When the Federal Reserve buys or sells Treasury notes and other securities from its member banks, it's engaging in what's known as Open Market Operations (OMO). OMO serves as one of the major tools the Fed uses to raise or lower interest rates.
Learn how Open Market Operations work and how they influence interest rates.
How Open-Market Operations Work
By buying and selling securities, the Fed can influence market conditions and therefore affect the economy.
When the Fed wants interest rates to rise, it sells securities to banks. This is known as a contractionary monetary policy. It's implemented with the goal of slowing inflation and stabilizing economic growth.
And when the Fed wants interest rates to fall, it buys securities. This is expansionary monetary policy, with the goal of stimulating growth.
The Fed sets its target for interest rates at its regular Federal Open Market Committee (FOMC) meetings, which take place about every six weeks.
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, who can then spend it freely.
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 a portion 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, and it's usually about 10% of deposits. In March 2020, the Fed lowered it to zero.
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.
How Open-Market Operations Affect Interest Rates
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 London Inter-bank Offered Rate (LIBOR). 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.
If banks have lots of extra reserves, and LIBOR falls, you'll start to see lower rates on those loans when you're shopping for credit. It makes it easier and more enticing for you to take out a loan.
OMO and Quantitative Easing
In response to the 2008 financial crisis, the FOMC lowered the fed funds rate to almost 0%. Without being able to lower the rate further, the Fed was forced to rely more heavily on open market operations.
It expanded this with the asset purchase program called quantitative easing (QE). QE was a way to lower longer-term interest rates.
By buying up assets such as mortgage-backed securities (MBS) from member banks, the Fed was able to give them credit, which expanded the money supply, lowered interest rates, and boosted the economy.
QE1: December 2008-August 2010
In QE1, or the first round of quantitative easing, 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 Treasurys.
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 repurchase agreements, or reverse repos, to control the fed funds rate.
End of QE
The Fed signaled the end of its expansionary open market operations at its Dec. 14, 2016, FOMC meeting. The Committee raised the fed funds rate to a range between 0.5% and 0.75%. 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 would allow another $6 billion to mature. Its goal was to retire $30 billion a month.
The Fed aimed to 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.
In August 2019, the Fed stopped reducing its $3.8 trillion in holdings of securities amassed during QE. It cited soft business spending. It also mentioned concern that inflation was slightly below its 2% target.
QE in 2020
As the Covid-19 crisis swept through American businesses in 2020, the Fed once again deployed QE to restore order to the financial markets. It bought up billions of dollars in Treasurys and MBS throughout the year, growing its portfolio to $6.6 trillion by December 2020.
The world's other major central banks also expanded their QE programs, increasing their collective balance sheet by about 50% over the course of the year.
- The Federal Reserve uses open-market operations to manipulate interest rates.
- Through buying or selling securities, the Fed increases or decreases their supply, affecting demand and therefore pushing rates up or down.
- Open-market operations are one of the tools the Fed uses to influence the economy.
- Other tools include adjusting the fed funds rate and the reserve requirement for banks.
- Lastly, when necessary the Fed also uses qualitative easing to affect the interest rates on longer-term securities such as Treasurys.