21 Aug, 2020
Discovering Open Market Operations and Quantitative Easing
This informal CPD article on Discovering Open Market Operations and Quantitative Easing was provided by Narciso Gianluigi at the Institute of International Monetary Research.
Central Banks (CB)
There is no single economy in the world that would function the way it does without a so-called central bank (CB). Central banks are in most cases public institutions that play a role of vital importance in modern economies. They are the guardians of price stability. In fact, through their monetary policies, they work to keep inflation in check, which is a crucial task in contributing to the smooth functioning of the entire economy, avoiding financial instability and uncertainty that would otherwise be harmful for agents’ economic activities and their initiatives.
But how do Central Banks make monetary policy decisions? In normal times in the economy, central banks lend regularly money to commercial banks at a set nominal rate that is defined as the “policy interest rate”. This rate affects commercial banks’ ability to borrow and lend, thus the quantity of money they can create by lending money to their customers and creating new deposits (i.e. money); which will ultimately explain the rate of inflation in the economy. CBs usually use three different policy tools: the discount rate (which is the interest rate that commercial banks pay to borrow from the central bank for very short-term loans), the reserve requirements (the minimum amount of reserves that must be held by a commercial bank, most of which in an account at the central bank) and open market operations (or OMOs).
Open Market Operations (OMOs)
OMOs consist of buying and selling assets. The central bank engages with commercial banks in selling or buying short-term government securities, affecting the amount of banks’ reserves and thus their ability to lend out money to the public. If the inflation rate is below a pre-determined target, the central bank will buy government securities from banks, creating new bank reserves and cutting the policy interest rate. Since banks have now more reserves than previously, they are incentivised to extend new loans to consumers, increasing the amount of money in the economy and thus pushing inflation up. If, on the other hand, the inflation rate is above target, the opposite transaction will happen, with the central bank selling – instead of buying – government securities, which would destroy money and bring inflation down.
Are OMOs always efficient in controlling inflation at the desired rate and hence in ensuring price stability?
Are OMOs always efficient in controlling inflation at the desired rate and hence in ensuring price stability? The short answer is no. In extreme scenarios, for example, in a major financial crisis, cutting the policy interest rate to almost 0% through OMOs may not be enough and only have a negligible impact on inflation. In this scenario where the interest rate cannot go any lower and inflation threatens to s turn into deflation while the economy is still tanking, the CB can create more money by performing “extraordinary” market operations. That is, instead of buying short-term securities or lending to banks, it buys longer government securities (for instance at 5, 10 or 20-year bonds) or even other riskier type of assets, such as mortgage-backed securities, directly from commercial banks and other non-bank financial institutions – as it happened in 2008 during the Global Financial Crisis. This type of asset purchases goes by the name of Quantitative Easing (QE).
Quantitative Easing (QE)
In other words, QE is an expansionary monetary policy whereby a CB buys a wide range of financial assets (both public and private) with long maturities. By doing so, the CB will be creating new deposits in the economy, thus preventing the collapse in the amount of money during deep recessions and other major crises.
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