Interest rates are indirectly affected by open market operations (OMOs). OMOs are a tool in monetary policy allowing a central bank to control the money supply in an economy. Under contractionary policy, a central bank sells securities on the open market, which reduces the amount of money in circulation. Expansionary monetary policy entails the purchase of securities and an increase in money supply. Changes to the money supply affect the rates at which banks borrow reserves from one another due to the law of supply and demand.
The federal funds rate is the interest rate at which banks borrow reserves from one another overnight to meet the reserve requirement. This is the interest rate that the Fed targets when conducting OMOs. Short-term interest rates offered by banks are based on the federal funds rate, so the Fed can indirectly influence interest rates faced by consumers and businesses by the sale and purchase of securities.
In 1979, the Fed began using OMOs as a tool under Chairman Paul Volcker. To combat inflation, the Fed began selling securities in an attempt to reduce the money supply. The amount of reserves shrank enough to push the federal funds rate as high as 20%. 1981 and 1982 saw some of the highest interest rates in modern history, with average 30-year fixed mortgage rates rising above 18%. Conversely, the Fed purchased over $1 trillion in securities in response to the 2008 recession. This expansionary policy, called quantitative easing, increased the money supply and drove down interest rates. Low interest rates helped stimulate business investment and demand for housing.
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