One thing I have noticed from my time and study of the sciences is that people who are very analytical (typical scientists) tend to name things in a very self-explanatory way. I’d throw open market operations of the Fed in that category as they are exactly what they sound like, operations the fed conducts on the open market. Essentially, open market operations are avenues for the federal reserve to manipulate the amount of bank reserves in the banking system either permanently or temporarily. Their hope by doing this is to influence short-term interest rates and base money in the economy. All of this happens at the trading desk of the New York Fed, where they trade different types of securities including U.S. treasuries and Mortgage-Backed Securities (MBSs) as examples.
Permanent Vs. Temporary Open Market Operations (OMOs)
Naturally, with something as dynamic as the monetary system and the economy, a certain degree of flexibility is required for the tools of the federal reserve. In terms of open market operations, the permanence of said operations is one mode of flexibility, which involved the intended amount of time that the asset is to be on the Fed’s balance sheet. This leads us to two different categories for open market operations, permanent and temporary.
Permanent Open Market Operations of the Fed
Involving the pure purchase or sale of the securities, permanent open market operations change the size of the fed’s System Open Market Account (SOMA). SOMA contains the assets, denominated in dollars, that are used as collateral for the fed’s liabilities (i.e., bank reserves). Even though these purchases are described as permanent, that doesn’t mean they aren’t reversed, it just means that there isn’t a predetermined date of sale upon the initial purchase. Quantitative Easing (QE) is an example of a permanent open market operation. With QE, assets (U.S. treasuries as an example) are purchased from commercial banks, and they stay on the fed’s balance sheet, at least until the fed decides to do Quantitative Tightening (QT). Again, these operations are considered permanent because there isn’t a predetermined sale date upon the initial purchase of the asset.
As a side note for SOMA, the transactions for this portfolio are made by the Federal Reserve Bank of New York and its holdings are distributed to each of the Reserve Banks on a percentage basis. SOMA also holds foreign currencies such as the Euro and the Japanese Yen, so the portfolio does not only contain dollar-denominated assets. As a final note on permanent OMOs, these transactions can involve longer-term securities (i.e., longer duration treasuries), as was the case for QE, in order to maintain downward pressure on longer-term interest rates. This was a major play for the fed during and after the Great Financial Crisis (GFC) to make monetary conditions for accommodative for struggling entities.
Temporary Open Market Operations of the Fed
Contrary to permanent operations, temporary operations are by definition, temporary in nature. This is where the repurchase agreements lie. By nature of the repurchase agreements (repos), the fed buys securities with a promise to sell them back in the future. For reverse repos the roles are switched so the fed sells securities with a promise to buy them back (repurchase) them in the future. These agreements are typically overnight, meaning they are opened one day and closed the next. If this isn’t clear to you right away, I have another post where I go more in depth on how repo transactions work (HERE) and also more in depth on their characteristics and nature (HERE).
However, temporary open market operations are not exclusively repos, they also include rolling over the maturing treasuries that are being held as well as reinvesting the principal payments from their other holdings. All of this is carried out by the open market trading desk at the New York fed (The Desk).
Expansionary Vs. Contractionary Monetary Policy
The whole point of these open market operations is to implement the fed’s current monetary policy which is intended to advance them towards their congressionally mandated goals of maximum employment and stable prices (Overview of the Federal Reserve). As you can assume, all of the operations discussed above influence the amount of bank reserves held by eligible institutions. When the fed purchases a security from them, they pay in bank reserves, which means that the amount of bank reserves on the institution’s balance sheet increases. When the fed sells a security to the depository institution, the opposite happens, and the amount of bank reserves held by that institution decreases. All of this is what defines the difference between expansionary and contractionary monetary policy. The idea is that by increasing the amount of bank reserves held by depository institutions (expansionary monetary policy), they will increase their lending, therefore promoting economic growth. By the fed’s buying of securities, they are also decreasing the supply of that security on the open market, leading to price increases and therefore lower yields on those securities, leading to a lower fed funds rate and hopefully lower interest rates to encourage borrowing. This gives two avenues to increase bank lending capacity, more bank reserves and lower interest rates.
The converse is intended with contractionary monetary policy where the amount of bank reserves decreases on the depository institution’s balance sheet. Also, by the fed’s selling of securities into the open market, the supply of said securities increases, lower the price and therefore increasing the yield, leading to an increasing fed funds range and placing upward pressure on other interest rates. These higher interest rates are supposed to encourage saving and decrease the amount of bank lending to higher risk borrowers.
Final words
The specific use of diction in the above paragraphs was intentions, specifically by using “intended” with respect to expansionary and contractionary monetary policy. I say this is what the fed intends or intended these open market operations to do because the system has changed, especially with respect to bank reserves. Without a reserve requirement for banks, bank lending is not constrained by the amount of bank reserves on their balance sheet. Again, the lending capacity of banks is no longer constrained by bank reserves. The concept of fractional reserve banking of the past few centuries is no longer applicable to how the current system works. Nowadays with the Supplementary Leverage Ratio (SLR), essentially a ratio of how much leverage an institution may use dependent on their asset holdings, and the Eurodollar system, the rules of banking have changed.
To your wealth and future,
James Forsythe
[1] https://www.newyorkfed.org/markets/soma-holdings
[2] https://www.federalreserve.gov/monetarypolicy/bst_openmarketops.htm
