• Open market operations, or OMOs, are the Federal Reserve's most flexible and frequently used means of implementing U.S. monetary policy.

• The Federal Reserve has at its disposal several different types of OMOs, though the most commonly used are triparty repos and securities purchases.

• Open market operations enable the Federal Reserve to affect the supply of reserve balances in the banking system and thereby influence short-term interest rates and reach other monetary policy targets.

• In addition to open market operations, the Federal Reserve can impact the level of reserve balances by either reinvesting the proceeds of maturing securities in the System Open Market Account into new securities (reserve-neutral) or redeeming maturing securities (reserve-draining).

Open market operations are one of three basic tools used by the Federal Reserve to reach its monetary policy objectives. The other tools are changing the terms and conditions for borrowing at the discount window and adjusting reserve requirement ratios. The execution of OMOs in the "open market"—also known as the secondary market for securities purchases—is the Federal Reserve's most flexible means of carrying out its objectives. By adjusting the level of reserve balances in the banking system through open market operations, the Fed can offset or support permanent, seasonal or cyclical shifts in the supply of reserve balances and thereby affect short-term interest rates and by extension other interest rates.

The FOMC and Monetary Policy
The Federal Open Market Committee (FOMC) is the Federal Reserve System’s top monetary policy-making body. The FOMC delegates responsibility for implementing U.S. monetary policy to the Manager of the System Open Market Account (SOMA) at the Federal Reserve Bank of New York through the Authorization. This Authorization is contained in the minutes of the first FOMC meeting of each year.

The SOMA Manager is responsible for the staff of the Trading Desk at the Federal Reserve Bank of New York (“the Desk”). The Desk thus executes open market operations on behalf of the entire Federal Reserve System.

After each policy meeting, which occur every six to eight weeks, the FOMC issues a Directive to the SOMA Manager outlining the approach to monetary policy that the FOMC considers appropriate for the time period between its meetings. The Directive contains the rate at which the FOMC would like fed funds to trade over the intermeeting period. The FOMC’s announcements of changes in monetary policy thus specify the changes in the Fed's target rate.

Open Market Transactions
The Federal Reserve conducts open market operations with primary dealers—government securities dealers who have an established trading relationship with the Federal Reserve. So while the target policy rate is the uncollateralized lending rate between banks (fed funds), the Fed operates in the collateralized lending market with primary dealers (repo). This structure works because the primary dealers have accounts at clearing banks, which are depository institutions. So when the Fed sends and receives funds from the dealer's account at its clearing bank, this action adds or drains reserves to the banking system.

Through this adjustment to the supply of reserve balances, open market operations influence the federal funds rate—the interest rate that depository institutions pay when they borrow unsecured loans of reserve balances overnight from each other. Banks borrow reserves in the federal funds market in order to meet reserve requirements set by the Federal Reserve, and to ensure adequate balances in their accounts at the Fed to cover checks and electronic payments that the Fed processes on their behalf. Changes in the federal funds rate often have a strong impact on other short-term rates.

To most effectively influence the level of reserve balances, the Federal Reserve has created what is called a “structural deficiency.” That is, it has created permanent additions to the supply of reserve balances that are somewhat less than the total need. Then on a seasonal and daily basis, the Desk is in a position to add balances temporarily to get to the desired level.

Specifically, the Desk has created the SOMA portfolio through the purchase of U.S. Treasury securities in the open market. Since the SOMA portfolio is a “buy-and-hold” portfolio, where securities purchased in it are typically held to maturity, a security purchase by the Fed results in a permanent increase in the level of reserve balances.

In addition to the SOMA portfolio, the Fed’s total portfolio includes a long-term repo book and a short-term repo book. Repos, also called repurchase agreements or RPs, are a form of collateralized loan where the Fed lends money to primary dealers, and the primary dealers give the Fed high-quality securities as general collateral against the loan.

While the SOMA portfolio is managed to offset factors that permanently drain balances from the banking system—like Federal Reserve Notes—the long-term repo book is used to offset seasonal movements in factors. Long-term repos currently have a maturity of 14-days and are conducted early every Thursday morning.

The short-term repo book, which consists of repos with shorter-than-14-day maturities, is dominated by overnight repos. These operations are typically conducted every day to fine-tune the level of banking reserves needed on that day. While typically these operations will add balances, occasionally the system will need to have balances extinguished, in which case the Desk will conduct a reverse repo.

Reverse repo transactions are the opposite of RPs. Instead of lending money to the dealers, the desk borrows money from the dealers versus collateral from the System Open Market Account.

Repo and reverse repos can be conducted for terms up to 65 business days. They are typically settled on a same-day basis, though they can be settled on a forward date as well. For information on eligible collateral for repos, see the Federal Reserve Act, and the Domestic Authorization, which is in the minutes for the first FOMC meeting each year.

Gathering Information, Preparing to Act
Staff on the Desk start each workday by gathering information about the market's activities from a number of sources. The Fed's traders discuss with the primary dealers how the day might unfold in the securities market and how the dealers' task of financing their securities positions is progressing. Desk staff also talk with the large banks about their reserve needs and the banks' plans for meeting them and with fed funds brokers about activities in that market.

Reserve forecasters at the New York Fed and at the Board of Governors in Washington, D.C., compile data on bank reserves for the previous day and make projections of factors that could affect reserves for future days. The staff also receives information from the Treasury about its balance at the Federal Reserve and assists the Treasury in managing this balance and Treasury accounts at commercial banks.

Following the discussion with the Treasury, forecasts of reserves are completed. Then, after reviewing all of the information gathered from the various sources, Desk staff develop a plan of action for the day.

That plan is reviewed with interested parties around the system during a conference call held each morning. Conditions in financial markets, including domestic securities and money markets and foreign exchange markets also are reviewed at this time.

Conducting Open Market Operations
When the conference call is complete, the Desk conducts any agreed-upon open market operations. The Desk initiates this process by announcing the OMO through an electronic auction system called FedTrade, inviting dealers to submit bids or offers as appropriate.

For a repo operation, the announcement states the auction close time, repo type (repo or reverse) and term of the operation, but does not specify its size. The size of the operation is announced later, after the operation is completed. The dealers' propositions are evaluated on a competitive best-price basis. Primary dealers typically are given about 10 minutes to submit their propositions and are notified of the results about a minute after the close of the auction. Auction results are also simultaneously sent to the Bank’s external website and to the wire services.

Auctions for outright security purchases into the SOMA portfolio are typically arranged later in the morning and follow a similar procedure to repo. The announcement contains the maturity range for securities the Fed is looking to purchase, as well as a list of any securities to be excluded in this maturity range. These operations tend to be open about 30 minutes. Dealers bid on securities, and the Fed compares the relative richness of propositions across securities, accepting the best relative rates from the propositions submitted.

When securities in the SOMA portfolio mature, which happens every week with bills and every month for different maturity notes and bonds, the Desk determines whether to reinvest the maturing proceeds into new Treasury debt issued at primary auction, or to redeem the maturing proceeds. Typically the proceeds are reinvested, which would maintain the size of the SOMA portfolio and therefore the size of the permanent reserve-adding nature of the portfolio. Occasionally, due to portfolio guidelines or reserve needs, proceeds are redeemed, which reduces the size of the SOMA portfolio and effectively drains reserve balances from the banking system.

August 2007