What Are Open Market Operations (OMOs), and How Do They Work?

Open Market Operations (OMO)

Investopedia / Xiaojie Liu

What Are Open Market Operations (OMOs)?

Open market operation (OMO) is a term that refers to the purchase and sale of securities in the open market by the Federal Reserve (Fed). The Fed conducts open market operations to regulate the supply of money that is on reserve in U.S. banks. The Fed purchases Treasury securities to increase the money supply and sells them to reduce it.

By using OMOs, the Fed can adjust the federal funds rate, which in turn influences other short-term rates, long-term rates, and foreign exchange rates. This can change the amount of money and credit available in the economy and affect certain economic factors, such as unemployment, output, and the costs of goods and services.

Key Takeaways

  • Open market operations are one of three tools used by the Fed to affect the availability of money and credit.
  • The term refers to a central bank buying or selling securities in the open market to influence the money supply.
  • The Fed uses open market operations to manipulate interest rates, starting with the federal funds rate used in interbank loans.
  • Buying securities adds money to the system, lowers rates, makes loans easier to obtain, and increases economic activity.
  • Selling securities removes money from the system, raises rates, makes loans more expensive, and decreases economic activity.

Open Market Operations Explained

Understanding Open Market Operations (OMOs)

To understand open market operations, you first have to understand how the Fed, the central bank of the U.S., implements the nation's monetary policy.

In an effort to keep the U.S. economy on an even keel and to forestall the ill effects of uncontrolled price inflation or deflation, the Board of Governors of the Federal Reserve sets what's called a target federal funds rate.

The federal funds rate is the interest rate that depository institutions charge each other for overnight loans. This constant flow of money allows banks to earn a return on excess cash in their Fed balances while maintaining the reserves required to meet the demands of customers.

As a benchmark, the federal funds rate influences a variety of other rates, from savings deposit rates to home mortgage rates and credit card interest rates.

Open market operations is one of the tools that the Fed uses to keep the federal funds rate at its established target.

The U.S. central bank can lower the interest rate by purchasing securities (and injecting money into the money supply). Similarly, it can sell securities from its balance sheet, take money out of circulation, and put upward pressure on interest rates.

The Board of Governors of the Federal Reserve sets a target federal funds rate and then the  Federal Open Market Committee (FOMC) implements the open market operations to achieve that rate.

Types of Open Market Operations

There are two types of OMOs: permanent open market operations and temporary open market operations.

Permanent Open Market Operations

Permanent open market operations refer to the Fed's outright purchase or sale of securities for or from its portfolio. Permanent OMOs are used to achieve traditional goals. For example, the Fed will adjust its holdings to put downward pressure on longer-term interest rates and to improve financial conditions for consumers and businesses. Permanent OMOs are also used to reinvest principal received on currently held securities.

Temporary Open Market Operations

Temporary open market operations are used to add or drain reserves available to the banking system on a short-term basis. They address reserve needs that are deemed to be transitory. Unlike Permanent OMOs, which involve outright purchases or sales, Temporary OMOs are temporary transactions. They're either repurchase agreements (repos) or reverse repurchase agreements (reverse repos).

A repo is a transaction where the Fed's trading desk buys securities and agrees to sell them back at a future date. A reverse repo involves the Fed selling securities with the agreement that it will buy them back in the future. Overnight reverse repos are currently used by the Fed to maintain the federal funds rate in its FOMC-established target range.

U.S. Treasury securities, or Treasuries, are government bills, notes, and bonds that are purchased by many individual consumers. They're also purchased and held in large quantities by various types of financial institutions. They are backed by the full faith and credit of the government and are considered a safe investment. Treasuries are first issued by the government and then traded in the secondary market.

Expansionary and Contractionary Monetary Policy

The Fed's monetary policy can be expansionary or contractionary.

If the Fed's goal is to expand the money supply and boost demand, the policy is expansionary. The Fed will buy Treasuries to pour cash into the banks. That encourages banks to lend the excess money that it doesn't have to keep in reserve 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 to contract the money supply and decrease demand, the policy is contractionary. The Fed will sell Treasuries to pull money out of the system. Less money in the economy means interest rates drift upwards and borrowing decreases. Consumers pull back on their spending. Businesses trim their plans for growth. Economic activity slows down.

Benefits of Open Market Operations

Open market operations allow the Federal Reserve (or the central banks in other countries) to prevent price inflation or deflation without directly interfering in the market economy. Instead of using regulations to control lending, the Fed can simply raise or lower the cost of borrowing money.

This allows the Federal Reserve to moderate the business cycle and reduce economic shocks. During recessions, the central bank lowers the cost of borrowing money, encouraging business activity and growth. In times of froth, the Fed increases the cost of borrowing money in order to rein in speculation and deflate potential bubbles.

Open market operations can also be used to affect job growth. By lowering interest rates, the Fed can make it easier to start businesses and hire workers, resulting in increased employment.

Example of Open Market Operations

In 2019, the Federal Reserve used Temporary OMOs (term and overnight repos) to support a healthy supply of bank reserves during what it referred to as "periods of sharp increases in non-reserve liabilities," and to "mitigate the risk of money market pressures that could adversely affect policy implementation."

It also used repos to counteract the stress caused by COVID in 2020 and to ensure that banks could maintain plentiful amounts of reserves. Repos also helped accommodate the "smooth functioning of short-term U.S. dollar funding markets."

Open Market Operations vs. Quantitative Easing

As discussed above, open market operations is one of the Fed's policy tools frequently used to expand the money supply and support economic activity or contact the money supply and slow that activity.

Quantitative easing (QE) is an alternate, non-traditional tool that the Fed also uses for monetary policy purposes. Essentially, it involves the buying of securities on a very large scale to spur or steady the economy.

The Fed normally employs quantitative easing after other monetary policy tools have been used but something more is needed to boost slow lending and economic activity. For instance, QE may be used when interest rates are already low but economic output is still less than what the Fed believes is healthy.

Why Does the Federal Reserve Conduct Open Market Operations?

Open market operations are used by the Federal Reserve to move the federal funds rate and influence other interest rates. It does this to stimulate or slow down the economy. The Fed can increase the money supply and lower the fed funds rate by purchasing, usually, Treasury securities. Similarly, it can raise the fed funds rate by selling securities from its balance sheet. This takes money out of circulation and pressures interest rates to rise.

What Are Permanent Open Market Operations?

The term "permanent open market operations" refers to outright purchases or sales of securities by a central bank (that won't be reversed in the short-term) to adjust the money supply. Permanent OMOs are the opposite of temporary open market operations, which involve repurchase and reverse repurchase agreements that are designed to temporarily add reserves to the banking system or drain reserves from it.

What Is the Fed Funds Rate?

The federal funds rate is the rate at which depository institutions lend available balances held by the Fed to each other overnight.

How Does the Federal Funds Rate Affect Banks?

Financial institutions typically base interest rates for consumer and business loans on the federal funds rate. For example, as the Fed conducts OMOs that raise or lower the fed funds rate, banks and credit card companies will change their rates accordingly.

The Bottom Line

In open market operations, the Federal Reserve buys or sells securities on the open market to raise or lower interest rates. They are one of the tools that the Fed has at its disposal to boost or slow down the country's economic activity. By engaging in open market operations, the Fed injects or drains funds from the nation's money supply.

Open market operations can be permanent or temporary. The permanent type of OMO involves the outright purchase (or sale) of securities. Temporary OMOs involve buying or selling securities with the agreement to reverse the transaction in the near future.

Article Sources
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