Although monetary policy is made in Washington, open market operations are actually conducted in New York-in a well-guarded trading room on the eighth floor of the Federal Reserve Bank of New York, which is only a few blocks from Wall Street. The Federal Open Market Committee (FOMC) in Washington decides on the general aims and objectives of monetary policy, but then it is up to the manager of the System Open Market Account, who is located at the Federal Reserve Bank of New York, to do the actual buying and selling to carry out the FOMC’s intentions.
The location in the heart of the New York financial district puts the manager of the System Open Market Account in close contact with the government securities dealers the Fed does business with. Every morning of the work week, the account manager meets with some of the securities dealers to get the “feel of the market,” and even the opening handshakes (firm or limp? dry or sweaty palms?) probably reveal a hint of whether the market is likely to be strong or weak, bullish or bearish.
Feedback from the securities dealers is only one component of the vast array of data and information marshaled by the account manager in mapping plans for open market operations on any given day. The starting point, of course, is the stance of monetary policy as expressed by the FOMC with respect to bank reserves, the money supply, and interest rates. Given these targets, the account manager has to figure out how to achieve them by open market operations-whether to buy or sell, how much, from or to whom, and when.
Each morning, a little after 9:30, the account manager receives a report on the reserve position of the banking system as of the night before. A key indicator of whether the quantity of reserves is high or low relative to demand is provided by the federal funds rate, the rate charged on funds lent by one bank to another. If many banks have excess reserves and only a few have deficiencies, the federal funds rate is likely to fall, because there will be many eager lenders and few borrowers. On the other hand, if many banks have reserve deficiencies and only a few are in surplus, the rate will rise, because there will be many eager borrowers and few lenders. The federal funds rate thus provides the Fed with a sensitive barometer of reserve supply relative to demand.
A little later in the morning, the account manager is provided with a detailed projection covering expected movements in various items that can affect the reserve position of the banking system-including currency holdings of the public (which show considerable seasonal variation), deposits in foreign accounts at the Federal Reserve banks, and other technical factors. A change in any of these can cause reserves to go up or down and thereby affect bank lending capabilities, interest rates, and growth in the money supply. For example, as the public cashes checks in order to get more currency, commercial banks must pay out vault cash and thereby suffer a loss in reserves.
A call is also made to the U.S. Treasury to determine what is likely to happen to Treasury balances in tax and loan accounts at commercial banks- deposits of the U.S. government generated by tax payments of the public and receipts from bond sales-and to find out what is likely to happen to Treasury balances at the Federal Reserve banks, from which most government expenditures are made. As funds are shifted from Treasury tax and loan accounts in commercial banks to Treasury balances at the Federal Reserve, the commercial banking system loses reserves.
By 11:00 a.m., the account manager has a good idea of money market conditions, including what is happening to interest rates, and of anticipated changes in the reserve position of the banking system. The manager also knows what the FOMC wants. If the FOMC had asked for moderate growth in reserves to sustain moderate growth in the money supply, and if all the other technical factors just discussed are expected to pour a large volume of reserves into the banking system, the account manager may decide that open market sales are necessary to prevent an excessive expansion in reserves. If, on the other hand, reserves are expected to go up too little or even to decline as a result of these other forces, the Fed may engage in large-scale open market purchases. It is clear, therefore, why knowledge of the amount of government securities that the Federal Reserve bought or sold on a given day, or during a given week, in itself tells us almost nothing about the overall posture or intent of monetary policy. Many purchases and sales are used to offset technical influences on reserves.
At 11:15 it is time for a daily long-distance conference call with a member of the board of governors in Washington and one of the Federal Reserve bank presidents. The account manager outlines the plan of action for the day and explains the reasons for this particular strategy. Once the decision is approved, the purchase or sale of securities (usually Treasury bills) takes place.
The account manager instructs the traders in the trading room of the Federal Reserve Bank of New York to call the primary government securities dealers and ask them for firm bids for stated amounts of specific maturities of government securities (in the case of an open market sale) or for their selling price quotations for stated amounts of specific maturities (in the case of an open market purchase).
The account manager may instruct the Fed’s traders to buy or sell securities outright-that is, involving no additional commitments. Or they might decide to inject or withdraw reserves only temporarily, say for several days. One type of open market operation is particularly well suited to the temporary injection of reserves, namely, buying government securities under repurchase agreements. With a “repo” the Fed buys the security with an agreement that the seller will repurchase it on a specific date in the future, usually within a week or so. When the Fed buys, reserves go up, but when the security is sold back to the dealer a week or so later, reserves drop back down again.
A reverse repo is designed to do the opposite. It withdraws reserves from the banking system temporarily. With a reverse repo, also called a matched sale-purchase agreement, the Fed sells securities but simultaneously agrees to buy them back at a specific date in the future. When the Fed sells, reserves fall; but later when the Fed buys the securities back, reserves are restored.
In recent years, the Fed has relied to an increasing extent on repos and reverse repos. In terms of the dollar volume of open market operations, they now greatly exceed outright purchases and sales.
It takes only about half an hour for the traders to complete their “go-around” of the market and execute the open market operation. By 12:30 the account manager is back to monitoring bank reserve positions via the federal funds rate and to keeping track of trends in financial markets in general. If necessary to implement the original objective, the manager is prepared to engage in further open market operations during the afternoon.