What are Open Market Operations?

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Definition:

Open market operations (OMO) are the steps the Federal Reserve bank takes to either increase or decrease interest rates.

🤔 Understanding open market operations

One of the most important jobs of the Federal Reserve (the Fed) is to influence interest rates, by making it easier or harder for businesses and consumers to borrow money. But the Fed doesn’t just decide on an interest rate and enforce it by dictate. Instead, the Fed affects the rate through open market operations, which entails buying and selling U.S. Treasury securities. The central bank can lower interest rates — making it cheaper to borrow money — by buying securities from investors and increasing the supply of money. To increase interest rates, the Fed can sell government securities, which reduces the money supply and makes loans more expensive for businesses and consumers. This is one of the primary tools the central bank has at its disposal to either speed up or slow down economic growth.

Example

Suppose the United States were experiencing a period of rapid economic growth. In many ways, this is a good thing. Unemployment is low, and many people have more money to spend on consumer goods. But economic growth is also accompanied by inflation, which reduces the value of a dollar. To control inflation, the Federal Reserve uses monetary policy, including open market operations. In the example of too-rapid inflation, the Fed might use contractionary monetary policy. The central bank would sell government securities to investors. There’s now less money in people’s bank accounts, meaning commercial banks have less money to lend out. Because the supply of money to lend is now limited, the price goes up. In this case, that means an increase in interest rates.

Takeaway

Open market operations are like when the teacher changes the seating chart to get kids to stop talking…

When everyone is sitting next to their friends in class, it can lead to a lot of talking and laughter when there should be learning. The teacher might have to switch up the seating chart. This gets everyone away from their friends and reduces the amount of talking. Like a teacher controlling the amount of talking, the central bank can control interest rates. This helps to get the economy under control.

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Tell me more…

What are open market operations?

Open market operations are one of the tools the Federal Reserve has in its toolbox to help execute monetary policy (meaning policy related to an economy’s money supply). Open market operations, carried out by the Federal Open Market Committee (FOMC), allow the central bank to directly affect the amount of money in banks by injecting money into the economy or pulling money out.

An example of an open market operation by the Fed took place in early 2020. In response to an economic downturn, the Fed injected $1.5T into the economy. But the central bank didn’t just print cash and send it to banks. Instead, it injected this money using repurchase agreements, which is when the Fed sells short-term debt securities to a financial institution, and then buys them back at a higher price shortly after (usually the next day). Suddenly there’s now more money in the banks than there was before. A greater supply means that borrowers can get loans at a cheaper rate.

Why are open market operations used?

The purpose of open market operations is to push interest rates up or down toward a specific target rate (the federal funds rate). But the overall purpose of changing the rates is to either speed up or slow down economic growth.

The Federal Reserve wants to make sure the economy is always growing. During times of recession or downturn, the economy might need a bit of help. In that case, the central bank would use open market operations to help move things along. Just as you’d step on the gas pedal to make your car go faster, expansionary monetary policy is the Fed’s gas pedal.

But the Federal Reserve also doesn’t want the economy growing too quickly. Rapid economic growth often leads to inflation, which means an increase in the cost of goods and services and a decrease in the real value of the money in people’s wallets. One of the primary goals of the Fed is to keep the inflation rate in check — Its target rate is about 2%. If the inflation rate rises above 2%, the central bank might use contractionary monetary policy to slow things down.

How do open market operations work?

Open market operations allow the Federal Reserve to influence the money supply, the current interest rates, and the rate of economic growth. Open market operations involve two types of actions: expansionary monetary policy and contractionary monetary policy.

Expansionary monetary policy allows the Fed to jump-start a sluggish or slowing economy. The central bank does this through the open market purchasing of government securities — In other words, it takes those securities off the hands of investors and, in return, deposits money into their bank accounts. As a result, there’s now more money in bank accounts, which banks can use to lend to businesses and consumers. Because of the greater availability of money, banks can lend it out at a lower interest rate. These lower rates encourage businesses and consumers to borrow money and make big purchases, helping to contribute to economic growth.

When the economy is growing too rapidly and inflation is higher than what the Fed would like, it might use contractionary policy. Contractionary monetary policy is when the central bank sells securities to investors. As a result, there’s less money in those investors’ bank accounts, and therefore fewer reserves available for banks to lend out. Because of the limited supply of money, banks charge more for it by increasing interest rates. Because loans aren’t as readily available, fewer businesses and consumers may borrow money to expand or to make big purchases.

How do open market operations affect the US money supply?

Open market operations have a direct impact on the supply of money available in the economy. Influencing the money supply allows the Federal Reserve to indirectly influence interest rates.

The Fed has two types of monetary policy at its disposal. Expansionary monetary policy helps the government to grow the economy. The central bank might implement this type of policy when the country is experiencing slow inflation, or even deflation. When the Fed uses expansionary policy, it increases the supply of money in the economy.

On the other hand, the central bank might resort to contractionary policy when the economy is growing too quickly. Contractionary policy reduces the money supply, which helps to slow inflation.

How do open market operations affect interest rates?

The Federal Reserve can’t directly set the interest rates that banks use to lend money. But it can indirectly influence those rates through open market operations. By either increasing or decreasing the supply of money in the economy, the Fed can increase or decrease interest rates.

When something is more readily available, it often becomes more affordable. The same principle applies to money. As the amount of money in the economy increases, the cheaper you can borrow it. When the Fed uses expansionary policy to increase the money supply, banks are willing to lend it out for a lower rate.

But when the money supply goes down, the price often goes up. If a bank has a smaller amount of money to lend, it’s going to charge more for that money. Therefore, contractionary policy allows the Fed to indirectly increase interest rates on debt.

Why are open market operations important?

One of the primary jobs of the Federal Reserve is to keep inflation in check using the tools at its disposal, including open market operations.

Open market operations are the primary tool the Fed has available to it to help control economic growth. The Fed can use this tool to help make money available to consumers during times of economic downturn, while slowing spending during too-rapid inflation. Without intervention from the Fed, the economy may continue to move in a direction or at a speed that hurts consumers in the long run.

What are the advantages and disadvantages of open market operations?

Open market operations give the Federal Reserve the ability to influence interest rates without actually being able to tell banks what to charge for a loan. By injecting money into the economy or taking money out of it, the Fed can push rates one way or the other.

Not only do these actions by the Fed benefit the economy, but they can benefit individuals as well. If you were planning to buy a house soon and the Fed used open market operations to reduce interest rates, you might end up getting a better deal on your home loan.

One of the downsides of open market operations is that they’re a constant balancing act. The Federal Reserve wants to make sure both inflation and employment stay at a healthy level. If the economy starts growing too fast, the Fed may use its powers to increase interest rates. But when money becomes more expensive, the economy feels it. A slowdown can eventually lead to fewer people making big purchases and even a reduction in employment.

There are also disadvantages on a personal level. The returns on interest-bearing investments are often tied to the target rates the Fed sets. Suppose you were enjoying a nice 2% rate on your high-yield savings account. The Fed lowers rates, and your bank follows suit by cutting your rate from 2% to 1%. That’s one way open market operations may cost you money.

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This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

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© 2022 Robinhood. All rights reserved.