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What Are Open Market Operations, and How Do They Work?

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Open market operations (OMO) is a tool of monetary policy that refers to the buying and selling of bonds and government securities in the open market to control the money supply in the economy. For instance, a Central Bank buys government securities if it intends to increase the money supply in the economy and vice versa.

By using OMOs, the Fed can adjust the federal funds rate, which in turn influences other short-term rates, long-term rates, and foreign exchange rates. This can change the amount of money and credit available in the economy and affect certain economic factors, such as unemployment, output, and the costs of goods and services.

Understanding Open Market Operations (OMOs)

To understand open market operations, you first have to understand how the Fed, the central bank of the U.S., implements the nation’s monetary policy.

In an effort to keep the U.S. economy on an even keel and to forestall the ill effects of uncontrolled price inflation or deflation, the Board of Governors of the Federal Reserve sets what’s called a target federal funds rate.

The federal funds rate is the interest rate that depository institutions charge each other for overnight loans. This constant flow of money allows banks to earn a return on excess cash in their Fed balances while maintaining the reserves required to meet the demands of customers.

As a benchmark, the federal funds rate influences a variety of other rates, from savings deposit rates to home mortgage rates and credit card interest rates.

Open market operations are one of the tools that the Fed uses to keep the federal funds rate at its established target.

The U.S. central bank can lower the interest rate by purchasing securities (and injecting money into the money supply). Similarly, it can sell securities from its balance sheet, take money out of circulation, and put upward pressure on interest rates.

The Board of Governors of the Federal Reserve sets a target federal funds rate and then the  Federal Open Market Committee (FOMC) implements the open market operations to achieve that rate.3

Types of Open Market Operations

There are two types of OMOs: permanent open market operations and temporary open market operations.

Permanent Open Market Operations

Permanent open market operations refer to the Fed’s outright purchase or sale of securities for or from its portfolio. Permanent OMOs are used to achieve traditional goals. For example, the Fed will adjust its holdings to put downward pressure on longer-term interest rates and to improve financial conditions for consumers and businesses. Permanent OMOs are also used to reinvest principal received on currently held securities.4

Temporary Open Market Operations

Temporary open market operations are used to add or drain reserves available to the banking system on a short-term basis. They address reserve needs that are deemed to be transitory. Unlike Permanent OMOs, which involve outright purchases or sales, Temporary OMOs are temporary transactions. They’re either repurchase agreements (repos) or reverse repurchase agreements (reverse repos).

A repo is a transaction where the Fed’s trading desk buys securities and agrees to sell them back at a future date. A reverse repo involves the Fed selling securities with the agreement that it will buy them back in the future. Overnight reverse repos are currently used by the Fed to maintain the federal funds rate in its FOMC-established target range.

Benefits of Open Market Operations

Open market operations allow the Federal Reserve (or the central banks in other countries) to prevent price inflation or deflation without directly interfering in the market economy. Instead of using regulations to control lending, the Fed can simply raise or lower the cost of borrowing money.

This allows the Federal Reserve to moderate the business cycle and reduce economic shocks. During recessions, the central bank lowers the cost of borrowing money, encouraging business activity and growth. In times of froth, the Fed increases the cost of borrowing money in order to rein in speculation and deflate potential bubbles.

Open market operations can also be used to affect job growth. By lowering interest rates, the Fed can make it easier to start businesses and hire workers, resulting in increased employment.