Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Open Market Operations to Steer the Economy
Transcript
- Lucas: So when people talk about central banks raising interest rates, the picture in their head is usually a committee vote, a press release, and then the next day rates go up. But the actual mechanism—the thing the Fed does at 9:30 in the morning to make that rate stick—is called an open market operation. And it's both simpler and more intricate than most people realize. Luna: Right, the Fed doesn't just announce a rate and hope for the best. There's a whole plumbing system underneath. So what exactly is an open market operation? Lucas: At its core, it's the buying or selling of government securities—usually Treasury bonds—by a central bank in the open market. When the Fed buys a Treasury bond from a bank, it credits that bank's reserve account at the Fed. That adds reserves to the banking system, pushes down short-term interest rates. When the Fed sells a Treasury bond, it drains reserves, pushing rates up. Luna: And this is the tool they use day-to-day to hit the federal funds rate target they announced at the FOMC meeting? Lucas: Exactly. The federal funds rate is the rate at which banks lend reserves to each other overnight. The Fed can't directly control that, but by adding or draining reserves through open market operations, they influence the supply and demand for reserves, which moves the rate. It's the most hands-on thing they do. Luna: But isn't that a bit old school? I mean, since 2008, the Fed has been using interest on excess reserves as a primary tool. Open market operations seem almost quaint. Lucas: Great point. And you're right—since the financial crisis, the Fed moved to what's called an 'ample reserves' regime. Before 2008, they had scarce reserves and fine-tuned the rate with small daily open market operations. Now, with trillions in reserves, they rely more on the interest rate they pay on reserves, or IOER, to set a floor. But open market operations didn't disappear. They just changed form. Luna: Changed how? Lucas: Instead of small daily operations, they now do large-scale asset purchases—QE—during crises, and they use repos to manage short-term liquidity. For example, in September 2019, repo rates spiked to almost 10 percent, and the Fed had to step in with overnight repo operations. That was a classic open market operation, just bigger and more emergency-driven. Luna: And those repo operations—how do they work exactly? Lucas: A repo, or repurchase agreement, is essentially a collateralized loan. The Fed lends cash to a bank or primary dealer in exchange for Treasury securities as collateral, with an agreement to reverse the trade the next day. That adds temporary reserves to the system. It's an open market operation because the Fed is buying the security with a promise to sell it back. Luna: So in 2023, when the Fed was still tightening, did they actually sell securities from their balance sheet, or was it all rate hikes on reserves? Lucas: A bit of both. They raised the policy rate by hiking IOER, but they also let their balance sheet shrink through quantitative tightening—QT. That's essentially the reverse: they stopped reinvesting maturing securities, which is a passive form of open market sales. The cumulative effect by mid-2026 has been a reduction of about $1.6 trillion in the Fed's portfolio since 2022. Luna: And that's not a sale, it's just letting them roll off. But it still drains reserves. Lucas: Exactly. Now, one interesting nuance: the Fed operates in the Treasury market, but it also deals in agency mortgage-backed securities. During QE, they bought MBS too. And as of June 2026, they're still holding about $2.4 trillion in MBS, which creates this political question about whether a central bank should be in the housing finance business. Luna: Right, because when they buy MBS, they're effectively subsidizing mortgage rates. So open market operations have distributional effects, not just aggregate effects. Lucas: Precisely. And that's one reason why the composition of the balance sheet matters. The Fed's outright holdings of Treasury securities are about $4.8 trillion as of last month. That's still well above pre-crisis levels, but they've been gradually shifting toward shorter maturities to avoid distorting the long end of the curve. Luna: Operation Twist, but for the 2020s. Lucas: Exactly that. In 2011 and 2012, the Fed sold short-term Treasuries and bought long-term ones to flatten the yield curve. Today, they're doing the opposite in a way—letting long-term securities roll off while keeping short-term ones, which steepens the curve. That's all open market operations, just with a maturity twist. Luna: Let's bring this down to a smaller central bank for a second. The Bank of Canada, for instance, doesn't have as deep a bond market. How do they manage? Lucas: They actually use a different framework. The Bank of Canada targets a specific overnight rate, but instead of doing daily open market operations, they use a corridor system with a standing liquidity facility. They set a ceiling with the Bank Rate and a floor with the deposit rate. The overnight rate trades between those two. They do occasional open market operations to manage settlement balances, but it's much less frequent than the Fed. Luna: So the tool is universal, but the implementation depends on market depth and institutional design. Lucas: Right. And in the euro area, the ECB does weekly main refinancing operations—basically open market operations with a one-week maturity. They also have longer-term operations. But the key is that every central bank uses some form of asset purchase or sale to steer the rate, even if they call it something different. Luna: One thing that's always confused me: when the Fed does a repo, is that an open market operation or not? Lucas: Technically, yes. The Fed defines open market operations as the purchase or sale of securities in the open market. A repo is a purchase with a simultaneous agreement to sell. So it's an open market operation, just a temporary one. The Fed's Trading Desk at the New York Fed handles all of this, and they have a whole suite of tools: outright purchases, outright sales, repos, and reverse repos. Luna: And the reverse repo facility is what they use to drain reserves, right? In 2023, the overnight reverse repo facility was taking in over $2 trillion a day. Lucas: That's right. The ON RRP, as it's called, allows money market funds and other eligible counterparties to lend cash to the Fed overnight in exchange for Treasury collateral. That drains reserves because it moves cash from the private sector to the Fed's balance sheet. At its peak in June 2023, it hit $2.3 trillion. As of this month, it's down around $300 billion as reserves have normalized. Luna: So the plumbing has gotten more complex, but the core idea is still: buy securities to add reserves, sell them to drain. Lucas: Exactly. And that's why understanding open market operations is fundamental. It's the lever behind the lever. The FOMC sets the target, but the Desk makes it real.