The principal policy tool of the Federal Reserve (and many other central banks as well) is open market operations. By definition, open market operations in the United States consist of buying and selling U.S. government and other securities by the Federal Reserve System to affect the quantity and growth of legal reserves and, ultimately, general credit conditions. Open market operations are the most flexible policy tool available to the Fed, suitable for fine-tuning short-term interest rates and the availability of credit in the financial markets when this is necessary. Other central banks around the world may use different types of securities to buy or sell in conducting their open market operations, especially if they lack a “deep” market for their government’s debt. Among the more common financial instruments traded by many central banks today are bank deposits, derivative securities, and central bank debt. Open market operations are rapidly becoming the most popular tool of leading central banks around the globe. An important example is the new European Central Bank (ECB) that was granted the open market tool; it selects which financial instruments can be used and under what terms and conditions, but the ECB’s operations must be carried out through the central banks of its member countries.
Effects of Open Market Operations on Interest Rates The open market tool has two major effects on the banking system and credit conditions. First, it has an interest rate effect. For example, in the United States, the Fed typically buys or sells a large quantity (often exceeding a billion dollars worth) of government securities in the financial marketplace at any one time. If the Fed is purchasing securities, this adds additional demand for these securities in the market, which tends to increase their prices and lower their yields. In this case, interest rates decline. If the Federal Reserve is selling securities from its portfolio, this action increases the supply of securities available in the market, tending to depress their prices and raise their yields. In this case, interest rates tend to rise.
Effects of Open Market Operations on Reserves The principal day-today effect of central bank open market operations is to change the level and growth of legal reserves. For example, a Federal Reserve purchase of government securities increases the reserves of the banking system and expands its ability to make loans and create deposits, increasing the growth of money and credit. In contrast, a sale of securities by the Federal Reserve decreases the level and growth of reserves and ultimately reduces the growth of money and credit. The impact of Federal Reserve open market operations on the reserve positions of depository institutions with accounts in the United States is illustrated in Exhibit 13.1 .
Fed Purchases In the top portion of Exhibit 13.1 , we assume the Fed is making purchases of U.S. government securities in the open market from either depository institutions, which keep their reserve accounts at the Federal Reserve banks, or from other institutions and individuals. If purchases are made from depository institutions, the Federal Reserve System would record the acquisition of securities in the System’s asset account—U.S. securities—and pay for the securities acquired by increasing the reserve accounts of the selling institutions. Thus, reserves of depository institutions at the Fed rise, while institutional holdings of securities fall by the same amount. Note that both total and excess reserves rise in the wake of a Fed purchase, assuming that depository institutions have no reserve deficiencies to begin with. With these extra reserves, additional loans can be made and deposits created that will have an expansionary impact on the availability of credit in the economy.
An expansionary effect would also take place were the Federal Reserve to buy securities from an institution or individual other than a depository institution. Legal reserves would increase, but total deposits—a component of the money supply—would increase as well. Deposits would rise because the central bank would issue a check to pay for the securities it purchased and that check would be deposited in some financial institution, which would, in turn, present the check to the Federal Reserve for crediting to the institution’s legal reserve account. Excess reserves would then have risen, making possible an expansion of deposits and loans on the part of depository institutions. Note, however, that the rise in excess reserves is less in this case than would occur if the Fed bought securities only from depository institutions that maintain reserve accounts with the Federal Reserve banks. This is due to the fact that some of the new legal reserves created by the Fed purchase must be pledged as required reserves behind the newly created deposits. Therefore, Federal Reserve open market purchases of securities have less of an effect on total credit and deposit expansion if the Fed’s transaction involves only nondeposit financial institutions and individuals.
Fed Sales Central bank sales of securities reduce the growth of reserves, deposits, and loans. For example, as shown in the bottom half of Exhibit 13.1 , when the Federal Reserve sells U.S. government securities from its portfolio to a depository institution or to a dealer with an account at a depository institution, that institution must pay for those securities by letting the Fed deduct the amount of the purchase from its reserve account. Both total reserves and excess reserves fall. If depository institutions were fully loaned up with no excess reserves available, the open market sale would result in a reserve deficiency. Some institutions would be forced to sell loans and securities or borrow funds in order to bring in additional reserves, thereby reducing the availability of credit.
Suppose the central bank were to sell securities to an individual or a nondeposit institution. As Exhibit 13.1 reveals, in this instance, both reserves and deposits fall. Credit becomes less available and usually more expensive.
How Open Market Operations Are Conducted in the United States All trading in securities by the Federal Reserve System is carried out through the System’s Trading Desk, located at the Federal Reserve Bank of New York. The Trading Desk is supervised by the manager of the System Open Market Account (SOMA), a vice president of the New York Fed. The SOMA manager’s activities are, in turn, supervised and directed by the Federal Open Market Committee. In reality, the Fed does not trade with the public; rather all Fed security purchases and sales are made through a select list of primary U.S. government securities dealers who agree to buy or sell in amounts called for by the Trading Desk at the time the Fed wishes to trade. Many of these dealers are banks that have securities departments. The rest are exclusively dealers in U.S. government and selected private securities.
Federal Reserve purchases and sales of Treasury bills, repurchase agreements, and other financial instruments normally are huge in volume. For example, during the month of October 2006, Fed purchases of repurchase agreements (RPs) exceeded $175 billion and its rollover of reverse RPs were nearly $650 billion. By the end of that month the Fed held securities in its own portfolio amounting to more than $772 billion (at face value), of which more than $277 billion were U.S. Treasury bills and better than $495 billion were Treasury notes and bonds. It also held in custody on behalf of foreign governments and official institutions nearly $1.7 trillion in marketable securities. Most of its portfolio is short in maturity, rolling over within a year, keeping Fed traders in New York busy much of the time.
The Policy Directive How does the SOMA manager decide whether or not to buy or sell securities in the open market on a given day? The manager is guided, first of all, by a policy directive issued to the Federal Reserve Bank of New York following the conclusion of each meeting of the Federal Open Market Committee (FOMC). The SOMA manager attends each FOMC meeting and participates in its policy discussions. He or she listens to the views of each member of the Federal Reserve Board and the Reserve bank presidents, who describe economic conditions in their region of the country. The manager also receives the benefit of a presentation by staff economists of the Federal Reserve Board who analyze current economic and financial developments.
In recent years, with the issuance of a policy directive to the SOMA manager at the Fed’s Trading Desk in New York, the FOMC has been releasing to the public a Federal Open Market Committee Statement regarding its planned course of action after each committee meeting (normally by 2:15 pm. EST on the last day of an FOMC meeting). These policy statements reflect the central bank’s efforts to be more transparent (i.e., to make more public disclosures) and to be more accountable to the public for what it does. An example of a recent policy statement is shown in Exhibit 13.2 . This statement summarizes the Federal Reserve’s view of current economic developments, particularly those that pertain to the growth of output in the economy and to movements in prices and employment. The FOMC specifies a target level for a key money market interest rate—the effective federal funds rate.
We note that the FOMC policy statement is extremely general in nature and recognizes the need for flexibility as market conditions change. Many factors other than Federal Reserve operations affect interest rates and credit availability. Consequently, the Federal Open Market Committee must be flexible and trust the SOMA manager’s judgment in responding to daily conditions in the money market, which subsequently may be quite different from those anticipated when the FOMC held its last meeting.
The Conference Call As an added check on the decisions of the SOMA manager, a conference call between staff economists at the Federal Reserve Board, a member of the FOMC, and the SOMA manager is often held each day before trading occurs. The SOMA manager updates those sitting in on the conference call on current conditions in the money market and then makes a recommendation on the type and volume of securities to be bought or sold that day. At this point, the conference call participants may make alternative recommendations. Usually, however, the SOMA manager’s recommendation is taken and trading proceeds.
Types of Open Market Operations There are four basic types of Federal Reserve open market operations. (See Exhibit 13.3 .) The so-called straight, or outright, transaction refers to the sale or purchase of securities in which outright title passes to the buyer on a permanent basis. In this case, a permanent change occurs in the level of legal reserves, up or down. Thus, when the Federal Reserve wants to bring about a once-and-for-all change in reserves, it tends to use the straight or outright type of transaction—something that normally takes place only a few times during the year. One reason the Fed wishes to make occasional permanent additions to its portfolio of government securities is to account for the secular growth in the liquidity demands of a growing economy.
In contrast, when the Fed wishes to have a temporary effect on bank reserves, correcting temporary mismatches between the demand for and supply of reserves, it employs a repurchase agreement with a securities dealer. Under a repurchase agreement (RP)—today the most popular type of open-market operation—the Fed buys securities from dealers but agrees to sell them back within a short period of time, usually the following day. The result is a temporary increase in legal reserves that will be reversed when the Fed sells the securities back to the dealers. Such RPs frequently are used during holiday periods or when factors are at work that have resulted in a temporary shortfall in reserves.
A good example of how the RP can be used to deal with temporary emergencies appeared in September 2001 when, in the wake of a terror attack on the United States, the Fed injected about $80 billion in additional liquidity into the U.S. financial system using repurchase agreements with primary security dealers. A week later, as market conditions stabilized, the Fed withdrew most of these extra funds.
The Fed can also deal with a temporary excess quantity of reserves by using a matched-sale purchase (MSP) transaction, commonly called a reverse RP. In this instance, the Fed agrees to sell securities to dealers for a brief period and then to buy them back. Frequently, when deliveries are slowed by weather or strikes, the result is a sharp increase in the volume of uncollected checks (float), giving depository institutions millions of dollars in excess reserves until the unpaid items are cleared. The Fed can absorb these excess reserves using reverse RPs until the situation returns to normal. Incidentally, reverse RPs are used for the types of problems just described because the Fed is not allowed by law to use a simpler and less costly approach to the problem—borrowing from the public—in order to reduce the volume of reserves available to the banking system.
The third type of open market operation is the runoff. The Federal Reserve may deal directly with the U.S. Treasury in acquiring and redeeming securities. Suppose the Fed has some maturing U.S. Treasury securities and wishes to replace them with new securities currently being offered by the Treasury in its latest public auction. The amount of securities the Fed takes will not then be available to the public, reducing the quantity of securities sold in the marketplace. Other things being equal, this would tend to raise security prices and lower interest rates.
On the other hand, the Fed may decide not to acquire new securities from the Treasury to replace those that are maturing. This would mean the Treasury would be forced to sell an increased volume of securities in the open market to raise cash in order to pay off the Fed. At the same time, the Treasury would draw funds from its deposits held at private banks, reducing bank reserves, to redeem the Fed’s maturing securities. Other things equal, security prices would fall and interest rates rise. Credit market conditions would tighten up. Moreover, the Federal Reserve saves on transaction costs (in the form of dealer fees) by dealing directly with the Treasury and not conducting a regular open market transaction through private security dealers.
Finally, the Fed also conducts purchases and sales of securities on behalf of foreign central banks and other official agencies and institutions that hold accounts with the New York Federal Reserve Bank, known as agency operations. The Fed may buy or sell securities from its own portfolio to accommodate these foreign accounts or merely act as an intermediary between the foreign accounts and security dealers.
For example, suppose that the Federal Reserve Bank in New York has just received a request from the Bank of Japan to purchase U.S. government securities. That central bank has probably built up too much cash in its U.S. accounts and has decided to earn some interest on that cash by buying some U.S. Treasury bonds. To pay for the securities, the Bank of Japan transfers a portion of its deposit at a U.S. bank to its deposit account at the New York Fed. The Fed’s Trading Desk may contact private dealers and make the purchase on behalf of the Bank of Japan, crediting the dealers’ banks for the purchase price of the securities and reducing the Bank of Japan’s deposits at the Fed. In this case, total reserves of the U.S. banking system do not change, falling initially but then rising back to their original level.
However, the Fed may decide to sell the Bank of Japan securities from its own portfolio (that is “from System account”). In this case, bank reserves fall initially, as the Bank of Japan pays for its purchase, but do not rise again. The money received from this Fed sale is “locked up” within the Federal Reserve System and does not flow out to private banks. In general, sales of Federal Reserve-held securities to foreign accounts reduce U.S. bank reserves; purchases of securities from foreign accounts that go into the Fed’s own security account increase U.S. bank reserves.
Goals of Open Market Operations: Defensive and Dynamic In the use of any of its policy tools, the Federal Reserve, like other central banks, always has in mind the basic economic goals of maximum employment, a stable price level, and sustainable economic growth. However, only a portion of the Federal Reserve’s daily open market activity is directed toward those particular goals. The Fed is also responsible on a day-to-day basis for stabilizing the money and capital markets and keeping the financial markets functioning smoothly. These technical adjustments in market conditions are often referred to as defensive open market operations. Their basic purpose is to preserve the status quo and to keep the present pattern of interest rates and credit availability about where it is.
For example, suppose the Fed believes the current level of reserves held by the banking system—about $42 billion—is just right to hold interest rates and credit conditions where they are. However, due to changes in other factors affecting bank reserves (such as the public demanding more currency and coin from banks to spend over the holidays), total reserves in the system are expected to fall to $41 billion. The Fed is likely to buy about $1 billion in securities so that total reserves remain at $42 billion—a defensive operation.
In contrast, when the Federal Reserve is interested in the pursuit of broader economic goals, it engages in dynamic open market operations. These operations are designed to upset the status quo and to change interest rates and credit conditions to a level the Fed believes more consistent with its economic goals. For example, if the Fed believes the economy needs to grow faster to create more jobs, it may come to the conclusion that total reserves in the banking system must increase from $42 billion to $44 billion. In this case, the Fed’s Trading Desk is likely to launch an aggressive program of buying securities until reserve levels reach $44 billion. Open market operations have now become dynamic, not merely defensive.
The fact that open market operations are carried out for a wide variety of purposes makes it difficult to follow a central bank’s daily transactions in the marketplace and to draw firm conclusions about the direction of monetary policy. On any given day, the central bank may be buying or selling securities defensively merely to stabilize market conditions without any longer-term objectives in mind. The central bank is really a balance wheel in the financial system, supplying or subtracting reserves as needed to eliminate demand-supply mismatches on any given day. Although experienced central bank watchers find the daily pattern of open market operations meaningful, unless the investor possesses inside information on the motivation of central bank actions, it is exceedingly difficult to “read” daily open market operations. A longer-term view is usually needed, supplied in part by the FOMC’s policy statement, to see the direction in which the central bank is trying to move the financial system.