The U.S. Federal Reserve conducts open market operations—the buying or selling of bonds and other securities to control the money supply. With these transactions, the Fed can expand or contract the amount of money in the banking system and drive short-term interest rates lower or higher, depending on the objectives of its monetary policy.

The Importance of Open Market Operations

Open market operations are one of three key tools the Fed uses to achieve its policy objectives, and arguably the most powerful and frequently used. (The other two tools are banks' reserve requirement ratios and the terms and conditions for bank borrowing at the Fed's discount window.)

Conducted by the trading desk at the Fed's New York branch, open market operations enable the Fed to influence the supply of reserves in the banking system. This process then affects interest rates, banks' willingness to lend and consumers' and businesses' willingness to borrow and invest.

Key Takeaways

  • The Federal Reserve buys and sells government securities to control the money supply and interest rates. This activity is called open market operations.
  • The Federal Open Market Committee (FOMC) sets monetary policy in the United States, and the Fed's New York trading desk uses open market operations to achieve that policy's objectives.
  • To increase the money supply, the Fed will purchase bonds from banks, which injects money into the banking system. It will sell bonds to reduce the money supply.

The Role of the Federal Open Market Committee

The Federal Open Market Committee (FOMC) sets monetary policy in the United States, with a dual mandate of achieving full employment and controlling inflation. The committee meets eight times a year to set policy, essentially determining whether to increase or decrease the money supply in the economy. The New York Fed's trading desk then conducts its market operations with the aim of achieving that policy, buying or selling securities in open market operations.

Expanding the Money Supply to Fuel Economic Growth

During a recession or economic downturn, the Fed will seek to expand the supply of money in the economy, with a goal of lowering the federal funds rate—the rate at which banks lend to each other overnight.

To do this, the Fed trading desk will purchase bonds from banks and other financial institutions and deposit payment into the accounts of the buyers. This increases the amount of money that banks and financial institutions have on hand, and banks can use these funds to provide loans. With more money on hand, banks will lower interest rates to entice consumers and businesses to borrow and invest, thereby stimulating the economy and employment.

Contractionary Monetary Policy

The Fed will undertake the opposite process when the economy is overheating and inflation is reaching the limit of its comfort zone. When the Fed sells bonds to the banks, it takes money out of the financial system, reducing the money supply.

This will cause interest rates to rise, discouraging individuals and businesses from borrowing and investing, while encouraging them to put their money in less productive investments such as interest-bearing savings accounts and certificates of deposit. This has the effect of slowing inflation and economic growth.

Open Market Operations and Quantitative Easing

The Fed's open market operations were largely obscure to the public until the 2007-2008 Global Financial Crisis, which prompted the Fed to undertake an unprecedented level of asset purchases via open market operations from the end of 2008 through October 2014. During this time the federal funds target rate was kept at a historic low: a range of 0% to 0.25%. At the end of this period the Fed's asset holdings had reached $4.5 trillion—five times the pre-crisis levels.

This asset-purchase program was commonly known as "quantitative easing."

The Bottom Line

Whether the Fed wants to stimulate or cool economic growth, one of its most important tools is open market operations. The Fed's buying or selling of securities has ripple effects through the money supply, interest rates, economic growth, and employment.