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Open Market Operations

Open Market Operations

OMO. Something the Bank of England has an entire department doing. All the time.

Britain’s pension funds were on Wednesday at the centre of the financial crisis sparked by the mini-budget forcing the Bank of England to launch a £65 billion emergency bailout.

The Bank warned of a “material risk to UK financial stability” and stepped in to buy long-term gilts, as plunging markets for UK debt sent borrowing costs spiralling and forced pension funds to dump their assets. Economists compared the crisis to the run of withdrawals that led to the collapse of Northern Rock in the financial crisis.

As Andrew Again explained so very well in the comments to this thread. Given that this is in fact his own bread and butter, daily work, we should be taking his description as having at least some validity.

Pensions funds own lots of gilts because Gordon Brown forced them to. There’s not much return on gilts (return after inflation has been negative for a long time, not what you want in a pension fund “investment”) so they repo them – stick them in a bank and borrow. Use that money to buy higher yielding corporate bonds. All well and good. Except when gilts prices decline violently and vehemently those gilts no longer cover the borrowings, the pensions funds must ship cash into the banks to cover the loans. They do this by flogging off other stuff.

That’s what was happening. So, Open Market Operations. The Bank of England does this all the time, there’s an entire department doing nothing but. Buying and selling a few bits of gilts here and there whenever. To maintain an orderly market. This is the Mother of All OMOs. About which we can note two things.

1) The BoE has spent £5 billion so far (It’s £5 billion a day starting yesterday). That’s moved the entire market by 1% of yield. That’s a lot, lot, of movement for such a piddly sum. As ever, central banks – those with some authority in the markets – can move markets by what they say they’ll do rather than actually having to do it. Expectations management matters.

2) This is largely a self-solving problem over time. As Andrew Again points out, it’s not possible to repo for decades. These arrangements have to be reset every few months at least. As they are reset then they’ll be reset at the new prices. And with a very decent slug of expectations about near future prices too. Absolutely no one, today, trying to repo will be offered the sort of terms that were on offer a week back. So, over time the prices of the repos, thus the margin calls, reset as the entire market reprices. The problem of haemorraghing cash solves itself over the time it takes for repos to mature and reprice.

This is OMO, it’s not QE.

Now, it is true that if the BoE doesn’t reverse these actions when the market is repriced then the money supply effects will be largely indistinguishable from QE but that’s another matter – something that we’ll find out.

But while Mother of All etc, OMO is a known and necessary function of the BoE. The scale might surprise, but the essentials of the action are pretty normal.

Now, of course, we’re going to get the Potatorous Insistence that this proves that printing more money is the only possible solution. But that would be to confuse two very different things. We can have strategic problems, long running ones. We can also have tactical problems. Short term. Either or both can be dangerous, of course. But as an analogy – and analogy, no more – think of a bank that is illiquid as against one that is insolvent. The first is a tactical problem that is easy for a central bank to solve by supplying liquidity. The second a strategic one which the central bank should solve by an orderly liquidation and the shareholders lose everything, Har Har.

This is a tactical problem brought on by the vehemence and speed with which gilts prices have changed. It’s not a strategic one about the size, depth or pricing of the gilts market.

Well, so far at least. And as a tactical problem it has a short term solution. The big test here (for Jim especially) is whether the reversal of the solution does in fact happen on time.

Ah, one more thing:

On Wednesday afternoon it started by buying around £1bn worth of long-dated gilts, bonds issued when the Treasury wanted to borrow for 20 years or more, having offered to snap up £2bn. It can buy up to £5bn a day between now and October 14, when it said it will stop the programme.

They’ve spent £1 billion so far. That’s £1 billion in a roughly £2 trillion market. Which has moved the yield on that entire market by 1%. Expectations matter, eh?