Open Market Operations

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Open Market Operations

Open market operations are purchases and sales of securities between a central bank (for example, the Federal Reserve in the United States, the Bank of England in the United Kingdom, and the European Central Bank in most of Europe) and the banking system. These securities are usually government-issued (mostly bonds on government debt), although they can include private and foreign securities, and gold. When the central bank buys a security from a bank it increases the bank’s asset position with respect to the central bank. This allows the bank to make more loans to its clients, thus increasing the overall amount of money available to the public. By contrast, a central bank sale of securities has the converse effect.

Banks holding excess asset positions with the central bank can loan these surplus funds to banks with deficit positions. These trades are usually in the form of overnight loans at an interest rate negotiated individually between the parties of the agreement. For example, in the United States such loans are called federal funds and the volume weighted average of the interest rate charged is called the federal funds rate. In addition, most central banks have standing deposit and lending facilities so that banks that cannot find favorable counterparties can trade with the central bank instead. Standing facilities therefore limit the variability of the overnight rate charged in bilateral trades between banks.

Open market operations allow the central bank to modify the banking system’s overall asset position and, hence, to control the average interest rate charged on these overnight loans. This overnight rate then serves as a reference rate for loans at longer maturities. For example, to make a borrower indifferent to the choice between a two-day loan and a one-day loan that is rolled over the next day, the loan rate charged on the two-day loan should be an average of the rates charged on the two one-day loans. Similar arbitrage arguments (with some adjustments for risk and uncertainty about the value of one-day loans in the future) link interest rates at different maturities (often referred to as the term structure ) with the overnight rate that the central bank manages through open market operations. Ultimately, fluctuations in longer-term interest rates affect investment decisions and the future level of economic activity.

In most modern economies, independent central banks are commissioned with two main responsibilities: (1) the conduct of monetary policy, broadly meant as managing the amount of money in the economy so that it is compatible with price and exchange rate stability, and economic growth; and (2) regulation of the banking and financial systems. The central bank is the banking system’s banker (as well as the government’s). Its ability to conduct open market operations and modify the overall asset position of the banking system allows the central bank control over the economy’s money supply and the overnight interest rate. Insofar as high levels of economic activity can generate inflation and overnight rates are linked through arbitrage to long-term rates (which ultimately determine investment and the overall level of economic activity), open market operations are the main vehicle by which a central bank implements its monetary policy objectives.

SEE ALSO Banking; Banking Industry; Central Banks; Federal Reserve System, U.S.; Interest Rates; Money, Supply of; Policy, Monetary