Open market operations


Open market operations

Open market operations (also known as OMO) is the buying and selling of government bonds on the open market by a central bank. It is the primary means of implementing monetary policy by a central bank. The usual aim of open market operations is to control the short term interest rate and the supply of base money in an economy, and thus indirectly control the total 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.[1][2]

Contents

Process

Since most money is now in the form of electronic records rather than cash, open market operations are conducted simply by electronically increasing or decreasing ('crediting' or 'debiting') the amount of base money that the 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, action is taken in order to maintain the short term interest rate (that is, to increase the supply of base money). The central bank goes to the open market to buy a financial asset such as government bonds, foreign currency, gold, or seemingly nonvolatile (until the 2008 financial fallout) MBS's [3] (Mortgage Backed Securities). To pay for these assets, bank reserves in the form of new base money (for example newly printed cash) is transferred to the sellers bank, or to seller if it is a bank, and the sellers account is credited. Thus, the total amount of base money in the economy has increased. Conversely, if the central bank sells these assets in the open market, the amount of base money that the buyer's bank holds decreases, effectively destroying base money.

Possible targets of open market operations

  • 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

USA

In the United States, as of 2006 the Fed sets an interest rate target for the Fed funds (overnight bank reserves) market. When the actual Fed 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 Fed 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 (Fed) 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.[4] The Fed 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.[5] Very rarely will it permanently destroy money by the outright sale of securities.[citation needed] 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 who are called primary dealers.

Money is created or destroyed by changing the reserve account of the bank with the Fed. The Fed 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.

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,[6] 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 2008 October 6, the ECB made available 250 million in EUR on October 8 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 of 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.

Switzerland

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.[7]

India

India’s Open Market Operation is much influenced by the fact that it is a developing country and the capital flows are much different than other 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 post the reforms, the use of CRR as an effective tool was de-emphasized and the use of Open market operations. OMO’s are more effective in adjusting market liquidity.

The two traditional type of OMO’s used by RBI:

  1. Outright Purchase (PEMO): Is outright buying or selling of government securities. (Permanent).
  2. REPO (Repurchase Agreement): Is short term, and are subject to repurchase.[8]

But even after sidelining CRR as an instrument, there was still less liquidity and skewedness in the market. And thus on the recommendations of the Narshiman 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 monitor market interest rates. For the LAF, two rates are set by the RBI: Repo rate and reverse repo rate. Repo rate is applicable while selling securities to RBI (Thus daily injection of cash flow(liquidity)), while reverse repo rate is applicable when banks buy back those securities(Absorption of liquidity). Also, these interest rates that are fixed by the RBI also help in determining other market interest rates.[9]

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 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.[10]

Under 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). And the RBI cannot use this account for paying any interest or discounts and cannot credit any premiums to this account. And the Government in collaboration with the RBI fixes a ceiling amount on the issue of these instruments.[11]

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.

See also

References

  1. ^ Open market operations: A Glossary of Political Economy Terms - Dr. Paul M. Johnson
  2. ^ Open Market Operations - William F. Hummel
  3. ^ "Temporary Open Market Operations Historical Search - Federal Reserve Bank of New York". Newyorkfed.org. 2000-07-07. http://www.newyorkfed.org/markets/omo/dmm/historical/tomo/search.cfm. Retrieved 2011-09-19. 
  4. ^ Repurchase and Reverse Repurchase Transactions - Fedpoints - Federal Reserve Bank of New York
  5. ^ Open Market Operation - Fedpoints - Federal Reserve Bank of New York
  6. ^ "European Central Bank". FXPedia. http://www.fxpedia.com/European_Central_Bank. Retrieved 2011-09-19. 
  7. ^ "Monetary policy instruments (situation in 2009)". Swiss National Bank. http://www.snb.ch/en/iabout/monpol/id/monpol_instr. Retrieved 1 March 2011. 
  8. ^ "Central Banks Guide". http://www.centralbanksguide.com/open+market+operation/. 
  9. ^ "Economics by Paul Anthony Samuelson". http://books.google.co.in/books?id=gzqXdHXxxeAC&pg=PA645&lpg=PA645&dq=when+and+how+rbi+uses+OMO&source=bl&ots=y6mdxFE8AX&sig=9C1-Dn5Bu4Vt2hI3bwBUDPsuTZk&hl=en&ei=UGyUTpqTKsfPrQfg0eTIBg&sa=X&oi=book_result&ct=result&resnum=4&ved=0CDwQ6AEwAw#v=onepage&q&f=false. 
  10. ^ "The Hindu: Features Of stabilization scheme". http://www.hindu.com/biz/2004/04/05/stories/2004040500361600.htm. 
  11. ^ "Implementation Of Monetary Policy". http://rbi.org.in/scripts/BS_SpeechesView.aspx?Id=498. 

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