open market operations
/ OMO /
The central bank announces it wants the policy rate at, say, 5 percent. But how does it actually make banks lend to each other at 5 percent? It cannot simply order them to. Instead, it goes into the financial markets and buys or sells safe assets — mostly government bonds — to change how much money is sloshing around the banking system. This buying and selling is called open market operations, and it is the central bank's everyday workhorse for steering interest rates.
Here is the mechanism. When the central bank buys government bonds from banks, it pays for them with newly created money, which lands in the banks' accounts as reserves. With more reserves, banks have more money to lend and less need to borrow, so the overnight interest rate falls. When the central bank sells bonds, it takes money out of the banking system — banks pay with reserves, reserves get scarcer, and the rate rises. So buying bonds pushes rates down; selling bonds pushes rates up. The bank fine-tunes these operations day by day to keep the actual rate glued to its target.
Open market operations are the most flexible and least disruptive of the central bank's tools, which is why they are used constantly while the discount rate and reserve requirements change rarely. They also explain something that surprises newcomers: the central bank does not 'set' the money supply by decree — it adjusts it indirectly by trading bonds. In modern systems with abundant reserves, central banks increasingly steer rates by adjusting the interest they pay on reserves, but open market operations remain central to large-scale moves like quantitative easing.
To nudge the overnight rate down, a central bank buys 10 billion dollars of government bonds from banks, crediting their reserve accounts with 10 billion of new money; flush with reserves, banks compete to lend, and the interbank rate drifts lower.
Buying bonds adds reserves and pushes rates down; selling bonds does the reverse.
Remember the direction: the central bank buys bonds to loosen (lower rates) and sells bonds to tighten (raise rates). Beginners often get this backwards because they confuse the bond's price with its yield.