Open Market Operations (OMO)

What are the Different Types of Open Market Operations?

Open market operations come in two varieties:

1) Permanent Open Market Operations (POMOs) – The central bank consistently uses open market operations to influence monetary policy. This occurs when a central bank sells or purchases securities outright in order to permanently influence the supply of money.

• Quantitative Easing (QE) – A type of unconventional permanent open market operation commonly used in near-zero interest rate environments, quantitative easing refers to when a central bank purchases long-term Treasury securities, mortgage-backed securities, and other longer-term securities in order to influence longer-term interest rates. QE is usually seen as a last resort for central banks. When interest rates are already at near-zero levels and the economy is still contracting, such as was the case at the beginning of the pandemic, central banks are left with limited options that do not involve targeting a negative policy rate.
• Quantitative Tightening – The opposite of quantitative easing, quantitative tightening refers to an unconventional open market operation in which the central bank reduces the size of its balance sheet in order to reduce the supply of money in the economy.

2) Temporary Open Market Operations (TOMOs) – The central bank temporarily addresses reserve needs by influencing the supply of money on a short-term basis.

• Repurchase Agreements (Repos) – When a central bank agrees to sell securities and repurchase them for a slightly higher price shortly thereafter, typically overnight.
• Reverse Repurchase Agreements – Occurs when a central bank agrees to purchase securities and resell them for a slightly higher price.

What is an Example of Open Market Operations?

One notable example of open market operations occurred directly following the economic contraction brought about by the COVID-19 pandemic.

After a strong correction in the equities markets and the lingering effects of shutdown policies on the U.S. economy, the Fed took action by conducting open market operations.

The Fed enacted a quantitative easing plan, in which it initially announced $700 billion in asset purchases.

Three months later, the Fed began monthly purchases of $80 billion in Treasury securities and $40 billion in mortgage-backed securities, a policy that lasted until March 2022.

The Fed grew the supply of bank reserves by purchasing assets from the open market, thus increasing the overall money supply throughout the economy and maintaining a dovish monetary policy while the market recovered, reflecting a positive outlook on the future performance of the economy while it remained at lower levels due to the onslaught of the pandemic.

Despite the recovery we’ve seen, however, prolonged open market operations come with other consequences.

While the Fed continued to stimulate the economy, inflation has begun to skyrocket, with the Consumer Price Index (CPI) rising 7.9% YoY in February, the largest increase since 1982.

As a result, the Fed increased its target federal funds rate by 25 basis points after the FOMC’s March 16th meeting, and most expect that it will do the same after its next six meetings.

The prospect of a rising rate environment will have a significant effect on stock market valuations, as rising rates mean companies are not only forced to borrow at higher rates but also that their future cash flows are being discounted more, meaning the present value of these companies’ cash flows is now lower, resulting in lower perceived share prices.