalization process, the Fed has been using overnight reverse repurchase agreements as an additional control over the federal funds rate. 

Since 2017, the Fed has been working on normalizing its balance sheet as well. Between 2008 and 2014, the central bank significantly increased its holding of longer-term securities in a lengthy expansionary period. The Fed wanted to keep interest rates low as the U.S. economy continued to recover from the financial crisis. 

For example, in order to increase the amount of credit that was available for home purchases, the Fed bought $175 billion in direct obligations from Fannie Mae, Freddie Mac and the Federal Home Loan Banks. This increased the amount of money these lending organizations had in their accounts, making it easier for them to loan money for mortgages. The Fed also bought $1.25 trillion in mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. To target the private credit markets between March 2009 and October 2009, the Fed bought $300 billion in longer-term Treasuries.

The Fed also extended the average maturity of its Treasury security holdings using open market operations. To do this in 2011, the central bank bought $400 billion of Treasuries with remaining maturities of six years to 30 years and sold the same amount of Treasuries with remaining maturities of three years or less.

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost