Understanding Open Market Operations and Their Impact on Interest Rates
Key Takeaways
- Open market operations (OMOs) involve buying and selling government securities to influence monetary policy.
- Selling securities reduces banks’ reserves, leading to higher interest rates.
- Buying securities increases banks’ reserves, leading to lower interest rates.
- The Fed uses open market operations to target and influence the federal funds rate.
- OMOs are a key tool for the Fed to combat inflation and recession through monetary policy.
Open market operations (OMOs) are an economic policy tool used by the U.S. Federal Reserve to affect the availability of money and credit.
The Fed, which is the central bank of the United States, utilizes OMOs to influence interest rates in the U.S. economy.
Depending on the condition of the economy, the Fed will seek to implement either contractionary or expansionary policy by selling or buying government securities in the public financial exchanges. Banks’ reserves are reduced with the selling of securities (contractionary policy) and increased with the buying of securities (expansionary policy).
Open market operations affect consumer interest rates and economic stability. Rates tend to rise with contractionary policy (selling securities) and fall with expansionary policy (buying securities).
This article looks at relevant historical examples, like the Fed’s Paul Volcker years and the 2008 recession, of OMOs’ real-world applications.
How Open Market Operations Influence Interest Rates
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.
When the Fed buys securities from banks, this in theory increases their money supply; they have more money to lend. When banks have more money to lend, they want to offload that money by earning interest on it rather than having it sit idle. When this happens, a bank will reduce its interest rates to make borrowing attractive.
Conversely, when the Fed sells securities to banks, this means they have less money on hand to lend out. The less money on hand means that banks will increase interest rates to earn the most on their limited supply of reserves.
Real-World Impact of Open Market Operations on Interest Rates
In 1979, the Fed under then-Chair Paul Volcker began using OMOs as a tool. To combat inflation, the Fed started selling securities in an attempt to reduce the money supply. A year later, the number of reserves shrank enough to push the federal funds rate as high as 20%. The years 1981 and 1982 saw some of the highest interest rates in modern history, with average 30-year fixed mortgage rates rising above 16%.
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.
What Are Open Market Operations?
Open market operations are one of the main tools that a central bank uses to affect monetary policy in an economy. Open market operations involve buying and selling securities to either expand or contract the economy. Selling securities on the open market contracts the economy, while buying securities expands it.
What Tools Does the Fed Use for Monetary Policy?
Tools that the Fed uses to control monetary policy include the reserve requirement, open market operations, the discount rate, and quantitative easing. Changes to each of these will have a contractionary or expansionary effect.
How Do Open Market Operations Affect the Federal Funds Rate?
As part of open market operations, when the Fed buys securities from banks, it increases the money supply and the banks’ reserves, which results in a reduction in the fed funds rate. Conversely, when the Fed sells securities to banks, this reduces the money supply and the banks’ reserves, which increases the fed funds rate.
The Bottom Line
One of the tools used to affect monetary policy by a central bank (such as the U.S. Federal Reserve) is open market operations (OMOs), the buying and selling of securities. Depending on whether the central bank wants to employ a contractionary or expansionary monetary policy, it will sell or buy securities from banks, respectively.
This impacts the number of reserves that banks have on hand, which affects the interest rates they charge on lending. Selling securities decreases reserves and increases rates, while buying securities increases reserves and decreases rates.