What Are Open Market Operations (OMO)?
Open market operations (OMO) refers to the Federal Reserve (the Fed) practice of buying and selling U.S. Treasury securities, along with other securities, on the open market in order to regulate the supply of money that is on reserve in U.S. banks. The Fed purchases Treasury securities to increase the supply of money and sells them to reduce long-term interest rates.
The objective of OMOs is to adjust the level of reserve balances to manipulate the short-term interest rates and that affect other interest rates. The Federal Reserve conducts open market operations to achieve the desired target federal funds rate by buying or selling government bonds from or to commercial banks.
- Open market operations (OMO) refers to a central bank buying or selling short-term Treasuries and other securities in the open market in order to influence the money supply.
- In the U.S., open market operations are a method the Fed uses to manipulate interest rates—specifically the federal funds rate used in interbank loans.
- Buying securities adds money to the system, making loans easier to obtain and interest rates decline.
- Selling securities from the central bank's balance sheet removes money from the system, making loans more expensive and increasing rates.
Open Market Operations Explained
Understanding Open Market Operations (OMO)
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 percentage that depository institutions charge each other for overnight loans. This constant flow of vast sums of money allows banks to keep their cash reserves high enough to meet the demands of customers while putting excess cash to use.
The federal funds rate also is a benchmark for other interest rates, influencing the direction of everything from savings deposit rates to home mortgage rates and credit card interest.
Basically, open market operations are the tools the Fed uses to reach that target federal funds rate by buying and selling securities in the open market. The central bank is able to increase the money supply and lower the market interest rate by purchasing securities using newly created money. Similarly, the central bank can sell securities from its balance sheet and take money out of circulation, putting upward pressure on interest rates.
Open market operations allow the Federal Reserve to buy or sell Treasuries in such large quantities that it has an impact on the supply of money distributed in banks and other financial institutions around the U.S.
Types of Open Market Operations (OMO)
In short, 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.
There are two types of OMOs. Permanent open market operations (POMO) refers to the Fed (or any central bank) constantly using the open market to buy and sell securities in order to adjust the money supply. POMO has been one of the tools used by the Federal Reserve to implement monetary policy and influence the American economy.
In contrast, temporary open market operations are used to add or drain reserves available to the banking system on a short-term basis, addressing reserve needs that are deemed to be transitory in nature. Unlike POMOs, which involve outright purchases or sales, these operations are either repurchase agreements (repos) or reverse repurchase agreements (reverse repos or RRPs). This means that the Fed undertakes the transaction with an agreement to do the opposite—buy back if it sells, or resell if it buys—in the future.
U.S. Treasuries are government bonds that are purchased by many individual consumers as a safe investment. They are also traded on the money markets and are purchased and held in large quantities by financial institutions and brokerages.
Up or Down?
There are only two ways Treasury rates can move, and that's up or down. In the Federal Reserve's language, the policy is expansionary or contractionary.
If the Fed's goal is expansionary, it buys Treasuries in order to pour cash into the banks. That puts pressure on the banks to lend that money out to consumers and businesses. As the banks compete for customers, interest rates drift downwards. Consumers are able to borrow more to buy more. Businesses are eager to borrow more to expand.
If the Fed's goal is contractionary, it sells Treasuries in order to pull money out of the system. Money gets tight, and interest rates drift upwards. Consumers pull back on their spending. Businesses trim their plans for growth, and the economy slows down.
Why Does the Federal Reserve Conduct Open Market Operations?
Basically, open market operations are the tools the Federal Reserve (the Fed) uses to achieve the desired target federal funds rate by buying and selling, mainly, U.S. Treasuries in the open market. The Fed can increase the money supply and lower the market interest rate by purchasing securities using newly created money. Similarly, the central bank can sell securities from its balance sheet and take money out of circulation, thereby pressuring market interest rates to rise.
What Are Permanent Open Market Operations (POMO)?
Permanent open market operations (POMO) refers to a central bank practice of constantly using the open market to buy and sell securities in order to adjust the money supply. It has been one of the tools used by the Federal Reserve to implement monetary policy and influence the American economy. POMOs are the opposite of temporary open market operations, which involve repurchase and reverse repurchase agreements that are designed to temporarily add or drain reserves available to the banking system.
How Does the Federal Funds Rate Affect Banks?
By law, commercial banks must maintain a reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank. Any money in their reserve that exceeds the required level is available for lending to other banks that might have a shortfall. The interest rate the lending bank can charge for these loans is called the federal funds rate, or fed funds rate. Banks often base their interest rates for consumer or business loans on the federal funds rate.