Open market operations
The Federal Reserve Bank of New York under the direction of the Federal Open Market Committee (FOMC)conducts “domestic operations” in pursuit of monetary policy. Through open market operations, the Fed buys or sells U.S. Treasury securities in the secondary market in order to produce a desired level of bank reserves.
These securities are held in the System’s portfolio, which is known as the SOMA. The “primary dealers,” designated by the New York Fed, serve as its counter parties in open market operations and other securities transactions.
The Fed adds extra credit to the banking system when it buys Treasury securities from the dealers, and drains credit when it sells to the dealers. As the laws of supply and demand take over in the reserves market, the cost of funds for the remaining reserves finds its level at the federal funds rate.
Open market operations are the means of implementing monetary policy by which a central bank controls its national money supply by buying and selling government securities, or other financial instruments. Monetary targets, such as interest rates or exchange rates, are used to guide this implementation.
Since most money is now in the form of electronic records, rather than paper records such as banknotes, open market operations are conducted simply by electronically increasing or decreasing ('crediting' or 'debiting') the amount of money that a bank has, e.g., in its reserve account at the central bank, in exchange for a bank selling or buying a financial instrument.
Newly created money is used by the central bank to buy in the open market a financial asset, such as government bonds, foreign currency, or gold. If the central bank sells these assets in the open market, the amount of money that the purchasing bank holds decreases, effectively destroying money.
The process does not literally require the immediate printing of new currency. A central bank account for a member bank can simply be increased electronically. However this will increase the central bank's requirement to print currency when the member bank demands banknotes, in exchange for a decrease in its electronic balance. Often, the percentage of the total money supply consisting of physical banknotes is very small. In the United States only around 10% of the "M2" money supply actually exists in the form of physical banknotes or coins. The rest exists as credits in computerized bank accounts.
Current goals and procedures of open market operations
In the United States, as of 2006 the Fed sets an interest rate target for the Fed funds (overnight bank reserves) market. When the actual Fed funds rate is higher than the target, the desk will usually increase the money supply via a repo (effectively lending). When the actual Fed funds rate is less than the target, the desk will usually decrease the money supply via a reverse repo (effectively borrowing).
The European Central Bank has similar mechanisms for their operations; however, it uses a four-tiered approach with different goals: beside its main goal of steering and smoothing Eurozone interest rates while managing the liquidity situation in the market the ECB also has the aim of signalling the stance of monetary policy with its operations.
The regular weekly "main refinancing operations" and the monthly "longer-term refinancing operations" provide liquidity to the financial sector, while ad-hoc "fine-tuning operations" (in the form of reverse or outright transactions, foreign exchange swaps and the collection of fixed-term deposits) aim to smooth interest rates caused by liquidity fluctuations in the market and "structural operations" are used to adjust the central banks' longer-term structural positions vis-a-vis the financial sector.
The Swiss National Bank currently targets the 3 month Swiss franc LIBOR rate, and borrows or lends Swiss francs directly with Swiss banks (in other words, without using repos) on an almost daily basis. These borrowings or loans are typically made for 1 day or 1 week, but may be as long as 1 month.
Possible targets of open market operations
- Under inflation targeting, open market operations target a specific short term interest rate in the debt markets. This target is changed periodically to achieve and maintain an inflation rate within a target range. However, other variants of monetary policy also often target interest rates: both the US Federal Reserve and the European Central Bank use variations on interest rate targets to guide open market operations.
- Besides interest rate targeting there are other possible targets of open markets operations. A second possible target is the growth of the money supply, as was the case in the U.S. in the late 1970s through the early 1980s under Fed Chairman Paul Volcker.
- Under a currency board open market operations would be used to achieve and maintain a fixed exchange rate with relation to some foreign currency. Under a gold standard, notes would be convertible to gold, so there would be no open market operations. However, open market operations could be used to keep the value of a fiat currency constant relative to gold.
- A central bank can also use a mixture of policy settings that change depending on circumstances. A central bank may peg its exchange rate (like a currency board) with different levels or forms of commitment. The looser the exchange rate peg, the more latitude the central bank has to target other variables (such as interest rates). It may instead target a basket of foreign currencies rather than a single currency. In some instances it is empowered to use additional means other than open market operations, such as changes in reserve requirements or capital controls, to achieve monetary outcomes.
Economist Robert Mundell has stated that when using open market operations it is only possible to pursue a single target at any given time. One cannot use open market operations to target interest rates while being on a gold standard. Likewise if you are targeting interest rates then the exchange rates will fluctuate.
How open market operations are conducted in the USA
In the U.S., the Federal Reserve (Fed) most commonly uses overnight repo agreements (repos) to temporarily create money, or reverse repos to temporarily destroy money, which offset temporary changes in the level of bank reserves.
The Fed also makes outright purchases and sales of securities through the System Open Market Account (SOMA) with its manager over the Trading Desk at the New York Reserve Bank. The trade of securities in the SOMA changes the balance of bank reserves, which also affects short term interest rates. The SOMA manager is responsible for trades that result in a short term interest rate near the target rate set by the Federal Open Market Committee (FOMC), or create money by the outright purchase of securities. Very rarely will it permanently destroy money by the outright sale of securities. These trades are made with a group of about 19 banks or bond dealers who are called primary dealers.
Money is created or destroyed by changing the reserve account at a bank. The Fed has conducted open market operations in this manner since the 1920s, through the Open Market Desk at the Federal Reserve Bank of New York, under the direction of the Federal Open Market Committee.
- Understanding Open market operation by M. A. Akhtar
- Federal Reserve System OMC
- European Central Bank OMC
- Federal Reserve Bank of New York: Open Market Operations
- How To Front-Run The Fed's Upcoming SOMA Limit Increase ZeroHedge, October 29, 2010