Open Market Operations
How the Federal Reserve Asset Purchase Program Works
When the Federal Reserve buys or sells securities from its member banks, it's engaging in what's known as Open Market Operations. The securities are Treasury notes or mortgage-backed securities. OMOs serve as one of the major tools the Fed uses to raise or lower interest rates.
When the Fed wants interest rates to rise, it sells securities to banks. This is known as contractionary monetary policy. It's implemented with the goal to slow inflation and stabilize economic growth. When the Fed wants to lower interest rates, it buys securities. Its purchase of securities is an example of expansionary monetary policy. Its goal is to lower unemployment and stimulate economic growth. The Fed sets its target for interest rates at its regular Federal Open Market Committee meetings, which take place about every six weeks.
How Open Market Operations Affect Interest Rates
When the Fed buys government securities from a bank, it adds credit to the bank's reserves. Although it's not actual cash, it's treated as such and has the same effect. It's similar to a direct deposit you might receive from your employer in your checking account. This gives the bank more money to lend to consumers.
Where does the Fed get the money to issue the credit to buy the bank's securities? As America's central bank, it has the unique power to create this money, in the form of credit, out of thin air. That's what people mean when they say the Federal Reserve is printing money.
Banks try to lend as much as possible to increase their profits. If it were up to banks, they'd lend it all. But the Fed requires banks to keep about 10 percent of their deposits in reserve when they close each night, so they have enough cash on hand for tomorrow's transactions. This is known as the reserve requirement. The reserve funds must be kept at the bank's local Federal Reserve branch office or in cash in the bank's vault. Unless there's a bank run, this is more than enough to cover most banks' daily withdrawals.
To meet the reserve requirement, banks borrow from each other overnight at a special interest rate, known as the federal funds rate. This rate floats depending on how much banks have to lend. The amount they borrow and lend each night is called fed funds.
When the Fed increases a bank's credit by buying up its securities, it gives the bank more fed funds to lend to other banks. This pushes the fed funds rate lower, as the bank tries to unload this extra reserve. When there isn't as much to lend, banks will raise the fed funds rate.
This fed funds rate influences short-term interest rates. Banks charge each other a bit more for longer-term loans. This is known as the Libor rate. It's used as the basis for most variable rate loans, including car loans, adjustable-rate mortgages, and credit card interest rates. It's also used to set the prime rate, which is what banks charge their best customers. Long-term and fixed rates depend more on the 10-year Treasury note. The rates are a little higher than Treasury yields.
Open Market Operations and Quantitative Easing
In response to the 2008 financial crisis, the FOMC lowered the fed funds rate to almost zero percent. After that, the Fed was forced to rely more heavily on open market operations. It expanded this with the asset purchase program called quantitative easing. Here are the specifics:
- Quantitative Easing 1 or QE1, December 2008-August 2010: The Fed purchased $175 million mortgage-backed securities from banks that had been originated by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Between January 2009 and August 2010, it also bought $1.25 trillion in MBS that had been guaranteed by Fannie, Freddie, and Ginnie Mae. Between March 2009 and October 2009, it purchased $300 billion of longer-term Treasuries from member banks.
- QE2, November 2010-June 2011: The Fed bought $600 billion of longer-term Treasuries.
- Operation Twist, September 2011-December 2012: As the Fed's short-term Treasury bills matured, it used the proceeds to buy long-term Treasury notes to keep interest rates down. It continued to buy MBS with the proceeds of MBS that matured.
- QE3, September 2012-October 2014: The Fed stepped up purchases of MBS to $40 billion per month.
- QE4, January 2013-October 2014: The Fed added $45 billion of long-term Treasury securities to its purchase program.
Thanks to QE, the Fed held an unprecedented $4.5 trillion of securities on its balance sheet. It gave banks tons of extra credit, which they needed to fulfill new capital requirements mandated by the Dodd-Frank Wall Street Reform Act.
As a result, most banks didn't need to borrow fed funds to meet the reserve requirement. That put downward pressure on the fed funds rate. To counteract this, the Fed began paying interest rates on required and excess bank reserves. It also used reverse repos to control the fed funds rate.
The Fed signaled the end of its expansionary open market operations at its December 14, 2016, FOMC meeting. The Committee raised the fed funds rate to 0.75 percent. The Fed used its other tools to persuade banks to raise this rate.
In the face of this contractionary step, the Fed continued to purchase new securities when old ones became due. That maintenance of open market operations provided an expansionary counterbalance to higher interest rates.
On June 14, 2017, the Fed outlined how it would reduce its holdings. It would allow $6 billion of Treasurys to mature without replacing them. Each month it will allow another $6 billion to mature. Its goal is to retire $30 billion a month. The Fed will do the same with its holdings of mortgage-backed securities, only with increments of $4 billion a month until it reaches $20 billion. The Fed began this policy in October 2017 and has plans to reduce its holdings by up to $420 billion through Q4 of 2018, with another reduction of up to $600 billion planned for 2019.
The Fed plans to continue at this pace for an undetermined number of years until it decides that its balance sheet has reached a more normalized level.