What are open market operations?
The Federal Reserve buys and sells US Treasury securities on the open market to regulate the supply of money that is on deposit in American banks, and therefore available for loan to businesses and consumers. He buys treasury securities to increase the money supply and sells them to reduce the money supply.
Using this free market buying system, the Federal Reserve can produce the target federal funds rate it has set. He calls this process his open market operations.TheThe
Key points to remember
- The Federal Reserve buys and sells Treasury bills in the open market to decrease or increase the amount of cash available in the system for loans to consumers and businesses.
- Loans become more difficult to obtain and more expensive, or easier to obtain and less expensive, through this process.
- These open market operations are the method used by the Fed to manipulate interest rates.
Understanding open market operations
The federal funds rate is the percentage of interest that banks charge each other for overnight loans. This constant flow of large sums of money allows banks to keep their cash reserves high enough to meet customer demands while using excess cash.
The federal funds rate is also a benchmark for other rates, influencing the direction of everything from savings deposit rates to residential mortgage rates and credit card interest.
The Federal Reserve sets a target rate for federal funds in an effort to equalize the US economy and to prevent the harmful effects of uncontrolled price inflation or deflation.
Its open market operations are the tools it uses to reach this target rate.
Why Treasury bills?
US Treasuries are government bonds that are purchased by many individual consumers as a secure investment. They are also traded on the money markets and are bought 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 residential mortgages to savings deposits.
Open market operations allow the Federal Reserve to buy or sell treasury bills in such large quantities that it has an impact on the supply of money distributed in banks and other financial institutions in the United States.
Up or down?
There are only two ways in which Treasury rates can move, it is up or down. In the language of the Federal Reserve, politics is expansionary or contractual.
If the Fed’s objective is expansionary, it buys treasury bills in order to pour cash into the banks. This forces the banks to lend this money to consumers and businesses. As banks compete for customers, interest rates fall. Consumers can borrow more to buy more. Companies want to borrow more to grow.
If the Fed’s goal is to contract, it sells Treasury bills in order to withdraw money from the system. Money is tightening and interest rates are drifting up. Consumers are shrinking their spending. Companies are cutting back on their growth plans and the economy is slowing down.
Explanation of open market operations
Federal Free Market Committee
The Federal Open Market Committee (FOMC) is the entity that decides the monetary policy of the Federal Reserve.TheThe
The FOMC sets a target rate for federal funds and then implements open market operations that reach this rate.