Federal Reserve Open Market Operations

Question

I am trying to understand how the Fed effects the fed funds rate. Here it says:

Once the Federal Open Market Committee deems that economic conditions warrant a change in the money supply through specific open market operation, the command to buy or sell a specific amount of U.S. Treasury securities is passed down through the New York Fed President to what is called the Domestic Trading Desk of the New York Federal Reserve Bank. The Domestic Trading Desk is then responsible for implementing the conducting the actually trades. It does this sending messages to a selected group of about 30 securities dealers who specializing in the U.S. Treasury securities. These dealers have 15 minutes to respond back with a indication of their willingness to buy participate in the exchange of securities. Some dealers are willing, others are not. In fact, the "open" part of open market operations means that the trades are open to any of the securities dealers willing to participant. The Domestic Trading Desk then has 5 minutes to respond back to the each of dealers that the terms of the exchange is acceptable.

Once all parties have agreed on the exchange terms, the resulting transactions work much like any other. If the Fed buys, then it collects the securities from the dealers in exchange for checks. If the Fed sells, then the dealers collect the securities from the Fed in exchange for checks. In both cases, the checks are cleared much like any of the millions of checks process each day.

So the Fed manipulates the reserves of banks in order to increase or decrease fed funds, and it uses open market operations to do this. I am curious, though: what if in the case of "raising rates", the Fed wants to sell securities but no bank wants to buy them? And, why wouldn't a bank buy securities anywhere else?

Thanks,

Answer 1

The actual details of the auction and so on are interesting, but in principle there is no magic. Its just demand and supply:

There is a number of agents that can supply or demand treasury bonds as well as other bonds. There's the government that issues the treasuries, the Fed that sometimes holds them, sometimes sells them, investors of all kinds( brokers, pension funds, individuals, money market funds, etc). All these agents want to sell more if they deem the price high(rates too low) and they want to buy if they deem the price is low (rates too high).

When supply shrinks, then agents that want to buy these assets bid up their prices (bid down the rates). similarly, when supply expands then the price falls (the rate rises) as the buyers bid down the prices after observing the quantity.

To push up an interest rate, the fed will sell bonds. This will increase supply, until the price falls (i.e. until the rate rises). To push down an interest rate, the fed will buy bonds. This will decrease supply, until the price increases (i.e. until the rate falls).

I am curious, though: what if in the case of "raising rates", the Fed wants to sell securities but no bank wants to buy them? And, why wouldn't a bank buy securities anywhere else?

If no bank wants to buy the securities, but the fed is trying to sell them, then their price would go down, down, down, increasing the rate, until somebody wants them. If this rate is too high for the Fed, then it can instead buy these securities, lowering the market rate. In principle, if nobody wants to buy it means they are willing to sell, if nobody wants to sell it means they are willing to buy.

The banks can buy securities wherever they want, but the rates of all securities are closely related to each other. If the fed lowers rates on Treasuries, the rates on corporates, munies, etc, are all going to follow suit, at least to some extent. This is because the securities are all close substitutes of each other, so if you were thinking of buying a treasury, but its price increases, you go and, for example, you try to buy a muni, thereby increasing its price too.

Answer 2

Here is one explanation that takes deposits and reserve requirements into account:

The Fed’s purchase of a bond can be illustrated using a balance sheet. Suppose the Fed buys a bond for \$1,000 from one of Acme Bank’s customers. When that customer deposits the check at Acme, checkable deposits will rise by \$1,000. The check is written on the Federal Reserve System; the Fed will credit Acme’s account. Acme’s reserves thus rise by \$1,000. With a 10% reserve requirement, that will create \$900 in excess reserves and set off the same process of money expansion as did the cash deposit we have already examined. The difference is that the Fed’s purchase of a bond created new reserves with the stroke of a pen, where the cash deposit created them by removing \$1,000 from currency in circulation. The purchase of the \$1,000 bond by the Fed could thus increase the money supply by as much as \$10,000, the maximum expansion suggested by the deposit multiplier.