Open market operations are a monetary policy tool used by central banks where the central bank buys or sells securities on the open market to increase or decrease the money supply and increase or decrease interest rates.
How Did Open Market Operations Evolve?
In the United States, the Federal Reserve Bank of New York conducts open market operations by generally buying or selling government bonds. The Federal Reserve discovered the usefulness of buying or selling government bonds just after WWI. As the Federal Reserve Banks purchased bonds on the open market, they noticed the money was placed in reserves at commercial banks. As the commercial banks increased their reserves, they were more active in issuing loans.
Open market operations have since evolved into one of the primary tools for the Fed in conducting monetary policy. Today the Fed uses open market operations to manage short term interest rates and liquidity as well as long term interest rates through the temporary or permanent purchase and sale of securities.
Why Are Open Market Operations Important to Investors?
As an investor, it is important to understand the impact open market operations have on yields and interest rates. When a central bank goes out into the market to purchase securities, it is bidding up the price which means the yield decreases. Similarly, if the central bank sells securities on the open market, it is competing against other sellers thus lowering the price. The result is a higher yield of that security.