Does it cost the Fed a whole bunch of money every time it conducts
open-market transactions to reduce or increase the money supply?  It
seems like it would.  If it does, who pays?  The Fed itself or
taxpayers?

Here's my thinking:

Either the Fed wants to increase the money supply, in which case it
will buy bonds from the public.

Or it wants to decrease the money supply, in which case it will sell
bonds to the public.

In either case, it seems to me, the only way they can make the buying
or selling of bonds palatable to the investment community is by
monkeying with the interest rate.

BUT...

naturally the interest rate is made appealing and advantageous to the
public by exactly the same amount it is disadvantageous to the Fed.

So, for example, if the Fed wants to sell a pile of bonds, they will
raise the interest rate.  The public gets more money.

Have I got this all wrong, or am I basically on the ball?

Because if I'm right, open-market transactions must cost SOMEBODY
billions of dollars every time the Fed orders them.  But who pays?

you have a couple of basic flaws in your market theory which may be
causing you some distress. first the fed does not deal with the
public. open-market transactions are conducted by the federal reserve
bank of new york with other banks. second, when the fed sets monetary
policy and makes a decision to either add or subtract reserves from
the system there is no negotiation, they just do it. the fed makes its
purchases or sales through a bank and either adds or subtracts
reserves as necessary in the bank's reserves account. the bank then
either has more or less money available to lend. that in turn tends to
either increase or decrease interest rates, capital spending and
general economic activity. what is most directly being effected is the
fed funds rate which is an interbank market.

hmmmm.  that's interesting.  thanks for your comment.  but now I'm
unclear on a related point.

when you say that the fed "just does it" and that there's no
negotiation, which banks exactly is the Fed doing this to?  All banks
evenly?  Or merely to the banks directly overseen by the Fed?

Because, from the affected bank's point of view, this seems pretty
unfair.  Here they have all this cash to play with, then the Fed just
steps in an unilaterally confiscates it, replacing it with bonds which
the bank cannot use as money?

It seems like the banks would be pretty pissed off, unless they get
something out of this deal I'm not seeing.  Why would they submit to
having billions of dollars of investable cash taken from them without
any negotiation?

What happens, for example, if this would put the bank's reserves below
the required level?  Are they now forced to borrow money from the Fed
to get their reserves back up to the legal level?  This would seem to
be costing them money.

What are they getting out of it?

First off, the Fed doesn't really have control over interest rates. Go
to http://bonds.yahoo.com/rates.html for a graphic of the yield curve.
The Fed sets by fiat the overnight Federal Funds rate... this is the
only rate directly set by the Fed. This rate basically only affects
very short-term debt. So the Fed can control the short end of the
yield curve pretty easily, but the Fed's market power is too weak
compared to everyone else on the longer end of the yield curve. For
longer-term rates, all the Fed can do is "jawbone" the market.

As far as open market operations, keep in mind that the Fed has
hundreds of billions of dollars at its disposal. 1) The Fed can print
new dollar bills within reason 2) The Fed receives interest payments
from the US Treasury on all of the T-securities it holds; the vast
majority of that interest is refunded right back to the Treasury, but
the Fed can use it to finance any open market operations. At the same
time, the Fed pays no interest on the deposits of member banks that it
holds.

When targeting the money supply, the Fed doesn't care about interest
rates. It just wants to add/remove $X billion in the market. Since it
doesn't have to "make a profit" with its operations, it just does
whatever's necessary to reach the $X target... including buying above
the market price or selling below the market price. The Fed will make
sure the necessary profit incentive is there for the banks in order
for the Fed to get the outcome it desires.

The Open Markets desk is in New York City. Banks are registered with
the Fed and do business on an electronic bid/ask system. You have to
be a big boy to play, but the system is fair among the big boys. These
aren't the retail banking arms of the banks, so they're not worried
about reserve requirements.