How are Open Market Operations (OMO) and bond yields related?

OMO or open market operation is a quantitative financial tool by which a country’s Central Bank (The Federal Reserve System of the U.S.A., the European Union of the U.K., the Reserve Bank of India, the People’s Bank of China and all others) regulates the supply of money in its economy. A Central Bank’s main responsibility is to keep the inflation in check by managing the money supply, ensure that enough foreign reserves are maintained and the value of the currency is stable and not volatile in the constantly changing global relations and scenarios.

What is an OMO or Open Operation?

OMO means that a country’s Central Bank (central bank) involves in either purchase or sale of the government securities from and tothe banks operating in that country. The central bank performs this on behalf of the Government of that country. OMO takes place constantly between the banks and the central bank to keep the amount of money supply in the economy in check.

When does the central bank perform an OMO sale ad when does it perform an OMO purchase?

OMO sale-
If the central bank witnesses a rise in the inflation which means that more money is chasing fewer goods thus implying that there is money in the economy, the central bank announces an OMO sale i.e. the sale of securities in return for money from the banks. By this, the central bank has sucked out money from the banks which are the vehicles of money supply. Now, with quantity of money having become less, lending becomes difficult and so the lending rates rise. With this rise, deposit rates also rise in the banks.

OMO purchase-
If the economy is facing a shortage of money and the rate of inflation is below the required level it means that there is a difficulty in conducting day-to-day businesses in that country. So, the central bank steps in and decides an OMO purchase whereby it purchases the securities from the banks and gives them money. With this, the banks become money rich. Lending gets cheaper and easier. As a natural consequence deposit rates fall because the people are interested in borrowing at cheaper rates from banks and investing in business and infrastructure projects or simply any money churning activity.

So, how are bond prices related to all this? How does OMO affects bond yields?

Now, with higher deposit rates being offered by the banks after an OMO sale, the bond investors feel that the coupons they would receive from buying an older bond would be lesser attractive than the new deposit rates and as a result they are willing to pay lesser to buy the old bonds.Hence the price of the old bonds begins to fall with an increase in interest rates in the economy. Therefore interest rates and bond prices are inversely proportional. The exact reverse would happen in the case of an OMO purchase. Let’s understand this with a $100 investment comparison through this table.

Open Market Operations, Bond Yields, Inflation, Interest Rates, Fed, RBI
How are interest rates related to open market operations? 
It can be seen that after an OMO sale the bank offers a better return than the bond investment. And so the people agree to buy the bonds for lesser as they are getting lesser returns. Thus, an OMO sale brings the bond prices down and an OMO purchase pushes the bond prices up.

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