Open market purchases raise bond prices, and open market sales lower bond prices. So, open market operations (OMOs) affect bond prices. Interest rates are negatively related to bond prices. It follows that open market purchases decrease interest rates, and open market sales increase interest rates.
Key Takeaways
- Open market purchases raise bond prices, and open market sales lower bond prices.
- When the Federal Reserve buys bonds, bond prices go up, which in turn reduces interest rates.
- Open market purchases increase the money supply, which makes money less valuable and reduces the interest rate in the money market.
- OMOs involve the purchase or sale of securities, typically government bonds.
How Open Market Purchases Affect Bond Prices
When the Federal Reserve buys bonds through open market operations, the Fed is increasing the demand for bonds. If an individual buys bonds, it is not enough to move prices up in the market. However, the Fed may spend hundreds of billions of dollars buying bonds through OMOs. The result of the Fed’s open market purchases is an increase in demand that is large enough to raise bond prices. Existing bondholders wanted those bonds for various reasons, so the Fed must offer them higher prices to convince them to sell.
How Buying Bonds Affects Interest Rates
When the Federal Reserve buys bonds, bond prices go up, which in turn reduces interest rates. The direct effect of a bond price increase on interest rates is easiest to see. If a $100 bond pays $5 per year in interest, then the interest rate on that bond is 5% per year. If the bond price goes up to $125, then $5 per year in interest is only a 4% interest rate.
In fact, the effect of a bond price change is stronger because the principal repaid at the end also remains constant. Suppose that the bond paying $5 per year had a face value of $100 and a time to maturity of 25 years. The change in the bond price from $100 to $125 would also result in a capital loss of $1 per year. The yield of the bond would drop from 5% to about 3%.
Finally, the Fed buys bonds with cash. The countries, firms, and individuals that the Fed bought bonds from now have more cash. Since they have more cash, the money supply has increased. Open market purchases increase the money supply, which makes money less valuable and reduces the interest rate in the money market.
Understanding Open Market Operations
OMOs are a tool used by central banks to implement monetary policy. OMOs involve the purchase or sale of securities, typically government bonds. Open market operations indirectly influence the federal funds rate, which serves as an interest rate for loans between banks. Banks must often borrow funds from each other to meet overnight reserve requirements. These funds are loaned at an interest rate called the federal funds rate.
By affecting the money supply through OMOs, the Fed can influence the federal funds rate. Low reserve borrowing rates make it relatively easy for banks to procure money, leading to lower interest rates for businesses and consumers. Bond prices are negatively related to interest rates. When interest rates go up, existing bonds bearing the old coupon rates are no longer as valuable as new bonds with the higher coupon rate. On the open market, the price of lower-interest bonds must fall to make the expected return equal for all comparable bonds.
Open Market Operations After 2008
From 2008 to 2013, the Federal Open Market Committee (FOMC) targeted extremely low-interest rates to rescue the US economy after the financial subprime rate collapse crisis and keep financial institutions in business. As part of this expansionary policy, the Fed purchased Treasuries and mortgage-backed securities. This increased the money supply, drove down interest rates, and sent bond prices higher.
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