Basic Process

• First, after evaluating the state of the economy, the Fed determines whether the money supply needs to increase or decrease and by how much.


• Second, if the Fed wants to increase the money supply it buys U.S. Treasury securities through open market operations and if it wants to decrease the money supply it sells securities.


• Third, the act of buying or selling Treasury securities causes a change in bank reserves. If the Fed buys, then bank reserves increase. If the Fed sells, then bank reserves decrease.


• Fourth, the change in reserves induces banks to change its lending activity. With more reserves, banks are willing to make more loans. With fewer reserves, banks are willing to make fewer loans.


• Fifth, the change in bank lending affects the creation of checkable deposits, which are an important component of the money supply. More loans mean more deposits and an increase in the money supply. Fewer loans mean fewer deposits and a decrease in the money supply.


• Sixth, the change in bank lending also affects interest rates. If banks are willing to lend more, then interest rates fall. If banks are willing to lend less, then interest rates rise.

Buy or Sell, More or Less

• Expansionary Monetary Policy: An increase the money supply and a reduction in interest rates results when the Fed buys U.S. Treasury securities in the open market. This is the recommended monetary policy to counter a recession, to stimulate the economy, and to reduce the unemployment rate.


• Contractionary Monetary Policy: A decrease the money supply and a boost in interest rates results when the Fed sells U.S. Treasury securities in the open market. This is the recommended monetary policy to counter an overheated expansion, to put the brakes no the economy, and to reduce the inflation rate.

Why Treasury Securities?

Treasury securities come in a wide variety of denominations and maturities. Some Treasury securities mature in 30 days, others in 30 years. Some can be purchased for as little as a few thousand dollars, others for substantially more.

Once Treasury securities are issued by the U.S. Department of Treasury, they are regularly traded through a secondary market, much like corporate stocks are traded through the stock market. This market is one of the broadest and most active of all financial markets. In addition to the Federal Reserve System, commercial banks, corporations, and even individuals regularly buy and sell these legal claims. Transactions are commonly arranged through securities dealers.

While the Fed could choose from among a wide assortment of financial instruments to conduct open market operations (corporate stocks, corporate bonds, commercial paper, etc.), it uses Treasury securities for a couple of reasons:

• One, Treasury securities are traded through a broad, active market. Open market operations by the Fed are relatively small compared to the overall volume of activity. In other words, intense buying or selling by the Fed is unlikely to have a much of an impact on the market itself. Moreover, the Fed is assured of finding a trading partner for any buying or selling it needs to do.


• Two, the Fed, especially Federal Reserve Banks, have significant ownership of Treasury securities. Because Treasury securities are an extremely safe, secure investment, the majority of Federal Reserve Bank assets are invested in these financial instruments (rather than corporate stocks, corporate bonds, commercial paper, etc.). If the Fed needs to sell, it has Treasury securities available. If it needs to buy, it can add Treasury securities to its existing stockpile.

The Federal Open Market Committee

The President of the New York Federal Reserve Bank is a permanent member of this committee and Vice Chairman of the FOMC. The remaining 4 slots are shared and rotated among the remaining 11 District Banks. One slot is shared by Boston and Philadelphia. Another is shared by Dallas, Atlanta, and Kansas City. A third by Cleveland, Chicago, and Richmond. And the fourth by San Francisco, Minneapolis, and St. Louis.

The New York President is a permanent member and serves as Vice Chairman because the New York Federal Reserve Bank is charged with carrying out specific open market operations. With New York City the financial center of the country, the New York Federal Reserve Bank is ideally suited for this task.

The 7 + 1 + 4 composition keeps the bulk of authority and power in the hands of the Board of Governors and the Chairman (the 7), while at the same time maintaining a channel for implementing monetary policy through the New York Federal Reserve Bank (the 1), as well as providing a decentralized nationwide input from the rest of the country through other Federal Reserve District Banks (the 4).

The FOMC usually meets 8 times a year, approximately every 6 weeks, and more often if needed, to evaluate the course of open market operations and determine if changes are needed.

How It All Works

The Domestic Trading Desk is then responsible for implementing the conducting the actually trades. It does this sending messages to a selected group of about 30 securities dealers who specializing in the U.S. Treasury securities. These dealers have 15 minutes to respond back with a indication of their willingness to buy participate in the exchange of securities. Some dealers are willing, others are not. In fact, the "open" part of open market operations means that the trades are open to any of the securities dealers willing to participant. The Domestic Trading Desk then has 5 minutes to respond back to the each of dealers that the terms of the exchange is acceptable.

Once all parties have agreed on the exchange terms, the resulting transactions work much like any other. If the Fed buys, then it collects the securities from the dealers in exchange for checks. If the Fed sells, then the dealers collect the securities from the Fed in exchange for checks. In both cases, the checks are cleared much like any of the millions of checks process each day.

There is, however, one big difference.

When the Fed buys, it makes payment with checks written on the New York Federal Reserve Bank rather than commercial banks. The securities dealers deposit these checks as then would any others. As the checks are processed, reserves are added to commercial banks used by the securities dealers. With a normal check, the addition of reserves to these commercial banks would be offset by a reduction of reserves at other commercial banks.

Not so with open market operations. There is no offsetting reduction of reserves at other commercial banks. The accounting balance is achieved by the addition of U.S. Treasury securities to the asset side of the Fed. What this means is that the banking system receives a net gain in reserves, which it can then use to make loans, create deposits, and expand the money supply. And because more reserves are available for lending, banks are also willing to charge lower interest rates.

When the Fed sells, it collects payment with checks written on the commercial bank accounts used by the securities dealers. As these checks are processed, reserves are deducted from the commercial banks used by the dealers.

However, unlike normal check processing, there is no offsetting addition of reserves at other commercial banks. The accounting balance is also achieved by the reduction of U.S. Treasury securities on the asset side of the Fed. In this case, the banking system ends up with a net loss in reserves, which means it makes fewer loans, creates fewer deposits, and contracts the money supply. And because fewer reserves are available for lending, banks are now inclined to charge higher interest rates.

Accommodating Trades

These sorts of open market operations are accommodating trades, or reactive open market operations. They are designed to accommodate for other disruptions, usually temporary, in the economy or the banking system that might affect bank reserves and interest rates.

These means that open market operations actually come in two varieties--reactive and proactive.

• Reactive open market operations respond to day-to-day economic and banking conditions. They are designed to stabilize the normal ebb and flow of banking activity without seeking an overall increase or decrease in the money supply. The Fed might buy securities one day to counter a temporary reduction in reserves caused by unusual cash withdrawals, then sell securities a few days later to counter a temporary increase in reserves caused by a big influx of end-of-the-month paychecks. Reactive operations generally balance out over the course of a few days--a little buying one day, then a little selling the next. Without such operations, banking operations would be a great deal more volatile.


• Proactive open market operations are intended to change the overall money supply to stabilizing business cycles, reduce unemployment and inflation, and promote economic growth. Proactive operations are longer term and sustained. The Fed might continue to buy securities over a period of several days or weeks as it seeks to increase the money supply and stimulate the economy. Alternatively, it might sell securities for an extended period to decrease the money supply and reduce inflation.

Two Other Tools

• Discount Rate: The Fed can adjust the interest rate that it charges banks for borrowing reserves. Higher or lower rates affect the amount of excess reserves that banks have available to make loans and create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which they can use to make more loans at lower interest rates, which then increases the money supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use to make fewer loans at higher interest rates, which then decreases the money supply. Changes in the discount rate are most often used as a signal for monetary policy actions.


• Reserve Requirements: The Fed can further adjust the proportion of reserves that banks must keep to back outstanding deposits (the reserve ratio). Higher and lower rates affect the deposit multiplier and the amount of deposits banks can create with a given amount of reserves. If the Fed lowers reserve requirements, then banks can use existing reserves to make more loans and thus increase the money supply. If the Fed raises reserve requirements, then banks can use existing reserves to fewer more loans and thus decrease the money supply. This tool is seldom used as a means of controlling the money supply.