FED Open Market Operations

Federal Reserve Act authorized the individual Federal Reserve banks to buy and sell in the open market

...at home and abroad, either from or to domestic or foreign banks, firms, corporations or individuals, cable transfers and bankers' acceptances and bills of exchange of the kinds and maturities by this Act made eligible for rediscount, with or without the indorsement of a member bank.... To buy and sell...bonds, notes and other obligations which are direct obligations of the United States or which are fully guaranteed by the United States as to principal and interest....

In the first years of their existence the Federal Reserve banks bought and sold in the open market bankers' acceptances for their own account and for the account of foreign central banks in order to develop a market for this credit instrument, to supply and withdraw reserves at their own initiative, to reinforce the credit control exercised through the discount rate, and to earn expenses and dividends. While the effort to build up an active acceptance market met only with limited success, it demonstrated to the Reserve authorities the potentiality of open market operations as a method of regulating the volume of bank credit.

Open market operations affect the total volume of reserves available to the banking system in a manner and at a time deemed desirable by the Reserve authorities. Although they cannot be directed to meet the requirements of specific banks, reserves supplied through open market purchases centered in New York quickly reach the banks that need them most, either through borrowing of Federal funds or sales of securities by such banks. The additional reserves are used by individual member banks to correct reserve deficiencies or to reduce their indebtedness to the Reserve banks. When individual banks do not need reserves, they usually lend or invest the acquired excess reserves to earn an income.

Open market purchases are likely to raise prices and lower yields of Government obligations. Owing to the large marketable public debt, the lower yield on Government obligations tends to affect other securities as well, resulting in a general decline in interest rates. Furthermore, the additional reserves may induce member banks, especially those located in financial centers, to lower interest rates on loans in an endeavor to employ the idle funds. Conversely, open market sales reduce member bank reserves, with the consequent tendency for interest rates to rise and security prices to decline. High interest rates discourage borrowing, especially flotation of long-term issues, and thus aid the Reserve authorities in their credit restraint policy.

As stated before, open market purchases have also been undertaken to support prices of Government securities even when such purchases conflicted with the credit restricting policy of the Reserve authorities.