Open Market Operations and U.S. Federal Reserve Monetary Policy

Introduction to Open Market Operations

Monetary policy may involve several facets, including reserve requirements, the discount rate, and interest rate targeting. The U.S. Federal Reserve's long-standing strategy has been to use interest rate targeting through open market operations primarily to keep the economy in a state of equilibrium.

Today, open market operations — the purchase and sale of U.S. Treasury and other federal agency securities — are the principal tool used by the Federal Reserve in implementing monetary policy. The Federal Open Market Committee (FOMC) of the Federal Reserve decides on the short-term objective, which can be either a desired quantity of reserves or a desired price, also called the federal funds rate; this, in turn, has the effect of making interest rates increase or decrease. "The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight" (Federal Reserve), which allows it to either slow down or stimulate the economy, but at a slight remove from the more direct effects of actions such as manipulating the discount rate.

If the FOMC decides it wants the funds rate to fall — that is, for interest rates to decrease — it buys government securities from a bank and pays for them by increasing that bank's reserves. "As a result, the bank now has more reserves than it wants. So the bank can lend these unwanted reserves to another bank in the federal funds market. Thus, the Fed's open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls" (Federal Reserve). If the Fed wants rates to rise, it reverses this process, lowering the supply of reserves in the system, causing the funds rate — and eventually commercial interest rates — to rise.

It is easy to see that this is a fairly indirect route to stimulating or cooling the economy, dependent not only on what the Fed wants, but also on what the commercial market — U.S. industry and consumers — wants. It could therefore be regarded as a more holistic approach than others in which the Fed would directly pump money into, or siphon it out of, the commercial market.

Considering the long tenure of Federal Reserve Chairman Alan Greenspan, it is likely that the preference for open market operations as the regulator of the nation's economy — via this form of interest rate "soft manipulation" — was strengthened during his chairmanship. However, the FOMC's preference for an open market operations approach to monetary policy predates Greenspan. It is equally likely that there are cogent reasons for the policy having been instituted in the first place, and for its continuation despite calls by some for using reserve requirements or the discount rate instead. Arguably, using the "invisible" method of Federal Reserve bank internal lending is likely to lead to greater stability in financial markets.

Long History of FOMC Voting Behavior

Chappell and McGregor (2000) analyzed the voting records of 84 Federal Open Market Committee members who served during a 30-year period from 1966 to 1996, a span longer even than the influence of Chairman Greenspan.

United States monetary policy decisions, despite the influence of the Federal Reserve Chairman, are made by the Federal Open Market Committee. The FOMC guides monetary policy through directives composed by a committee consisting of the seven members of the Board of Governors and five of the twelve district Federal Reserve Bank presidents. The FOMC is not a single agent whose preferences might change slowly, if at all. On the contrary, the FOMC can be viewed as a group with an aggregation of preferences, making it all the more remarkable that the preferred policy has held for so long. The directives of this group must be approved by a majority vote at regular meetings; whether this works to enhance relative immutability or to diminish it seems fairly clear. In view of the fact that monetary policy has not changed appreciably for more than two decades, the full member vote would seem to be either a rubber stamp or an indication that the top executives of U.S. federal banking institutions are remarkably in tune with one another.

There are other reasons for the apparent consistency of the group in continuing to choose open market operations and interest rate targeting to fine-tune the economy. Discussions of monetary policy at the Fed usually begin with a report from the staff covering economic forecasts and outlining alternative policy options to those currently in place. Members then comment, and general discussion follows. The chairman, or a member chosen by the chairman, proposes wording for the policy directive to emerge from the meeting. Chappell and McGregor (2000) note that the chairman plays a major role in directing policy in two ways. First, through his influence on the language of the policy, he may be able to shift it in a direction he favors, subliminally influencing the reaction of the full committee. Second, that influence may be compounded by the fact that the chairman may have already shaped the content of the staff report beforehand. According to Chappell and McGregor (2000), the chairman has both consensus-building and agenda-setting powers; it may therefore be that all that is needed to understand why the FOMC has long preferred open market operations is to examine the biases and rationales of the chairmen with respect to the U.S. economy.

It should not be suggested, however, that there is never any dissent within the FOMC. "In the past, differences among the governors and the bank presidents have led to widely publicized conflicts within the FOMC over whether to respond more actively to a sluggish U.S. economy" (Chappell and McGregor 2000, 407), that is, whether to return to a more activist stance than the open market operations approach allows.

In fact, during 1992, under the first Bush administration, three of the governors were prepared to manipulate the discount rate in order to mitigate some of the effects of the economic slowdown. Two others were concerned that the Fed had already lowered rates too much and eased monetary policy too far (Chappell and McGregor 2000, 407). That change did not occur, however, because by requiring directives to result from committee consensus, such changes are also slow in coming unless pushed forward by the chairman through his considerable influence.

Despite all these factors suggesting that consensus would be the likely outcome in almost all cases, Chappell and McGregor (2000) also documented "the considerable diversity in policy preferences of FOMC members over the 1966–1996 time period" (407). Despite this diversity, Chappell and McGregor concluded that accurately describing the forces underlying FOMC policy choices would ultimately be useful in ensuring ethical behavior by politicians. They noted, however, that despite the dissent, the policy did not change.

By 2004, Chappell, writing with McGregor and Vermilyea, was prepared to claim that although decisions are "formally majoritarian" at the Federal Reserve FOMC, "the Board Chairman has often been portrayed by the media as a monetary policy dictator" (Chappell et al. 2004, 906).

In May 1982, U.S. News and World Report listed Fed Chairman Paul Volcker as the second most powerful person in the United States. The academic literature on monetary policy making similarly suggested a very prominent role for the chairman. Woolley, as noted by Chappell et al., made the connection between the person and power of the Federal Reserve Chairman and monetary policy decisions, observing that "the Chairman's roles as liaison with external clients and resource allocator within the Fed give him leverage over the FOMC, and other research has documented both the influence of various Chairmen on monetary policy decisions and the factors that have shaped their policy positions" (Chappell et al. 2004, 906).

In their earlier study, Chappell and McGregor (2000) suggested that there was internal dissent in the FOMC. By 2004, however, they noted that internal consensus — or at least the consensus arrived at in the process of issuing policy directives — gives the Fed "power and credibility in dealing with external clients, including the President, the Congress, and the public" (Chappell et al. 2004, 906). In setting the policy favoring open market operations, however, the Chairman's preference still dominates. Chappell et al. note:

Although the need to garner majority support and achieve consensus may sometimes limit the power of the Chairman, the presence of an ethic favoring consensus might accentuate it. For example, if members are reluctant to challenge proposals offered by an agenda-setting Chairman, then he may be able to tilt outcomes toward his favored positions (Chappell et al. 2004, 906).

It would appear that while the preferences of any given set of Fed governors and Reserve Bank presidents can influence monetary policy and the continuing preference for open market operations, it has been — at least since the Reagan administration — primarily the Chairman's desires that cause that policy to remain in effect.

Shrinking Government Debt and the Open Market Operations Policy

Schreft and Smith (2002) noted that for several decades, the Federal Reserve had relied "almost exclusively" on open market operations in Treasury securities in order to supply liquidity. During the Clinton administration, however, there were significant budget surpluses, leading some commentators to wonder about the implications for the open market operations policy. The conclusion of their model was that "as long as the supply of government debt exceeds the demand for reserves at the desired target, monetary policy with the desired inflation target can be implemented through open market operations with no difficulty" (Schreft and Smith 2002, 848).

On the other hand, with declining debt, the model holds that the supply of reserves will become so limited that the central bank will no longer be able to provide the desired degree of liquidity to support its inflation objective (Schreft and Smith 2002, 848). This would be less problematic if the Federal Reserve were more willing to use reserve requirements as part of its monetary policy. However, as long as reserves must be supplied from open market operations, problems arise, and the "central bank must resign to the fact that it cannot supply enough liquidity to meet the demand associated with its original inflation objective. Instead, it must operate with a higher inflation objective, where the limited supply of reserves can satisfy the reduced demand corresponding to the higher opportunity cost associated with the higher inflation rate" (Schreft and Smith 2002, 848). Should debt sink further and further, policy would need to keep adjusting by accepting higher rates of inflation; the ultimate problem would be that equilibrium would cease to exist, and the open market operations system would become more chaotic than "open."

What, then, impels the Federal Reserve Bank to cling steadfastly to the open market operations preference, especially in light of a worsening federal deficit?

Possibly it is the knowledge that if the situation became truly dire, the Federal Reserve could simply resolve the difficulty by uncoupling the supply of reserves from the government debt — in other words, moving away from open market operations in Treasury securities as the main vehicle by which liquidity is supplied. This could be accomplished by relying on the discount window to provide liquidity, "which in principle diffuses the problem altogether" (Schreft and Smith 2002, 848). It is possible to view the open market operations paradigm as one that, by experience, the FOMC has found works best except, perhaps, at the extremes of possible economic conditions. Therefore, until those extremes have been reached — as they arguably were during the stagflation of the 1970s — the open market operations approach will continue.

Another possible tactic in the event of economic distress would be replacing Treasury securities with other assets, or alternatively, expanding the use of repurchase agreements.

One must assume throughout that the macroeconomic objective of the Federal Reserve is to maintain long-term price stability and foster maximum sustainable GDP growth. Because of what he sees as the ease of carrying out adjustments to a strict open market operations stance, Orphanides does not regard shrinking government debt as a severe problem for open market operations policy. Of course, at the current time, government debt is not shrinking but expanding at an enormous rate, especially in comparison to the quite substantial reduction of debt under the Clinton administration. It has apparently not yet reached the critical point at which the FOMC would consider a more activist approach similar to the pre-stagflation manipulations of the money supply.

It is likely that Schreft and Smith, and others who think the open market operations framework can be easily adjusted and is therefore worth keeping, have been influenced by historical precedent. In its first decade, the Federal Reserve System did rely primarily on discounting for extending credit; it has, however, been a very long time since that was the case, with open market operations having become the norm for more than two decades.

It also seems almost as if the Federal Reserve is preserving the open market operations policy so that, should it become necessary, it can create a mirror image of the System's first decades. Schreft and Smith believe that, should a move out of Treasury securities become necessary over the next two decades, it would be no more than a mirror image of the "gradual increase in Federal Reserve holdings of government securities during the System's first two decades of operations" (Schreft and Smith 2002, 848).

Conclusion

In hindsight, it seems that the open market operations approach is the only sensible approach to an economy as large and diverse as the U.S. economy. The economic turmoil of the 1970s arguably delineated the change from the old industrial economy to the new global economy, even though that term was a couple of decades away. By then, the U.S. economy had become extremely diverse, and the country was deeply involved in global initiatives that had a greater and less manageable impact on the domestic economy than previous global exploits had. The Vietnam experience, for example, brought far greater opportunities for chaos in political and financial markets than had World War II or even Korea, which were single-minded pursuits of an identifiable and broadly supported goal. By the 1970s, the computer revolution was in its infancy, global political alignments were shifting rapidly, and the last colonies of the major exploration-age superpowers — France and Great Britain — were gaining independence and becoming players, for good or ill, in the global economy.

It seems almost naive in hindsight to think that direct manipulation — the activism Orphanides describes — could possibly have been effective in such a chaotic environment, in which the major need was stability. Volcker appears to have recognized this; Greenspan continued the course. Whether the economy is currently approaching one of those critical extremes — in this case, with government deficits fueling the extension — remains debatable. Meanwhile, it is clear from more than two decades of experience that the open market operations method of managing the U.S. economy has a great deal to recommend it.

Works Cited

Chappell, Henry W., Rob Roy McGregor, and Todd Vermilyea. "Majority Rule, Consensus Building, and the Power of the Chairman: Arthur Burns and the FOMC." Journal of Money, Credit & Banking 36.3 (2004): 407+.

Chappell, Henry W., Jr., and Rob Roy McGregor. "A Long History of FOMC Voting Behavior." Southern Economic Journal 66.4 (2000): 906+.

Federal Reserve. "Open Market Operations." 2005. federalreserve.gov.

Orphanides, Athanasios. "Monetary Policy Rules, Macroeconomic Stability, and Inflation: A View from the Trenches." Journal of Money, Credit & Banking 36.2 (2004): 151+.

Schreft, Stacey L., and Bruce D. Smith. "The Conduct of Monetary Policy with a Shrinking Stock of Government Debt." Journal of Money, Credit & Banking 34.3 (2002): 848+.