What are Open Market Operations?
Open Market Operations refer to a central bank selling or purchasing securities in the open market in an effort to influence the money supply.
How Do Open Market Operations Work?
The Federal Reserve is the central bank of the United States, and it makes decisions regarding monetary policy in its effort to keep inflation low and economic growth high.
One of the tools available to the Fed is its ability to conduct open market operations.
When the Federal Reserve decides to enact monetary policy action, the Federal Open Market Committee can instruct the Fed’s Domestic Trading Desk to either purchase or sell securities on the open market.
If the Fed chooses to purchase securities on the open market, it is purchasing the securities from depository institutions in exchange for liquidity (i.e. cash).
Moreover, when banks have more liquidity, they have more cash to lend to the public, which leads to increased spending throughout the economy.
What is the Purpose of Open Market Operations?
The Federal Open Market Committee (FOMC) makes decisions regarding the target range for the federal funds rate when it meets every six weeks.
The federal funds rate is defined as the rate at which banks lend to one another in order to meet their reserve requirements.
Moreover, the committee's decisions are forwarded as directions to the Fed’s Domestic Trading Desk (DTC), which enacts them through the trading of securities.
When the DTC successfully trades securities, it is effectively manipulating the supply of money in the economy.
- If securities are purchased in the open markets, more money is injected into the economy.
- But if securities are sold in the open markets, less money is circulating within the economy.
The end goal of the DTC is to manipulate the supply of money enough for the federal funds rate to reach the FOMC’s agreed-upon target.
Thereby, if the Fed is purchasing securities, it is trying to lower the effective federal funds rate (and the reverse is the case if the Fed is selling securities).
Open market operations affect the federal funds rate through the basic dynamics of supply and demand.
- If the Fed purchases securities, banks will have more reserves, which means they will need to borrow less to fulfill their reserve requirements.
- The interest rates at which reserves are borrowed decline, which has rippling effects throughout both the markets and the economy.
- When the federal funds rate declines, banks can borrow from one another at a cheaper rate, meaning they must charge consumers less interest on loans, which spurs demand for loans, leading to increased spending throughout the economy.
- All of these resulting effects on the economy highlight the importance of both the money supply and the federal funds rate when it comes to monetary policy and central banking, which is why open market operations are conducted in the first place.
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What are the Different Types of Open Market Operations?
Open market operations come in two varieties:
1) Permanent Open Market Operations (POMOs) – The central bank consistently uses open market operations to influence monetary policy. This occurs when a central bank sells or purchases securities outright in order to permanently influence the supply of money.
- Quantitative Easing (QE) – A type of unconventional permanent open market operation commonly used in near-zero interest rate environments, quantitative easing refers to when a central bank purchases long-term Treasury securities, mortgage-backed securities, and other longer-term securities in order to influence longer-term interest rates. QE is usually seen as a last resort for central banks. When interest rates are already at near-zero levels and the economy is still contracting, such as was the case at the beginning of the pandemic, central banks are left with limited options that do not involve targeting a negative policy rate.
- Quantitative Tightening – The opposite of quantitative easing, quantitative tightening refers to an unconventional open market operation in which the central bank reduces the size of its balance sheet in order to reduce the supply of money in the economy.
2) Temporary Open Market Operations (TOMOs) – The central bank temporarily addresses reserve needs by influencing the supply of money on a short-term basis.
- Repurchase Agreements (Repos) – When a central bank agrees to sell securities and repurchase them for a slightly higher price shortly thereafter, typically overnight.
- Reverse Repurchase Agreements – Occurs when a central bank agrees to purchase securities and resell them for a slightly higher price.
What is an Example of Open Market Operations?
One notable example of open market operations occurred directly following the economic contraction brought about by the COVID-19 pandemic.
After a strong correction in the equities markets and the lingering effects of shutdown policies on the U.S. economy, the Fed took action by conducting open market operations.
The Fed enacted a quantitative easing plan, in which it initially announced $700 billion in asset purchases.
Three months later, the Fed began monthly purchases of $80 billion in Treasury securities and $40 billion in mortgage-backed securities, a policy that lasted until March 2022.
The Fed grew the supply of bank reserves by purchasing assets from the open market, thus increasing the overall money supply throughout the economy and maintaining a dovish monetary policy while the market recovered, reflecting a positive outlook on the future performance of the economy while it remained at lower levels due to the onslaught of the pandemic.
Despite the recovery we’ve seen, however, prolonged open market operations come with other consequences.
While the Fed continued to stimulate the economy, inflation has begun to skyrocket, with the Consumer Price Index (CPI) rising 7.9% YoY in February, the largest increase since 1982.
As a result, the Fed increased its target federal funds rate by 25 basis points after the FOMC’s March 16th meeting, and most expect that it will do the same after its next six meetings.
The prospect of a rising rate environment will have a significant effect on stock market valuations, as rising rates mean companies are not only forced to borrow at higher rates but also that their future cash flows are being discounted more, meaning the present value of these companies’ cash flows is now lower, resulting in lower perceived share prices.
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