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Open Market Operations Definition

Dictionary of Financial Terms

Open market operations are what the Fed does to keep the fed funds rate close to the target set by the Federal Open Market Committee. The fed funds rate is the rate at which banks lend to each other overnight, and the Fed keeps it on target by supplying as much liquidity as there is demand for at the target rate. If the Fed failed to supply enough liquidity, the fed funds rate -- the cost of money -- would rise as the supply fell. Conversely, if the Fed supplied too much liquidity, the fed funds rate would fall as supply outstripped demand.

The open market operations by which the Fed supplies liquidity to the banking system are purchases from and sales to dealers of Treasury and other debt securities. It works this way: When the Fed buys securities from a dealer, the dealer's bank see its reserves increase by the amount the Fed paid for the securities.

Open market operations are either permanent or temporary. The Fed buys or sells securities on a permanent, or outright, basis, when its forecasts indicate that the amount of liquidity in the banking system will continue to need adjustment. It buys or sells them on a temporary basis when a shortage or excess of liquidity in the system is viewed as short-lived.

An outright purchase of Treasury notes or bonds by the Fed is called a coupon pass. A temporary purchase is called a repurchase agreement, since the dealers agree to buy the securities back from the Fed on a certain date. Permanent and temporary sales of securities by the Fed to dealers are much less common than purchases.

Open market operations are conducted by the Fed's Domestic Trading Desk (a.k.a. the Open Market Desk) at the New York Fed.

Definitions of Financial Terms

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