Open Market Operations & Interest Rates

This lesson adds to the academic material covered under Macroeconomic section. You will understand Open Market Operations, understand difference between Real and Nominal Interest Rates, and meaning of Quantitative Theory of Money. Central Bank uses few tools to control liquidity within the economy. Open Market Operations (OMOs) are an essential monetary tool. 

Open Market Operations are either permanent or temporary. The FED uses Repo and Reverse Repo Rates to regulate short-term rates example effective fed funds rate or overnight lending rates between banks. Outright purchase or sale of assets are permanent OMOs. Asset purchases increase aggregate supply of reserves i.e. money supply. Also known as quantitative easing, these operations are used when the interest rates are near zero making other monetary tools ineffective.

What are Reserves  and Repo Rates ?

• Cash banks hold either in the currency form in vaults or with the central banks.
• Central banks infuse reserves into the system through the repo market.
• Repo or repurchase agreements are short term secured loans where the party buys back the securities from the other party at a specific price at a specific time.
• Central bank buys securities it is increasing the liquidity and reserves of the system.
• This change in the price is known as the repo rate.  

Image: The middle Road | Data Source: http://www.federalreserve.gov 

Quantitative Easing

A tool used by the central banks to purchase assets to boost liquidity in the markets when interest rates are zero

Central Banks use Open Market Operations

Example FED, Bank of Japan, European Central Bank

FED buys primarily Treasuries, MBS (Mortgage Backed Securities) guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae and smaller amounts of Corporate Debt and Exchange Traded Funds

As policy rates lower bound is zero, QE through asset purchases can drive real interest rates below zero.

Note Nominal Interest Rates = Real Interest rates + Expected Inflation, a simplification of the Fisher equation. Buying assets not only boosts liquidity within the system but also increases inflation. Nominal Interest Rates are interest rates banks charge on deposits or return on bonds. Nominal interest rates include price effect and considered as opportunity cost of capital. Real Interest Rates define the purchasing power of households and adjusted for expected inflation. ex ante real interest rates = nominal interest rates – expected inflation. Expected inflation is important as central banks look at this aspect very carefully to take corrective policy measures. A higher expected inflation will induce central banks to increase policy rates; there is an outside lag between the time taken for policy action and its influence on the economy.

Video : The middle Road 

The Quantity Theory of Money

M * V = P * T

M * V = P * Y

• M= Quantity of Money
• V=Rate at which money circulates in the economy
• Y= Real GDP
• P= GDP deflator also price of fixed quantity of goods and services

• PY: Nominal GDP

Usually the velocity of the money is constant implying the money supply impacts nominal GDP. Recall GDP deflator is an estimator of inflation. Refer to the Macroeconomics GDP section.  It’s important to understand liquidity trap, a deflationary scenario as observed in Japan. A liquidity trap occurs when the interest rates are near zero and as the nominal interest rates cannot go less than zero, (unless supported by central banks) expected inflation is used to drive real interest rates negatively to boost lending and investment. This situation occurs during a deflationary scenario and the theory of liquidity preference does not hold.  An excellent read on the topic of liquidity trap is a paper by leading economist Paul Krugman titled Thinking about the liquidity trap. To know more on this subject, it’s good to understand the IS-LM curve. IS curve is impacted by the fiscal deficit and LM by monetary policies. The topic will be covered in detail under Macroeconomic courses. However, QE might not translate to boosting of credit as households prefer cash rather than investment in other assets. Banks rather than fostering credit flow, could invest in equities or bonds that leads to asset bubble. Central banks employ negative interest rates by charging commercial banks for excess reserves, effectively taxing them enabling lending of excess reserves. Although negative interest rates policies remain unconventional, Mario Draghi in 2016 considered them to be effective. Mario Draghi was President of the European Central Bank from 1 November, 2011 until 2019.

Negative Interest Rate Policies, a research paper by World Bank Group quotes Mario Draghi “[In] the first full year with negative interest rates, [banks’ net interest income] went up. […] So all in all the [NIRP] experience has been positive.”

Buying and Selling Bonds

Buying of assets boosts liquidity within the economy, encourages lending and investment within the economy. During the credit crisis, and recently during the pandemic, the FED used quantitative easing to foster credit growth within the economy. It’s important to understand the liquidity trap, – and will be covered separately in the macroeconomic courses. Central Banks sell bonds to suck up the liquidity from the system and increase interest rates within the economy. Unwinding of bonds by central banks is known as quantitative tightening.

How does buying bonds increase liquidity within the system? 

Central banks pay cash for buying bonds to Authorised Dealers/ Commercial Banks, the liquidity within the system increases (reserves), and nominal interest rates fall (short term & in some cases long term). One key aspect of this operation during the downturn is to revive the economy and boost demand-pull inflation.