The Federal Reserve sets interest rates not by decree but through open market operations — buying and selling securities to influence the supply of bank reserves. Here’s the mechanism.
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Open market operations (OMOs) are the Federal Reserve's primary day-to-day tool for implementing monetary policy — the buying and selling of U.S. Treasury securities in the open market to influence the federal funds rate and the level of bank reserves in the financial system. They are called "open market" operations because the Fed transacts in the open market (through primary dealer banks) rather than directly with the government or through administrative mandate.
When the Fed buys Treasury securities, it pays for them by crediting the reserve accounts of the selling banks — injecting money into the banking system and putting downward pressure on the federal funds rate (the overnight rate banks charge each other for reserve loans). When the Fed sells securities, it removes reserves from the system, putting upward pressure on the federal funds rate. By buying and selling in sufficient volume, the Fed can keep the federal funds rate within its target range.
The Federal Open Market Committee (FOMC) sets the target range for the federal funds rate at its eight annual meetings. The New York Fed's Open Market Trading Desk — known as "the Desk" — then executes the operations needed to keep the actual rate within the target band.
In the pre-2008 system, when bank reserves were scarce, even small OMOs had significant rate effects — a $5-10 billion operation could move the fed funds rate meaningfully. In the post-QE world, where the banking system holds trillions in excess reserves, this traditional OMO mechanism became less effective. The Fed shifted to paying interest on reserve balances (IORB) as the primary rate control mechanism — by setting the rate it pays on reserves, the Fed establishes a floor for the fed funds rate, since no bank will lend at less than what it can earn from the Fed.
OMOs come in two forms:
Temporary operations (repos and reverse repos) are short-term: the Fed buys securities with an agreement to sell them back shortly (repo, which injects reserves temporarily) or sells securities with an agreement to buy them back (reverse repo, which drains reserves temporarily). These manage day-to-day fluctuations in reserve supply.
Permanent operations are outright purchases or sales of securities with no reversal agreement. When the Fed engages in large-scale permanent purchases — as in QE1 through QE4 — it is using open market operations at scale to suppress long-term interest rates, not just to hit the overnight rate target. The QE programs were OMOs in structure but monetary policy tools in ambition.
An important post-2020 development was the surge in use of the Fed's Overnight Reverse Repo (ON RRP) facility, through which money market funds and other eligible counterparties can deposit excess cash at the Fed overnight in exchange for Treasury securities, earning the ON RRP rate. At peak (2022-2023), over $2 trillion was parked in ON RRP daily — a reflection of the enormous excess liquidity the COVID QE programs had injected and the lack of T-bill supply to absorb it.
Understanding OMOs helps decode Fed communications. When the Fed says it is "adding reserves," it's buying Treasuries — typically accommodative. When it says it is "draining reserves" or allowing its balance sheet to "run off," it is removing accommodation. The language of central banking maps directly onto the mechanics of open market operations. See The Federal Reserve Explained, what is quantitative easing, and central bank inflation controls.