Definition: Open market transactions (usually called open market operations, or OMOs) are purchases and sales of securities, mostly government bonds, by a central bank. They change the amount of reserves (central bank money) in the banking system, which in turn moves short-term interest rates.
Explanation
Commercial banks keep accounts at the central bank. The money in those accounts is called reserves, and banks lend it to each other overnight.
- When the central bank buys a bond from a bank or dealer, it pays by adding money to the seller’s reserve account. This creates new reserves. With more reserves around, banks need to borrow less from each other, so overnight interest rates tend to fall.
- When the central bank sells a bond, the buyer pays with reserves, which the central bank then removes from the system. Reserves shrink and overnight rates tend to rise.
There are two kinds of operation:
- Outright (permanent): the central bank simply buys or sells the bond.
- Temporary: done with repurchase agreements (repos). In a repo the central bank buys a bond and agrees to sell it back on a set date, which adds reserves only for that period. A reverse repo does the opposite and drains reserves for a while.
Who does it: in the United States the Federal Open Market Committee (FOMC) sets the policy and the trading desk at the Federal Reserve Bank of New York carries out the trades. The European Central Bank and the Bank of England run their own versions.
How things changed after 2008: many central banks now keep reserves plentiful (“ample reserves”). The Federal Reserve steers its policy rate mainly through the interest it pays on banks’ reserves and through its overnight reverse repo facility, rather than through day-to-day bond trades. Open market transactions are still used to keep reserves at the right level, and very large purchase programmes (quantitative easing, or QE) are open market transactions on a huge scale.
Examples
1. A simple purchase. The Fed buys $1 billion of Treasury bonds from a dealer.
| Fed balance sheet | Banking system | |
|---|---|---|
| Assets | +$1bn Treasury bonds | -$1bn Treasury bonds, +$1bn reserves |
| Liabilities | +$1bn reserves owed to banks |
The banking system now holds $1 billion more in reserves, which puts downward pressure on overnight rates.
2. The September 2019 repo spike. Overnight repo rates in the US jumped to around 10% on 17 September 2019 because reserves had become scarce. The New York Fed began offering overnight repos that day, its first in about a decade, to add reserves and bring rates back down.
3. Quantitative easing in 2020. At the start of the COVID-19 pandemic the Fed bought huge amounts of Treasury bonds and mortgage-backed securities. Its balance sheet grew from about $4 trillion in early 2020 to almost $9 trillion by 2022.