Open Market Operations
The central bank of a country employs open market operations to implement the monetary policy. In the US, this is done by Federal Reserve. Open market operations involve buying and selling government securities in the market to control the money supply and maintain the short-term interest rates. They are allowed to buy and sell only from a limited basket of securities. This is done by the trading desk at the Federal Reserve Bank of New York. These open market operations (OMOs) have short-term and long-term objectives.
The short-term objectives are specified by the Federal Open Market Committee or FOMC.
Open market operations are either temporary or permanent.
The Federal Reserve has a System Open Market Account or SOMA through which it outrightly buys securities for its portfolio. This is a permanent OMO. When the circulation of currency is greater, the FED steps in to mop up funds and reduce long-term interests. They help currently in reinvesting the principal payments from the Fed’s holdings as per the FOMC policies.
Types of Securities
The Fed’s Trading Desk buys treasury securities to keep the treasury market stable. They also roll over maturing Treasury holdings in auctions. Post-2008, the Trading desk changed the composition of its SOMA portfolio to control long-term interest rates and the overall financial condition of the market.
Agency Mortgage-Backed Securities
The Fed’s trading desk buys mortgage-backed securities or MBS that are guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. Usually, MBS purchases are made in recently produced coupons in the 30-year and 15-year fixed-rate agency MBS in the To-Be-Announced (TBA) market.
Commercial Mortgage-Backed Securities
Another instrument purchased in OMOs is Commercial Mortgage-Backed Securities or CMBS. These CMBS that are secured primarily by multi-family home mortgages are guaranteed fully (principal and interest) by Fannie Mae, Freddie Mac, and Ginnie Mae.
Temporary OMOs help the Fed react to transitionary reserve needs. They do this through repurchase agreements or REPOs and Reverse Repurchase Agreements or RRPs. The Trading Desk buys securities with the promise to resell it in the future. It functions like a collateralized loan, where the interest is the difference between purchase and sale prices. Reverse REPOS on the other hand works like collateralized borrowing by the Federal Reserve. These instruments help keep the targeted federal fund rate.
The Standing Repo Facility (SRF) is a backstop to reduce upward interest rate pressures that emerge in overnight U.S. dollar funding markets and spill over into the fed funds market. The Desk generally conducts both the ON RRP and SRF operations each business day.
Overnight repo operations under the SRF each business day at a pre-announced bid rate set by the FOMC are conducted by the Desk. The SRF allows Treasury, agency debt, and agency mortgage-backed securities to settle repo transactions.
The Overnight Reverse Repo Facility (ON RRP) helps provide support under overnight interest rates. It does this by acting as an alternative investment for money market investors when rates fall below the interest on reserve balances (IORB) rate.
This helps by offering a broad range of financial institutions an alternative risk-free investment option, despite being ineligible to earn IORB. The IORB rate and the ON RRP together set a floor under overnight rates, beneath which banks and non-bank financial institutions are not advised to invest funds in private markets.
Primary dealers, banks, money market mutual funds, and government- sponsored enterprises participate in the ON RRP. The ON RRP operations are conducted at a pre-announced offering rate set by the FOMC. Counterparties can invest funds in the ON RRP up to the per-counterparty limit. The Trading Desk offers U.S. Treasury securities held in the SOMA portfolio to settle ON RRP transactions.
Importance of the Federal Fund Rate
To achieve its twin objectives of maximum employment and stable prices, the Federal Reserve’s FOMC observes the economy and decides what the federal fund rate or the interest rates used by banks to each other for overnight loans are.
Banks are required to maintain reserves for regulatory purposes liquidity and reserves. They also require reserves if any of their customers seek to withdraw their funds. They earn interest from the feds for the reserves they maintain.
Federal funds rate impacts short-term interests but it can also impact long-term debt, consumer loans, and business loans. In either leaving the federal fund rate unchanged, higher or lower, the FOMC achieves its monetary policy targets.
Why Open Market Operations
The Fed takes part in open market operations to meet its target fund rate and is used as a monetary policy tool. It can do so by using either an expansionary monetary policy or a contractionary monetary policy.
In an expansionary monetary policy, the Fed wants interest rates to decrease. The Trading Desk buys securities in the open market thus increasing the reserves in banks. The federal fund rates reduce as do bank interest rates, thereby encouraging borrowing. This helps the economy to accelerate due to increased economic activity.
In a contractionary monetary policy, the Feds would like the fund rate to increase. Again by taking part in open market operations, they sell government securities. This leads to a lowering of reserves in banks and therefore an increase in the interest rate which encourages saving. This approach is used to restrict spending and reduce inflation.