How Interest Rates Are Related to Open Market Operations

Interest rates are indirectly affected by open market operations (OMOs); the buying and selling of government securities in the public financial exchanges. OMOs is a tool in monetary policy that allows a central bank to control the money supply in an economy. Depending on the condition of the economy, central banks will seek to implement either contractionary or expansionary monetary policy.

Open Market Operations and Interest Rates

Under a contractionary policy, a central bank sells securities on the open market, which reduces the amount of money in circulation. Expansionary monetary policy entails the purchase of securities and an increase in the money supply. Changes to the money supply affect the rates at which banks lend to one another, a reflection of the basic law of supply and demand.

In the U.S, the federal funds rate is the interest rate at which banks borrow reserves from one another overnight to meet their reserve requirements. This is the interest rate that the Federal Reserve targets when conducting OMOs. Short-term interest rates offered by banks are based on the federal funds rate, so the Fed can indirectly influence interest rates faced by consumers and businesses by the sale and purchase of securities.

When the Fed buys securities from banks, this in theory increases their money supply; they have more money to lend. When banks have more money to lend, they want to offload that money by earning interest on it rather than having it sit idle. When this happens, a bank will reduce its interest rates to make borrowing attractive.

Conversely, when the Fed sells securities to banks, this means they have less money on hand to lend out. The less money on hand means that banks will increase interest rates to earn the most on their limited supply of reserves.

Real-World Examples

In 1979, the Fed under Chair Paul Volcker began using OMOs as a tool. To combat inflation, the Fed started selling securities in an attempt to reduce the money supply. A year later, the number of reserves shrank enough to push the federal funds rate as high as 20%. 1981 and 1982 saw some of the highest interest rates in modern history, with average 30-year fixed mortgage rates rising above 16%.

Conversely, the Fed purchased over $1 trillion in securities in response to the 2008 recession. This expansionary policy, called quantitative easing, increased the money supply and drove down interest rates. Low interest rates helped stimulate business investment and demand for housing.

The Bottom Line

One of the tools used to affect monetary policy by a central bank is open market operations; the buying and selling of securities. Depending on whether the central bank wants to employ a contractionary or expansionary monetary policy, it will sell or buy securities from banks, respectively.

This impacts the number of reserves that banks have on hand which affects the interest rates they charge on lending. The more reserves they have from selling securities, the lower the interest rates charged. The fewer reserves they have from buying securities, the higher the interest rates charged.