Federal Reserve Open Market Operations and FOMC Policy

The Federal Open Market Committee and Its Functions

To many Americans, it may appear that U.S. monetary policy is the work of one man — Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve ("the Fed"). But that impression exists largely because Dr. Greenspan, while certainly an extremely powerful and influential figure, is simply the most visible of many important individuals serving on key boards. In the background, out of the limelight, are numerous other key players, including members of the Federal Open Market Committee (FOMC), which Dr. Greenspan also chairs.

What are the short-term functions of the FOMC's "open market operations"? Essentially, the FOMC buys and sells U.S. Treasury securities and securities from federal agencies. These transactions are the primary tools for implementing monetary policy established by the Federal Reserve. The immediate goal of open market operations is to maintain a desired quantity of financial reserves at a desired price, which is determined as the "federal funds rate." The federal funds rate is the interest rate at which banks and other financial institutions lend balances held at the Federal Reserve to other depository institutions around the country through overnight transactions.

What are the broader key functions of the FOMC? The 12-member policy-making committee meets eight times a year during its regularly scheduled sessions to carefully evaluate current economic and financial conditions in the country. At those sessions, the FOMC determines the most appropriate direction for ongoing U.S. monetary policy and assesses risks to the economic outlook. If important or crisis-related monetary issues arise between scheduled meetings, the board may convene an emergency session or participate in a conference call to review and make decisions.

Since the FOMC is the most important policy-making arm of the Federal Reserve, it makes decisions to advance the long-run objectives of price stability and sustainable economic growth. The broad role of the FOMC encompasses stimulating the economy, promoting strong economic growth, supporting employment as close to full employment as possible, setting the cost and availability of credit, and directing System operations in foreign currencies.

How are FOMC activities coordinated with the Department of the Treasury on a daily basis? FOMC policies directly affect the sale and purchase of U.S. Treasury securities. Because Federal Reserve purchases of Treasury securities add to reserves while Federal Reserve sales withdraw funds from the federal monetary system, there is daily interaction between the U.S. Treasury and FOMC staff.

Open Market Operations as the Fed's Primary Tool

What is the function of the "Desk" at the Federal Reserve Bank of New York? Each day, professionals at the Domestic Trading Desk must decide whether an open market operation is needed and, if so, whether it should be an "outright" or a "temporary" operation. The Desk consults with staff at the Federal Reserve Bank of New York and at the Board of Governors. Those staff members provide the Desk with estimates of the average supply of and demand for reserve funds needed to maintain the current two-week reserve period. For example, if staff at the Federal Reserve Bank of New York — or the Board of Governors staff, which numbers approximately 1,700 people — projects a large and persistent imbalance between reserve demand and supply lasting a month or more, the Desk may purchase or sell securities outright in order to better balance reserves.

Historically, the Fed has preferred open market operations as its main tool for conducting monetary policy. When the Fed buys securities, bank reserves increase; when the Fed sells securities, bank reserves decrease. This straightforward action-and-reaction mechanism, combined with the central bank's crucial need to regulate the money supply and promote favorable conditions in the financial sector, makes open market operations the logical centerpiece of monetary policy. There is little reason to abandon a tool that responds so directly and predictably to the Fed's intentions.

As Kaufman notes, open market operations "are flexible… [and] may be reversed quickly if conditions change unexpectedly." Securities purchased in the morning can be offset by sales in the afternoon. This reversibility is a defining advantage in an environment where economic conditions can shift rapidly — a reality made especially clear after the events of September 11, 2001.

The Three Tools of Monetary Control

The Federal Reserve exercises monetary control — that is, its ability to influence how much money banks can create — through three primary tools: open market operations, discount operations, and changes in reserve requirements. Open market operations involve the buying and selling of U.S. government Treasury securities in the open market, directly influencing the level of reserves in the Fed's depository system. Reserve requirements refer to the minimum amount of money that depository institutions, including banks, must hold in reserve to back the deposits of their customers.

The third tool, discount operations, involves the discount rate — the interest rate charged to U.S. commercial banks and other depository institutions when they borrow reserve funds from one of the 12 regional Federal Reserve Banks. Each Federal Reserve Bank is governed by a board of nine directors chosen from outside that bank's employee roster. Regarding earnings: after expenses are paid, each Federal Reserve Bank remits its remaining profits to the U.S. Treasury. Nearly 95% of the Reserve Banks' net earnings have been paid to the Treasury since the Federal Reserve System was established in 1914.