Open Market Operations

As you know, I recently posted a question which you can find here. The question asks what you would do based on a number of different events if you were to work at the Open Market Operation desk at the New York Federal Reserve. To answer this question, there is one thing you need to know, that being what it is you do. When working at the desk, your job is to keep the Federal funds rate (ie, the rate at which banks lend to each other) at the target rate. I'll explain:

When the Federal Reserve sets an interest rate target, it means that the Fed will provide an unlimited amount of money to keep the interest rate at that target. When banks need funds, they go to the Federal funds market to borrow from banks. If, for some reason, banks within that market are not lending, the interest rate will begin to creep up. If there was no one at the Fed watching this, interest rates would sky rocket and the economy would plunge into a depression. So, when they see the interest rate beginning to creep up, they start buying US Treasury bonds, which injects cash into the economy, bringing the interest rate back to the target. The same goes if the interest rate begins to fall. The Fed will start selling bonds to bring it back up to the target. These actions help keep the economy stable and keep interest rates from going out of control.

So where does the desk come in? The desk the one that buys and sells the bonds keeping the interest under control. These trades are called Open Market Operations. The Federal Reserve ALWAYS has someone at the desk preforming these OMOs during trading hours, as without that person, interest rates would fluctuate, and it could have very detrimental effects on the economy. For example, right now during the current recession, without someone at the desk, the Federal funds rate would probably be a lot higher, preventing growth.

Therefore, in response to the problem, there is only one thing you can alter: When the Federal funds rate rises above the target, you start buying bonds to bring it back down. True, the oil prices, China, the commercial bank failure, and the press conference do have economic implications, but there is nothing you can do about those. True, it is possible that the bank failure may be the cause of the rate going up, but there is nothing you can do about that. So, the answer is: When the Federal funds rate starts going up, start buying bonds to bring it back down to the target. Everything else is out of your control.



-The Economist