Open market operation
In macroeconomics, an open market operation is an activity by a central bank to exchange liquidity in its currency with a bank or a group of banks. The central bank can either transact government bonds and other financial assets in the open market or enter into a repurchase agreement or secured lending transaction with a commercial bank. The latter option, often preferred by central banks, involves them making fixed period deposits at commercial banks with the security of eligible assets as collateral.
Central banks regularly use OMOs as one of their tools for implementing monetary policy. A frequent aim of open market operations is — aside from supplying commercial banks with liquidity and sometimes taking surplus liquidity from commercial banks — to influence the short-term interest rate. Open market operations have become less prominent in this respect since the 2008 financial crisis, however, as many central banks have changed their monetary policy implementation to a so-called floor system, in which there is abundant liquidity in the payments system. In that situation central banks no longer need to fine tune the supply of reserves to meet demand, implying that they may conduct OMOs less frequently. For countries operating under an exchange rate anchor, direct intervention in the foreign exchange market, which is a specific type of open market operations, may be an important tool to maintain the desired exchange rate.
In the post-crisis economy, conventional short-term open market operations have been superseded by major central banks by quantitative easing programmes. QE are technically similar to open-market operations, but entail a pre-commitment of the central bank to conduct purchases to a predefined large volume and for a predefined period of time. Under QE, central banks typically purchase riskier and longer-term securities such as long maturity sovereign bonds and even corporate bonds.
Process of open market operations
The central bank maintains loro accounts for a group of commercial banks, the so-called direct payment banks. A balance on such a loro account represents central bank money in the regarded currency.Since central bank money currently exists mainly in the form of electronic records rather than in the form of paper or coins, open market operations can be conducted by simply increasing or decreasing the amount of electronic money that a bank has in its reserve account at the central bank. This does not require the creation of new physical currency, unless a direct payment bank demands to exchange a part of its electronic money against banknotes or coins.
In most developed countries, central banks are not allowed to give loans without requiring suitable assets as collateral. Therefore, most central banks describe which assets are eligible for open market transactions. Technically, the central bank makes the loan and synchronously takes an equivalent amount of an eligible asset supplied by the borrowing commercial bank.
When a central bank sells securities, that diminishes the money supply because the money transfers from the overall economy into the central bank, as payment for the securities. This selling of securities affects the overall economy by decreasing demand for products, services, and workers, while increasing interest rates and decreasing inflation. When the central bank buys securities on the open market, that has the opposite effects from selling securities.
Theoretical relationship to interest rates
Classical economic theory postulates a distinctive relationship between the supply of central bank money and short-term interest rates:central bank money is like any other commodity in that a higher demand tends to increase its price.
When there is an increased demand for base money, the central bank must act if it wishes to maintain the short-term interest rate. It does this by increasing the supply of base money: it goes to the open market to buy a financial asset, such as government bonds. To pay for these assets, new central bank money is generated in the seller's loro account, increasing the total amount of base money in the economy. Conversely, if the central bank sells these assets in the open market, the base money is reduced.
The process works because the central bank has the authority to bring money in and out of existence. It is the only point in the whole system with the unlimited ability to produce money. Another organization may be able to influence the open market for a period of time, but the central bank will always be able to overpower their influence with an infinite supply of money.
Side note: Countries that have a free floating currency not pegged to any commodity or other currency have a similar capacity to produce an unlimited amount of net financial assets. Understandably, governments would like to utilize this capacity to meet other political ends like unemployment rate targeting, or relative size of various public services, rather than any specific interest rate.
Mostly, however the central bank is prevented by law or convention from giving way to such demands, being required to only generate central bank money in exchange for eligible assets.
Possible targets
- Under inflation targeting, open market operations target a specific short-term interest rate in the debt markets. This target is changed periodically to achieve and maintain an inflation rate within a target range. However, other variants of monetary policy also often target interest rates: the US Federal Reserve, the Bank of England and the European Central Bank use variations on interest rate targets to guide open market operations.
- Besides interest rate targeting there are other possible targets of open markets operations. A second possible target is the contraction of the money supply, as was the case in the U.S. in the late 1970s through the early 1980s under Fed Chairman Paul Volcker.
- Under a currency board open market operations would be used to achieve and maintain a fixed exchange rate with relation to some foreign currency.
- Under a gold standard, notes would be convertible to gold, and so open market operations could be used to keep the value of a currency constant relative to gold.
- A central bank can also use a mixture of policy settings that change depending on circumstances. A central bank may peg its exchange rate with different levels or forms of commitment. The looser the exchange rate peg, the more latitude the central bank has to target other variables. It may instead target a basket of foreign currencies rather than a single currency. In some instances it is empowered to use additional means other than open market operations, such as changes in reserve requirements or capital controls, to achieve monetary outcomes.
How open market operations are conducted
United States
In the United States, before the 2008 financial crisis, the Federal Reserve used open market operations to keep its key policy rate, the federal funds rate, around the target set by the Federal Open Market Committee by adjusting the supply of reserve balances of commercial banks suitably. Since late 2008, however, the implementation of monetary policy has changed considerably. In contrast to the former so-called limited reserves regime, the Fed implemented what the institution refers to as an ample reserves regime where the market interest rate is not adjusted via open market operations, but more directly through changes in the Fed's central administered rates, which are the interest on reserve balances rate and the overnight reverse repurchase agreement offering rate. Open-market operations consequently are no longer used to steer the federal funds rate. However, they still form part of the over-all monetary policy toolbox, as they are used to always maintain an ample supply of reserves. In 2019, the Fed announced that it would continue to use this implementation regime over the longer run. The system is also known internationally as a floor system as opposed to the former corridor system, in which open market operations are used to determine the actual market interest rate.The Federal Reserve has conducted open market operations since the 1920s, through the Open Market Desk at the Federal Reserve Bank of New York, under the direction of the Federal Open Market Committee.
Eurozone
The European Central Bank has similar mechanisms for their operations; it describes its methods as a four-tiered approach with different goals: beside its main goal of steering and smoothing Eurozone interest rates while managing the liquidity situation in the market the ECB also has the aim of signalling the stance of monetary policy with its operations.Broadly speaking, the ECB controls liquidity in the banking system via refinancing operations, which are basically repurchase agreements, i.e. banks put up acceptable collateral with the ECB and receive a cash loan in return. These are the following main categories of refinancing operations that can be employed depending on the desired outcome:
- Regular weekly main refinancing operations with maturity of one week and,
- Monthly longer-term refinancing operations provide liquidity to the financial sector, while ad hoc
- "Fine-tuning operations" aim to smooth interest rates caused by liquidity fluctuations in the market through reverse or outright transactions, foreign exchange swaps, and the collection of fixed-term deposits
- "Structural operations" are used to adjust the central banks' longer-term structural positions vis-à-vis the financial sector.
MRO auctions are held on Mondays, with settlement occurring the following Wednesday. For example, at its auction on 6 October 2008, the ECB made available 250 million in EUR on 8 October at a minimum rate of 4.25%. It received 271 million in bids, and the allotted amount was awarded at an average weighted rate of 4.99%.
Since mid-October 2008, however, the ECB has been following a different procedure on a temporary basis, the fixed rate MRO with "full allotment". In this case the ECB specifies the rate but not the amount of credit made available, and banks can request as much as they wish. This procedure was necessitated by the 2008 financial crisis and is expected to end at some time in the future.
Though the ECB's main refinancing operations are from repo auctions with a weekly maturity and monthly maturation, Longer-Term Refinancing Operations are also issued, which traditionally mature after three months; since 2008, tenders are now offered for six months, 12 months and 36 months.