What it means
A central bank influences the economy partly by adjusting the amount of money in the banking system. When it buys securities such as government bonds from banks, it pays by crediting their reserve accounts, which increases the money available to lend.
When it sells securities, reserves fall. An outright purchase or sale is permanent because the central bank keeps or gives up the asset for good, unlike a repurchase agreement, which is a short-term loan secured on securities.
The Federal Reserve calls the outright version permanent open market operations, and it uses them to meet the long-term growth in demand for currency and reserves. Temporary operations handle seasonal and day-to-day swings.
For businesses and investors, the effects are indirect but important. Large-scale purchases push up bond prices and lower yields, which reduces borrowing costs across the economy, and large-scale sales do the opposite.
Programmes that buy bonds in huge amounts to support the economy, often called quantitative easing, are built on permanent operations. The central bank has to be careful about what it buys and how fast, because its actions can affect markets directly.
Some central banks buy only government debt, while others also buy mortgage or corporate bonds. The asset mix and the pace are published, so market participants can plan around them.
A nuance is that the central bank may later reverse the effect without selling, by allowing securities to mature without reinvesting the proceeds. This gradual run-off shrinks reserves slowly and avoids the market disruption that large outright sales could cause.
In practice
Real-world examples.
Example
A central bank notices that demand for currency grows by about $60,000,000,000 a year. It makes outright purchases of government bonds to supply the extra reserves and avoid relying only on short-term lending to banks. The purchases are announced in advance so markets can prepare.
Example
A mortgage lender sees bond yields fall after the central bank announces a new round of outright bond purchases. It lowers its fixed mortgage rates by a quarter of a percentage point. Customers refinancing at the new rate save money each month.
Example
A corporate treasurer reads that the central bank will stop reinvesting maturing bonds. She expects borrowing costs to drift up and decides to lock in a fixed rate loan earlier than planned. She also reviews her bank covenants in case funding costs rise further.
Formula
Calculation
Net change in bank reserves = securities purchased - securities sold
Suppose a central bank buys $80,000,000 of government bonds from banks and sells $30,000,000 of bonds held on its balance sheet in the same period. The net change in reserves is 80,000,000 - 30,000,000 = $50,000,000. Banks hold $50,000,000 more in reserves, which they can use to make loans or buy other assets.Case study
Seen in the real world.
Marlow Bank is an illustrative, fictional commercial bank in a country whose central bank announced it would buy $40,000,000,000 of government bonds over a quarter. The treasurer was asked to explain what this meant for the bank's funding.
The treasurer explained that the central bank would pay for the bonds by crediting banks' reserve accounts, so the system as a whole would hold $40,000,000,000 more in reserves. Marlow, which sold $2,000,000,000 of bonds, would see its reserves rise by that amount.
With extra reserves, Marlow could lower deposit rates and offer cheaper loans. The illustrative lesson is that permanent operations change the price and availability of credit for ordinary borrowers, even though the transactions take place between the central bank and banks. The treasurer used the announcement to update the bank's interest rate forecast. She also briefed the lending team so that new loan quotes reflected the likely fall in market rates, and she reviewed how much of the bank's own bond portfolio it might sell into the programme.
Watch out
Common mistakes.
- Confusing permanent operations with temporary ones, which reverse in days or weeks and are used for short-term liquidity.
- Thinking the central bank is printing banknotes, when it is creating electronic reserves credited to banks.
- Expecting an immediate change in lending, when banks decide whether to lend the extra reserves according to demand and risk.
Questions
People also ask.
What is the difference between permanent and temporary open market operations?
Permanent operations are outright purchases or sales of securities, while temporary operations are repurchase agreements that reverse after a short period.
Why do central banks use permanent operations?
They supply reserves to meet the long-term growth in demand for money and can lower long-term interest rates when conditions require. They are used less often than short-term tools.
How do these operations affect ordinary borrowers?
Bond purchases lower yields, which feed through to mortgage, business loan and corporate bond rates. Savers may see lower returns on deposits as a result.
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