What Are Open Market Operations?
The Federal Reserve purchases and sells U.S. Treasury securities on the open market in order to regulate the supply of money that is on deposit in U.S. banks, and therefore available to loan out to businesses and consumers. It purchases Treasury securities to increase the supply of money and sells them to reduce the supply of money.
By using this system of open market purchasing, the Federal Reserve can produce the target federal funds rate it has set. It calls this process its open market operations.
- The Federal Reserve buys and sells Treasuries on the open market in order to decrease or increase the amount of cash available in the system for loans to consumers and businesses.
- Loans become harder to get and more expensive, or easier to get and cheaper, as a result of this process.
- These open market operations are the method the Fed uses to manipulate interest rates.
Understanding Open Market Operations
The federal funds rate is the interest percentage that banks charge each other for overnight loans. This constant flow of vast sums of money allows banks to keep their cash reserves high enough to meet the demands of customers while putting excess cash to use.
The federal funds rate also is a benchmark for other rates, influencing the direction of everything from savings deposit rates to home mortgage rates and credit card interest.
The Federal Reserve sets a target federal funds rate in an effort to the U.S. economy on an even keel and to forestall the ill effects of uncontrolled price inflation or deflation.
Its open market operations are the tools it uses to reach that target rate.
U.S. Treasuries are government bonds that are purchased by many individual consumers as a safe investment. They also are traded on the money markets and are purchased and held in large quantities by financial institutions and brokerages.
The federal funds rate is a benchmark that influences all other interest rates for everything from home mortgages to savings deposits.
Open market operations allow the Federal Reserve to buy or sell Treasuries in such large quantities that it has an impact on the supply of money distributed in banks and other financial institutions around the U.S.
Up or Down?
There are only two ways Treasury rates can move, and that's up or down. In the Federal Reserve's language, the policy is expansionary or contractionary.
If the Fed's goal is expansionary, it buys Treasurys in order to pour cash into the banks. That puts pressure on the banks to lend that money out to consumers and businesses. As the banks compete for customers, interest rates drift downwards. Consumers are able to borrow more to buy more. Businesses are eager to borrow more to expand.
If the Fed's goal is contractionary, it sells Treasurys in order to pull money out of the system. Money gets tight, and interest rates drift upwards. Consumers pull back on their spending. Businesses trim their plans for growth, and the economy slows down.
Open Market Operations Explained
Federal Open Market Committee
The Federal Open Market Committee (FOMC) is the entity that decides on the Federal Reserve's monetary policy.
The FOMC sets a target federal funds rate and then implements the open market operations that achieve that rate.