The Federal Reserve (the Fed) is one of the nation’s most important policy setting bodies. But once the Fed has set its monetary policy guidelines, it has to go out into the market and implement that policy. If the Fed wants to loosen its monetary policy, it has to find a way to get money into the financial system. If the Fed wants to tighten its monetary policy, it has to find a way to get money out of the financial system.
[VIDEO] The Federal Reserve’s Open Market Operations
But exactly how does the Fed go about doing that? How does the Fed get money into and out of the financial system? Let’s take a look at the following pieces of the Fed’s open market operations to find out:
– Trading desk at the Federal Reserve Bank of New York
– Primary dealers
– Repurchase agreements (repos)
Trading Desk at the Federal Reserve Bank of New York
The Federal Reserve Bank of New York has the task of implementing the Federal Open Market Committee’s (FOMC) monetary policy decisions. More specifically, the managers and traders at the New York Fed’s trading desk have the responsibility.
For instance, when the Fed wants to loosen monetary policy and lower the Federal Funds rate, the traders at the Fed’s trading desk inject cash into the financial system. When the Fed wants to tighten monetary policy and raise the Federal Funds rate, the traders at the Fed’s trading desk extract cash from the financial system.
But how do the traders at Fed’s trading desk put money into and take money out of the market, and who takes or gives the money the Fed is looking to put in or take out? They do it by creating repurchase agreements (repos) with primary dealers.
Repurchase Agreements (Repos)
A repurchase agreement (repo) is an agreement between two parties in which the buyer agrees to buy an asset from the seller on the condition that the seller will buy the asset back at a specified price at a future date. When the initiating party is selling a security with the promise to buy it back in the future, it is called a repo. When the initiating party is buying a security with the promise to sell it back in the future, it is called a reverse repo.
Typically, when the Fed is creating repos and reverse repos with its primary dealers, it uses Treasury securities as the asset in the transaction. Also, when referring to repos in which the Fed is one of the parties, people refer to the repos from the point of view of the primary dealer. So here’s how it works.
When the Fed wants to inject money into the system, it buys Treasury securities from its primary dealers in a repo. This puts extra cash into the hands of the primary dealers that they can then disseminate throughout the financial system. When the Fed wants to extract money from the system, it sells Treasury securities to its primary dealers in a reverse repo. This takes cash out of the hands of the primary dealers, which prevents them from disseminating it throughout the financial system.
The Federal Reserve deals directly with a group of companies called primary dealers in its open market operations. A primary dealer is a securities dealer that has an agreement with the Fed to participate directly with the people running the trading desk at the Federal Reserve Bank of New York. As part of their agreement with the Fed, primary dealers are required to submit offers from and sell securities to the Fed.
The following companies are the current primary dealers with whom the Fed deals directly:
– BNP Paribas Securities Corp.
– Bank of America Securities LLC
– Barclays Capital Inc.
– Cantor Fitzgerald & Co.
– Citigroup Global Markets Inc.
– Credit Suisse Securities (USA) LLC
– Daiwa Securities America Inc.
– Deutsche Bank Securities Inc.
– Dresdner Kleinwort Securities LLC
– Goldman, Sachs & Co.
– Greenwich Capital Markets, Inc.
– HSBC Securities (USA) Inc.
– J. P. Morgan Securities Inc.
– Merrill Lynch Government Securities Inc.
– Mizuho Securities USA Inc.
– Morgan Stanley & Co. Incorporated
– UBS Securities LLC