A new paper suggests that ECB asset purchases influence markets and the economy significantly, mainly through three channels. First, through the asset valuation channel they reduce risk premia and provide capital relief to leveraged institutions, particularly banks. Second, through the signalling channel they enhance the credibility of rates staying low for long. Third, through the re-anchoring channel, asset purchases can reassure the private sector that the central bank remains committed to its long-term inflation target.
Andrade, Philippe, Johannes Breckenfelder, Fiorella De Fiore, Peter Karadi, and Oreste Tristani (2016), “The ECB’s asset purchase programme: an early assessment”, European Central Bank, Working Paper Series, No 1956 / September 2016.
The below are excerpts from the paper. Headings and cursive text have been added.
The ECB’s asset purchase programme
“The euro area asset purchase programme started in the fourth quarter of 2014 with the purchases of asset-backed securities and covered bonds…The Governing Council decided on 22 January 2015 for the adoption of further quantitative measures to expand the size and change the composition of the Eurosystem’s balance sheet. The previous two programmes were therefore supplemented with additional purchases of securities issued by euro area governments, agencies and EU institutions under the PSPP [Public Sector Purchase Programme].
- Combined monthly purchases would amount to EUR60 billion [and were later increased to EUR80 billion] and initially were to be carried out until at least September 2016 – and in any case until inflation returned to a path consistent with the ECB’s definition of price stability. On 3 December 2015, the intended minimal duration of the programme was extended until the end of March 2017. In December 2015, the Governing Council also decided to reinvest the principal payments on the securities purchased under the APP as they mature, for as long as necessary…
- The spectrum of securities covered by the PSPP includes only securities with a residual maturity ranging from two to 30 years…The intended allocation…was 88% to government bonds and recognised agencies, and 12% to securities issued by international organisations and multilateral development banks…To preserve normal secondary market functioning, purchases were initially subject to a security-specific issue-share limit of 25% and an issuer-specific limit of 33% in terms of nominal value. On 3 September 2015, the Governing Council decided to increase the security-specific limit also to 33%.”
For all the key points of the ECB asset purchase programme view post here.
Understanding the three transmission channels
“We group [transmission channels] into three main categories:
- Asset valuation channel… The asset valuation channel posits that [risk] premium is a function of the stock of long-term bonds held by the private sector… A policy of asset purchases replaces longer-term and/or riskier assets with short-term and safe central bank reserves…We specifically focus on two aspects of the asset valuation channel: the reduction of duration risk and the bank capital relief.
- The duration risk channel posits that the bond risk premium is increasing in the exposure of [private] bond holders…By reducing private sector holdings of such bonds, central bank purchases should reduce exposure to duration risk and thus lead to a decline in yields… Duration risk denotes the exposure of long-term bonds to unexpected changes in policy interest rates. Such risk induces a premium on bond yields…Long-duration bonds are riskier, because they are more sensitive to interest rate risk…
- The capital relief channel suggests that the increase in asset prices that [a purchase programme] generates is akin to a capital injection for leverage-constrained institutions,..the higher prices of sovereign bonds induced by the asset purchase programme should benefit banks through the ensuing increased valuation of their bonds holdings.
- Signalling channel…Quantitative easing is akin to forward guidance, namely an announcement that policy interest rates will remain at the lower bound for a longer period. The marginal benefit over forward guidance is to make the announcement more credible…Credibility is higher because large-scale purchases of long-term assets expose the central bank to the risk of losses on its balance sheet, in case short-term rates are abruptly increased. This provides an incentive for keeping policy rates low and to increase them only gradually on the exit from the crisis.
- Re-anchoring channel… Monetary policy…based solely on interest rates…may become ineffective when the lower bound constraint is reached. Private expectations may then start doubting the ability of the central bank to ensure price stability. They may at some point coordinate on a self-fulfilling, liquidity-trap equilibrium characterised by persistent deflation and deflation expectations, as well as low GDP levels…The implementation of a quantitative easing may be effective in reassuring the private sector of the central bank’s ability to re-anchor inflation expectations.”
On the risk of a de-anchoring of inflation in the euro area view post here.
Empirical evidence for the influence of the three channels
“Evidence is consistent with two aspects of an asset valuation channel: the reduction of duration risk and the bank capital relief…
- We find that asset price effects are produced on announcement, i.e. when information about the ECB programme is released. No statistically significant effects can be identified when purchases are carried out.
- Based on results from 24 [previous] studies… the median announcement effect of a QE programme for 10 percent of GDP is to reduce 10-year sovereign yields by 53 bps.
- We present evidence on the dynamic effect of the ECB asset purchase programme on sovereign and private yields, the exchange rate and various stock market indices…These effects are indeed quite persistent…comparable to that of standard monetary policy impulses, which have been shown to have significant impact on inflation and economic activity.
- The fall in yields after the programme announcement is larger, the longer the maturity of bonds.
- The results in this paper provide support for the capital relief channel. They show that the equity prices of banks holding a larger portfolio share of government bonds benefited more from the increase in bond prices.”
“The empirical evidence is also consistent with the signalling channel. After the announcement of the programme, market expectations of future short term interest rates edged down, while inflation expectations tended to increase… Based on the Survey of Professional Forecasters, we show that inflation and growth expectations increased…We also show that disagreement in expectations of future interest rates fell…[Hence] the downward shift in the yield curve did not reflect a worsening outlook for inflation and GDP growth.”
“Finally, the evidence suggests that the introduction of the asset purchase programme helped the ECB guide long-term inflation expectations closer to its price stability objective…The analysis of survey forecasts…reveals that, after decreasing noticeably during 2014, long-term inflation expectations returned towards level consistent with the ECB’s definition of price stability following the asset purchase programme announcement.”
On the impact of the ECB asset purchase programme on term and credit spreads also view post here.
The impact on the economy
“We then use a macro model featuring these three channels to assess the likely macroeconomic effects of the asset purchase programme. In our benchmark simulations, which abstract from the signalling channel, the programme contributes to stabilize the economy and push up the inflation rate. The model suggests that, compared to a counterfactual scenario without the purchase programme, the peak increase in inflation was around 40 basis points and in output around 1.1 percent.”
“In terms of macroeconomic effects, the programme is estimated to be roughly comparable to a decrease in standard policy interest rates by 1 percentage point.”
“In terms of the various channels, the asset valuation channel explains around two thirds and the re-anchoring explains around one third of the peak increase in inflation compared to the counterfactual scenario.”