What does it mean to drain reserves from the short term money markets?

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John Forman - The Essentials of Trading author

A member of the Trade2Win forum asked the following based on something he saw in the Financial Times.

Money market rates have been distorted as banks parked money overnight, with overnight funds rates far below the Bank of England’s 5.0 per cent rate. However, as of Thursday, money borrowed for three months on an unsecured basis was trading at a crisis high of about 1.5 percentage points above the three-month forward overnight rate, known as SONIA.The Bank said it would continue to drain reserves from the short term money markets to help keep those rates in line with its Bank Rate

what do they mean by drain reserves from the short term money markets ?

Central banks add and withdraw (drain) reserves as part of their market operations to keep their target rates in line. Basically that means they are controling the supply of reserves (money banks are required to have on deposit against the loans they make) to offset the demand situation. If the market rate is below the target that means there are too many reserves on offer, so the CB will drain reserves by selling short-term debt instruments (generally government).

When we talk about adding and withdrawing reserves It means draining reserves from the banks - bringing money into the central bank. That takes it out of the banking system. This is a very simple supply/demand thing. If there’s more money out there avaiable to be loaned, interest rates will go lower.

When the a central bank sells securities the banks pay for them with money (reserves), thus the reserves are taken out of the banking system and cannot be used to support lending. Aside from staying in the good graces of the central bank, the other banks will buy the securities to earn a better return than they would have been able to otherwise.

Note that these actions are only really designed to impact that overnight rate. They won’t generally impact anything more long-term than that.

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