Open Market Operations

How the Federal Reserve's Asset Purchase Program Works

open market operations
The Fed uses open market operations to change the amount of money its member banks can lend.. Photo: jdawnink/Getty Images

Definition: Open market operations is when the Federal Reserve buys or sells securities, such as Treasury notes or mortgage-backed securities, from its member banks. This is the major tool the Fed uses to raise or lower interest rates.

When the Fed want interest rates to rise, it sells securities to banks. That's known as contractionary monetary policy. It slows inflation and economic growth. When it wants to lower rates, it buys securities.

That's known as 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 meeting.

How Open Market Operations Affect Interest Rates

When the Fed buys 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.

Where does the Fed get the money to issue the credit? As America's central bank, it has the unique power to create this 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. Therefore, the Fed requires them 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. It 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 fed 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 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. (Source: "What Are the Tools of U.S. Monetary Policy?" Federal Reserve Bank of San Francisco.)

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. To find out how this works, see Treasury yields.

Open Market Operations and Quantitative Easing

In response to the 2008 financial crisis, the FOMC lowered the fed funds rate to near-zero. Since then, the Fed was forced to rely more heavily on open market operations. It expanded it with the asset purchase program called Quantitative Easing.

Here are the specifics:

  • QE1 (December 2008-August 2010) -- The Fed purchased $175 million MBS from banks that had been originated by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Between January 2009-August 2010, it also bought $1.25 trillion in MBS that had been guaranteed by Fannie, Freddie and Ginnie Mae. Between March 2009-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 Treasuries securities to its purchase program. (Source: "Open Market Operations,"  Federal Reserve.) 

Thanks to QE, the Fed now has an unprecedented $4.5 trillion of securities on its balance sheet. That's given banks tons of extra credit. They need that to fulfill new capital requirements mandated by the Dodd-Frank Wall Street Reform Act

As a result, most banks don't need to borrow fed funds to meet the reserve requirement. That puts downward pressure on the fed funds rate. To counteract this, the Fed began paying interest rates on required and excess bank reserves. It also uses 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 .75 percent. The Fed used its other tools to persuade banks to raise this rate. In the face of this contractionary step, it will continue to purchase new securities when old ones become due. That maintenance of open market operations will provide an expansionary counterbalance to higher interest rates.(Source: "Market Forces Challenge the Fed Power Over Rates," The Wall Street Journal, October 27, 2015.) 

On June 14, 2017, the Fed outlined how it will reduce its holdings. Once the fed funds rate reaches its target of 2.0 percent, the Fed will allow $6 billion of Treasurys to mature without replacing them. Each month it will allow another $6 billion to mature. It's 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. (Source: "Fed Unveils Plan to Shrink Its Balance Sheet," The Wall Street Journal, June 14, 2017.)