Central Bank of Iran Pins Hope on OMO to Curb Inflationary Effects of Liquidity

EghtesadOnline: The Central Bank of Iran is now focused on the upcoming open market operation hoping that the monetary policy would help curb inflationary effects of the ballooning liquidity because previous measures failed to produce the desired results the bank’s governor said.

News ID: ۷۴۸۳۴۲

03 September 2019

In an Instagram post Monday, Abdolnasser Hemmati wrote that the regulator will tap into OMO as it is indeed difficult to draw on the existing ineffective and limited methods, namely “controlling legal reserves and rationing credits”,  conventionally used to control high and rising liquidity in Iran.

The CBI is resolved to “re-channel the impact of ‘high powered money’ on liquidity by establishing the OMO,” he wrote.

High-powered money or powerful money is another name for monetary base. It refers to the total amount of bank notes and coins circulating in the economy, including those in the public’s hand plus currency that is physically held in vaults of commercial banks and lenders’ reserves with the central bank, according to Financial Tribune.

Hemmati pointed to the successful experience of world central banks in benefitting from the OMO functions, saying “through OMO the CBI will control the cost of money instead of trying to curb the volume of money”.

Regulating Interest Rates

“OMO will diminish the impact of powerful money on liquidity by regulating the interest rate in the interbank market,” he wrote.

OMO is a financial instrument through which central banks buy and sell securities in the open market to expand or reduce money supply.

In the OMO framework, central banks also buy government bonds to increase the money base (cash reserves) and by extension curb inter-banking lending rates.  By the same token, selling government bonds reduces the base money and raises interbank rates.

In short, within the OMO governments issue bonds to be later used by banks as collateral to borrow from the CBI. In the final step, the CBI decides interest rates or the price of bonds.

Regulations for launching the highly-touted monetary policy were approved by the Money and Credit Council -- a major monetary decision-making body -- in April.

Bonds as Collateral

The measure is also enshrined in the current fiscal budget (March 2019-20) which allows the CBI to launch the OMO to control interest rates and inflation. As per the budget law, “CBI’s trade in Islamic bonds issued by the government and banks can offer bonds as collateral to borrow from the CBI.”

Shedding light on how the mechanism works, the Majlis Research Center said earlier that purchasing bonds by CBI within OMO would apparently increase demand for such bonds that in turn reduce the yield of bonds and bring them closer to interbank borrowing rates.

“The procedure ultimately reduces borrowing cost and, thereby, facilitates the borrowing process.”

Increase in the volume of bonds is tantamount to increase in borrowing that in turn causes the interest rate on bonds to rise.

When interest rates of government bonds is higher than the interbank rate, banks with surplus cash reserves prefer to buy bonds instead of parking their money in the interbank market.

This is where central banks come in and play their role as the main purchaser of bonds in the secondary market.

Pointing to the depth of bond markets, the influential parliamentary think said the CBI decision to launch the initiative would come at an opportune time.

Adding up bonds that mature during the current year (270 trillion rials / $2.3 billion) and total bonds to be issued this year(910 trillion rials / $7.9 billion), as enshrined in the budget, the MRC says there will be enough bonds in the market for the effective implementation of OMO.

Hemmati has tied the success of the policy to government cooperation in issuing treasury bonds and controlling the borrowings of lenders from the CBI.