Open Market Operations

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The buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. Purchases inject money into the banking system and stimulate growth while sales of securities do the opposite.

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Open market operations are the principal tools of monetary policy. (The discount rate and reserve requirements are also used.) The U.S. Federal Reserve's goal in using this technique is to adjust the federal funds rate--the rate at which banks borrow reserves from each other.

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Activities by which the Securities Department of the Federal Reserve Bank of New York-popularly called the Desk-carries out instructions of the Federal Open Market Committee designed to regulate the money supply. Such operations involve the purchase and sale of government securities, which effectively expands or contracts funds in the banking system. This, in turn, alters bank reserves, causing a Multiplier effect on the supply of credit and, therefore, on economic activity generally. Open-market operations represent one of three basic ways the Federal Reserve implements Monetary Policy, the others being changes in the member bank Reserve Requirements and raising or lowering the Discount Rate charged to banks borrowing from the Fed to maintain reserves.

Purchase or sale of government securities by the Open Market desk at the Federal Reserve Bank of New York, as directed by the Federal Open Market Committee.

By buying and selling securities, mostly short-term Treasury obligations, i.e., Treasury bills, the Federal Reserve is able to: (1) meet the public demand for cash by adjusting bank reserves upward or downward, as needed, and (2) influence bank interest rates, including rates such as the Federal Funds (Fed Funds) rate that banks charge for short-term sale of Excess Reserves . Because reserve accounts at Federal Reserve Banks don't earn interest, banks try to hold reserves to a minimum or to the level of required reserves.

When the manager of the Fed's Open Market Desk at the Federal Reserve Bank of New York makes the decision to buy securities, the Fed writes a check on itself to the bank, or other institutional investor holding the securities, and deposits a check in a commercial bank. If the Fed buys $1 billion in Treasury bills, bank reserves are increased by that amount. Selling $1 billion in T-bills has the opposite effect, shrinking the reserves in the banking system, which tends to drive up the cost of credit, and interest rates. Because commercial bank reserve accounts don't earn any interest, banks try to hold their reserves at a minimum. When the Fed is worried that the inflation rate is rising, it pursues a tight money policy by selling securities. What results is higher interest rates, because the banks pass the added cost along to the borrowers.

The Fed also adds reserves to the banking system to meet the public's seasonal demand for cash. This demand for cash varies seasonally; it is highest in December, and lowest in late summer.

For these reasons, open market operations are the most flexible monetary tool the Fed has available in implementing its monetary policy objectives. Because commercial banks have about three-fourths of the nation's checking account deposits, the Fed, by managing the level of reserves in the banking system, is able to influence the nation's supply of money (the money supply or money stock), and the cost of credit. Both the Fed Funds rate, which is the market rate banks pay one another for nonborrowed reserves, and the bank prime rate are influenced to a large degree by the Fed's actions in open market operations.

Other tools of monetary policy are the Discount Rate and Reserve Requirements. See also Fiscal Policy; Matched Sale-Purchase Agreement; Reverse Repurchase Agreement; Swap Network.

Open-Market Operations are the purchase and sale of government securities and other assets by central banks. Along with reserve requirements, discount-window operations, and moral suasion, they constitute the instruments of monetary policy. When the U.S. central bank—the Federal Reserve System—was established in 1913, discount-window operations were considered the principal instrument of monetary policy. Open-market operations were simply used by the twelve regional banks in the Federal Reserve System to acquire interest-earning assets. In the mid-1920s, frustrated with competing against each other to purchase securities, the regional banks established the Open-Market Investment Committee (OIC), under the control of the Federal Reserve Bank of New York (FRBNY), to coordinate their open-market operations. The OIC then became involved in futile attempts to salvage the gold standard, which was abandoned in September 1931.

Both the efforts to salvage the gold standard and a tendency to subordinate open-market operations to the interests of the large banks prompted the OIC to conduct contractionary open-market operations in the midst of the Great Depression. In response to the public outrage that ensued, the government changed the Federal Reserve's structure, placing control of open-market operations in the Federal Open Market Committee (FOMC). The FRBNY was still represented on the FOMC, but its influence was counterbalanced by the seven members of the Federal Reserve Board in Washington, D.C., particularly its chair, who dominates decisions regarding the use of open-market operations.

In the 1940s the FOMC conducted open-market operations to maintain a fixed interest-rate structure, ranging from 3/8 percent on Treasury bills to 2.5 percent on government bonds. The March 1951 Treasury–Federal Reserve Accord freed the FOMC to use open-market operations to stabilize the economy on a noninflationary growth path. Ample evidence suggests the FOMC has not pursued this goalin good faith. But even if it did, it remains questionable that such stabilization can be achieved by means of open-market operations.

In the late 1950s the FOMC implemented a "bills only" policy (that is, it only purchased and sold Treasury bills). Except for Operation Twist in the early 1960s, when the FOMC bought government bonds to offset its sales of Treasury bills, this policy has remained in effect. During the 1960s the FOMC used open-market operations to target the level of the federal funds rate (FFR). In February 1970 it began to target the rate of growth of monetary aggregates, accomplished by setting target ranges for the FFR. So long as the FFR remained in the targeted range, the FOMC tried to target a particular rate of growth of monetary aggregates.

In the 1970s the target ranges for the FFR were narrow (for example, 0.5 percent). But in October 1979 the FOMC started to set such broad ranges for the FFR that it effectively abandoned efforts to control the FFR in favor of concentrating on control of the rate of growth of monetary aggregates, especially M₂ (a monetary aggregate, composed of currency in circulation, demand deposits, and large time deposits). The result was wild fluctuations not only in interest rates but also in the rate of growth of the monetary aggregates. In the late 1980s the FOMC acknowledged the failure of its efforts to target the rate of growth of monetary aggregates and returned to using open-market operations to target specific levels of the FFR.

Bibliography

D'Arista, Jane W. Federal Reserve Structure and the Development of Monetary Policy, 1915–1935. Washington, D.C.: Government Printing Office, 1971.

Dickens, Edwin. "U.S. Monetary Policy in the 1950s: A Radical Political Economic Approach." Review of Radical Political Economics 27, no. 4 (1995): 83–111.

———. "Bank Influence and the Failure of U.S. Monetary Policy during the 1953–1954 Recession." International Review of Applied Economics 12, no. 2, (1998): 221–233.