Interest rates are indirectly affected by open market operations (OMOs), the buying and selling of government securities in the public financial exchanges.

OMOs are tools in monetary policy that allow a central bank to control the money supply in an economy. Under a contractionary policy, a central bank sells securities on the open market, which reduces the amount of money in circulation. Expansionary monetary policy entails the purchase of securities and an increase in the money supply. Changes to the money supply affect the rates at which banks lend to one another, a reflection of the basic law of supply and demand.

In the U.S, the federal funds rate is the interest rate at which banks borrow reserves from one another overnight to meet their reserve requirements. This is the interest rate that the Federal Reserve targets when conducting OMOs. Short-term interest rates offered by banks are based on the federal funds rate, so the Fed can indirectly influence interest rates faced by consumers and businesses by the sale and purchase of securities.

Real-Life Examples

In 1979, the Fed under Chairman Paul Volcker began using OMOs as a tool. To combat inflation, the Fed started selling securities in an attempt to reduce the money supply. The amount of reserves shrank enough to push the federal funds rate as high as 20%. 1981 and 1982 saw some of the highest interest rates in modern history, with average 30-year fixed mortgage rates rising above 18%.

Conversely, the Fed purchased over $1 trillion in securities in response to the 2008 recession. This expansionary policy, called quantitative easing, increased the money supply and drove down interest rates. Low interest rates helped stimulate business investment and demand for housing.