Open market operation
An open market operation (also known as OMO) is an activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy. The usual aim of open market operations is to manipulate the short-term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply, in effect expanding money or contracting the money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.
Process of open market
Since most money now exists in the form of electronic records rather than in the form of paper, open market operations are conducted simply by electronically increasing or decreasing (crediting or debiting) the amount of base money that a bank has in its reserve account at the central bank. Thus, the process does not literally require new currency. However, this will increase the central bank's requirement to print currency when the member bank demands banknotes, in exchange for a decrease in its electronic balance.
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. The central bank goes to the open market to buy a financial asset, such as government bonds. To pay for these assets, bank reserves in the form of new base money (for example newly printed cash) are transferred to the seller's bank and the seller's account is credited. Thus, the total amount of base money in the economy is increased. Conversely, if the central bank sells these assets in the open market, the amount of base money held by the buyer's bank is decreased, effectively reducing base money.
The process works because the central bank has the authority to bring money in and out of existence. They are 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 time, but the central bank will always be able to overpower their influence with an infinite supply of money.
Side note: All governments in countries that have a free floating currency not pegged to any commodity or other currency has a similar capacity to produce an unlimited amount of net financial assets (bonds), but this capacity is utilized to meet other political ends like unemployment rate targeting, or relative size of various public services (military, education, health etc.), rather than any specific interest rate.
- 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, so there would be no open market operations. However, open market operations could be used to keep the value of a fiat 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 (like a currency board) with different levels or forms of commitment. The looser the exchange rate peg, the more latitude the central bank has to target other variables (such as interest rates). 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
In the United States, as of 2006, the Federal Reserve sets an interest rate target for the Federal funds (overnight bank reserves) market. When the actual Federal funds rate is higher than the target, the New York Reserve Bank will usually increase the money supply via a repo (effectively borrowing from the dealers' perspective; lending for the Reserve Bank). When the actual Federal funds rate is less than the target, the Bank will usually decrease the money supply via a reverse repo (effectively lending from the dealers' perspective; borrowing for the Reserve Bank).
In the U.S., the Federal Reserve most commonly uses overnight repurchase agreements (repos) to temporarily create money, or reverse repos to temporarily destroy money, which offset temporary changes in the level of bank reserves. The Federal Reserve also makes outright purchases and sales of securities through the System Open Market Account (SOMA) with its manager over the Trading Desk at the New York Reserve Bank. The trade of securities in the SOMA changes the balance of bank reserves, which also affects short-term interest rates. The SOMA manager is responsible for trades that result in a short-term interest rate near the target rate set by the Federal Open Market Committee (FOMC), or create money by the outright purchase of securities. More rarely will it permanently destroy money by the outright sale of securities. These trades are made with a group of about 22 (currently 18 as an immediate aftermath of 08/09 credit crisis) banks or bond dealers that are called primary dealers.
Money is created or destroyed by changing the reserve account of the bank with the Federal Reserve. The Federal Reserve has conducted open market operations in this manner 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. The open market operation is also a means through which inflation can be controlled because when treasury bills are sold to commercial banks these banks can no longer give out loans to the public for the period and therefore money is being reduced from circulation.
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:
- The regular weekly main refinancing operations (MRO) with maturity of one week and,
- The monthly longer-term refinancing operations (LTRO) provide liquidity to the financial sector, while ad-hoc
- "Fine-tuning operations" (in the form of reverse or outright transactions, foreign exchange swaps and the collection of fixed-term deposits) aim to smooth interest rates caused by liquidity fluctuations in the market and
- "Structural operations" are used to adjust the central banks' longer-term structural positions vis-a-vis the financial sector.
Refinancing operations are conducted via an auction mechanism. The ECB specifies the amount of liquidity it wishes to auction (called the allotted amount) and asks banks for expressions of interest. In a fixed rate tender the ECB also specifies the interest rate at which it is willing to lend money; alternatively, in a variable rate tender the interest rate is not specified and banks bid against each other (subject to a minimum bid rate specified by the ECB) to access the available liquidity.
MRO auctions are held on Mondays, with settlement (i.e. disbursal of the funds) 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 (250) 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 allottment. 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 (subject as always to being able to provide sufficient collateral). This procedure was made necessary by the financial crisis of 2008 and is expected to end at some time in the future.
Though the ECB's main refinancing operations (MRO) are from repo auctions with a (bi)weekly maturity and monthly maturation, Long Term Refinancing Operations (LTROs) are also issued, which traditionally mature after three months; since 2008, tenders are now offered for six months, 12 months and 36 months.
The Swiss National Bank currently targets the 3-month Swiss franc LIBOR rate. The primary way the SNB influences the 3-month Swiss franc LIBOR rate is through open market operations, with the most important monetary policy instrument being repo transactions.
India’s Open Market Operation is much influenced by the fact that it is a developing country and that the capital flows are very different from those in developed countries. Thus Reserve Bank Of India, being the Central Bank of the country, has to make policies and use instruments accordingly. Prior to the 1991 financial reforms, RBI’s major source of funding and control over credit and interest rates was the CRR (Cash reserve ratio) and the SLR (Statutory Liquidity Ratio). But after the reforms, the use of CRR as an effective tool was de-emphasized and the use of open market operations increased. OMO’s are more effective in adjusting market liquidity.
The two traditional type of OMO’s used by RBI:
- Outright purchase (PEMO): Is outright buying or selling of government securities. (Permanent).
- Repurchase agreement (REPO): Is short term, and are subject to repurchase.
However, even after sidelining CRR as an instrument, there was still less liquidity and skewedness in the market. And thus, on the recommendations of the Narsimham Committee Report (1998), The RBI brought together a Liquidity Adjustment Facility (LAF). It commenced in June, 2000, and it was set up to oversee liquidity on a daily basis and to monitor market interest rates. For the LAF, two rates are set by the RBI: repo rate and reverse repo rate. The repo rate is applicable while selling securities to RBI (daily injection of liquidity), while the reverse repo rate is applicable when banks buy back those securities (daily absorption of liquidity). Also, these interest rates fixed by the RBI also help in determining other market interest rates.
India experiences large capital inflows every day, and even though the OMO and the LAF policies were able to withhold the inflows, another instrument was needed to keep the liquidity intact. Thus, on the recommendations of the Working Group of RBI on instruments of Sterilization (December, 2003), a new scheme known as the Market stabilization scheme (MSS) was set up. The LAF and the OMO’s were dealing with day to day liquidity management, whereas the MSS was set up to sterilize the liquidity absorption and make it more enduring.
According to this scheme, the RBI issues additional T-bills and securities to absorb the liquidity. And the money goes into the Market Stabilization scheme Account (MSSA). The RBI cannot use this account for paying any interest or discounts and cannot credit any premiums to this account. The Government, in collaboration with the RBI, fixes a ceiling amount on the issue of these instruments.
But for an open market operation instrument to be effective, there has to be an active securities market for RBI to make any kind of effect on the liquidity and rates of interest.
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