Open Market Operations vs. Quantitative Easing: An Overview
The U.S. federal reserve was created by the Federal Reserve Act in 1913. Since its establishment, it has held responsibility for a three-part mandate which includes: maximizing employment, stabilizing prices, and monitoring interest rates. All three pieces of the Fed’s responsibilities can be analyzed individually and holistically. Monitoring price level movements is central to understanding the U.S. economy. Since 2012, the Fed has targeted a 2% inflation rate which it uses as a guide for price movement. The Fed follows the labor market’s employment capacity and analyzes unemployment along with wage growth in correlation with inflation. The Fed also has the ability to effectively influence interest rates on credit in the economy which can have a direct effect on business and personal spending.
With responsibility and authority to take actions for the optimization of these three key areas, the Fed can deploy several tactics. Here we will discuss the Federal Open Market Committee’s authority to take monitory policy actions and strategies it uses by looking at both open market operations and quantitative easing.
Open Market Operations
The Federal Open Market Committee has three main tools that it uses to take action for achieving its three-part mandate. Those actions include: open market operations (OMO), setting the federal funds rate, and specifying reserve requirements for banks.
Open market operations are a tool that allows the Fed to buy and sell securities on the open market, influencing the open market price and yield of specified securities. Most commonly the Fed will utilize Treasury securities for open market operations but it can also use other types of securities. Following the 2008 Financial Crisis, the Fed used mortgage-backed securities as part of its open market operations.
In general, buying debt securities in the open market increases their price and lowers the yield. Selling debt securities decreases the price and increases the yield. The Fed often uses open market securities in tandem with its stance on interest rates. Thus, when it is seeking to increase rates it would need to sell securities and vice versa. Generally, the Fed only uses debt securities in open market operations with a focus on Treasuries.
In addition to open market effects, the buying and selling of securities also affects the Fed’s balance sheet. OMO consists of the Fed either expanding or contracting its balance sheet through either buying or selling securities on the open market.
Tactically, the Fed can seek to deploy holistic monetary policies that utilize several of its tools in order to achieve an objective. Quantitative easing is one strategy that historically has been used by the Fed.
The phrase quantitative easing (QE) was first introduced in the 1990s as a way to describe the Bank of Japan's (BOJ) expansive monetary policy response to the bursting of that country’s real estate bubble and the deflationary pressures that followed. Since then, a number of other major central banks, including the U.S. Federal Reserve, the Bank of England (BoE), and the European Central Bank (ECB), have resorted to their own forms of QE. Although there are some differences between these central banks’ respective QE programs, we'll look at how the Federal Reserve’s implementation of QE has been effective.
QE was used following the 2008 Financial Crisis to help improve the health of the economy after widespread subprime defaults caused major losses resulting in broad economic damage. In general, policy easing refers to taking actions to reduce borrowing rates to help stimulate growth in the economy. Keep in mind, quantitative easing is the opposite of quantitative tightening which seeks to increase borrowing rates to manage an overheated economy.
From September 2007 through December 2018, the Federal Reserve took quantitative easing steps, reducing the federal funds rate from 5.25% to 0% to 0.25%, where it stayed for seven years. In addition to decreasing the federal funds rate and holding it at 0% to 0.25%, the Fed also used open market operations.
In this case of quantitative easing, the Fed used both federal funds rate manipulation and open market operations to help reduce rates across maturities. The federal funds rate reduction focused on short-term borrowing but the use of open market operations allowed the Fed to also decrease intermediate and longer-term rates as well. As mentioned, buying debt in the open market pushes prices up and rates down.
The Fed implemented large-scale asset purchases in multiple rounds from 2008 to 2013:
- November 2008 to March 2010: purchased $175 billion in agency debt, $1.25 trillion in agency mortgage-backed securities, and $300 billion in longer-term Treasury securities.
- November 2010 to June 2011: purchased $600 billion in longer-term Treasury securities.
- September 2011 through 2012: Maturity Extension Program—purchased $667 billion in Treasury securities with remaining maturities of six years to 30 years; sold $634 billion in Treasury securities with remaining maturities of three years or less; redeemed $33 billion of Treasury securities.
- September 2012 through 2013: purchased $790 billion in Treasury securities and $823 billion in agency mortgage-backed securities.
After four years of holding the new assets on the balance sheet, the Fed’s QE goals had reportedly been achieved and were markedly successful. As such, the Fed began the process of normalization in 2017 with an end to principal reinvestments. In the years following 2017, the Fed plans to use open market operations in somewhat of a tightening mode with staged plans for selling balance sheet assets in the open market.
- Open market operations are a tool the Fed can use to influence rate changes in the debt market across specified securities and maturities.
- Quantitative easing is a holistic strategy that seeks to ease, or lower, borrowing rates to help stimulate growth in an economy.
- Open market operations can be an important tool used in seeking to obtain the goals and objectives of quantitative easing.
Understanding OMO Goals
While the buying and selling of securities through OMO can have several goals, one of the main goals is to manipulate interest rates across maturities. Overall, buying large quantities of debt securities will increase the price in the open market and push the rates down. Alternatively, selling large quantities of debt securities in the open market will reduce the price and increase rates.