Open Market Operations 

Preview
You must first complete Module 8 Mega Series Understanding Stabilization Policies with 8A and 8B before viewing this Lesson

Open Market Operations 

 

Open Market Operations is one of the most important monetary tools  used by central banks to either temporarily moderate liquidity with the system or permanently change the aggregate money supply  through outright purchase of assets known as Quantitative Easing.

The key function of the Central is to promote macroeconomics and monetary stability within the system, promote an efficient and sustainable financial system, implement regulations that promote financial stability including smooth functioning of payment system. One tenet of the Central bank is to work as the lender of the last resort. The Central Bank regulates interest rates through policy rates that become the benchmark for lending and mortgage rates.

Central Banks use many monetary tools  to carry out its mandate but herein two key tools are discussed within open market operation context. The Central Banks operate in the temporary repo and reverse repo market to change the reserve requirement i.e. the funds banks park with banks or keep in their vaults. This regulates the liquidity within the system to modulate policy rates. The Fed uses this tool to fine tune effective fed funds rate (overnight borrowing rate for banks) or other policy rates. Riksbank tracks Repo Rate while Bank of England focusses on current Bank Rate, Reserve Bank of New Zealand  official Cash Rate etc.

 

 

Quantitative Easing or Asset Purchases 

 

 

Fig 6 : Asset Purchases by the FED Aug 2007 to Jan 2021 | The middle Road | Data federalreserve.gov

The other way is to use the permanent open market operations by buying securities or assets of mostly sovereign bonds (it could include other securities example mortgage back securities). Central Banks use this tool to also moderate long-term rates. Also known as Quantitative Easing (QE), this tool is used when interest rates are rock bottom and REDUCING policy rates to boost lending and investment within the system is no longer an option. Since, nominal interest cannot go less than zero, one key way to catalyze lending and investment would be to make real interest rates negative by driving up expected inflation. Example, a country is in recession and the country is near-zero interest rates i.e. 0%.

This means that the nominal interest rates are at 0% and with inflation at 0.5%, the real interest rates are at -0.5%. In the fig below, from 2008 to 2009, Bank of Canada aggressively increased its asset size, with 45.79% increase in asset between 2 Jan 2008 and 11 March 2009. Check out the inflation in Canada in 2009, 2010, 2011in fig below. Has the inflation shown major variation (usually calculated as standard deviation) over the years. Asset purchases by the central bank not only increase liquidity within the economy but also is designed to induce inflation. These asset purchases are driven by the printing of new cash increasing the money supply permanently by the central banks. Fig 7 Asset Purchases by Bank of Canada | Data Source Bank of Canada | Calculations and Graph The middle Road

Remember PY =MV, an increase in money supply will increase the nominal GDP, increasing inflation within the economy. Keeping velocity constant, so the percent change in V is zero, Y= F(K,L) (Production function), a change in  Y is zero. A 1% change in money supply causes a 1% increase in price levels ( 1% in rate of inflation). In the example mentioned, lets assume that asset purchases leads to increase in inflation expectation to 1%. Using Fisher approximated equation, the real interest rates are now = -1% a bump up of -0.5% due to increase in inflation expectation. As all actors within the economy are driven by real return i.e. increase in their purchasing power, holding cash will reduce purchasing power by -1%. This would motivate actors to invest/lend rather than hold cash. Note: In the Macroeconomics Module 8 in the Canadian Asset Purchases graph the figure of 78584 million is erroneously mentioned as 31-02-2008. It is as of 31-12-2008.

 

Note: In spite of QE by advanced countries, not much inflation has been observed. In the  United States only in the past couple of months has inflation zoomed out of comfort of 2%. Although inflation in the US did touch above 2% in the past, it is only in recent months has the inflation rate raised eyebrows. According to the FED, this is a temporary phenomena but The middle Road’s view is much more serious. 

 

Fig 8 | The middle Road | World Bank, IMF, International Financial Statistics and data files  Inflation as measured by the consumer price index reflects the annual percentage change in the cost to the average consumer of acquiring a basket of goods and services that may be fixed or changed at specified intervals, such as yearly. The Laspeyres formula is generally used. Fig approximated to 2 decimals

This method is part of permanent open market operations, it changes the aggregate supply of reserves (money supply) permanently within the system. In recent years, during era of low interest rates, unseen before historically, asset purchases have been used by selected central banks globally chiefly the FED. When Central Banks buy asset purchases they increase the liquidity within the system. As the central banks pay commercial banks cash for purchasing securities, they increase liquidity within the economy to boost credit offtake from financial institutions, promote lending and investments among corporates and households.

 

Is FED going to increase rates sooner than expected

 

 

The middle Road believes that the vaccine rollout in the US has been excellent that might have contributed to an increase in inflation in the last couple of months (driving up the economy) apart from the stimulus and asset purchases. The recovery of the economy has been faster.  However, if the inflation remains above the 2% level, the real interest rate in the US would be between -2% to -4%, a huge problem for an economy that has a healthy expected growth of 5% per annum with unemployment at 6.1%.

This abundant liquidity has already created asset bubbles i.e. buying assets above its intrinsic value. Real interest rates help economies that are either going through a deflationary phase of falling prices or anaemic very low persistent growth. A persistent negative real interest rates would fuel more inflation more time. It remains to be seen whether the inflation is temporary.

Fig 9 : Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average, retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPILFESL, May 17, 2021.

 

Though FED follows a dual mandate of balancing inflation and unemployment, 6.1% especially during the time of the pandemic is excellent. With a majority of the European Union countries on target to fully vaccinate 70% of the adult population by mid-July and China going full steam, the unemployment rate would reduce in the next few months. In the next couple of months, The middle Road expects the rate of inflation to be high. The middle Road’s outlook is that the FED will stop asset purchases despite President Biden’s expansionary budget. It depends on how much of the budget will be financed through increased taxes in real-time. If inflation especially core- inflation remains above 3%, the FED might gradually start increasing rates much sooner than expected maybe as early as 2022. The US economy debt as a percent of nominal GDP is 127% (Source The Balance) and expected to rise with negative real interest rates, US is a ticking time bomb facing a global explosion that could take many down. Only time will tell when the asset bubble will explode.

 

Lesson tags: #macroeconomics, #onlinecourses, #zpublications #zpublication
Back to: Understanding Stabilization in Macroeconomics

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.