IS (05.2024) The benefits and costs of asset purchases

Question 1

What are the two main purposes for which central banks use asset purchases?

Answer 1

Central banks use asset purchases :

• to respond to disturbances in monetary policy transmission and to stabilize financial markets,
• as well as to ease financing conditions to stimulate aggregate demand near the lower bound on interest rates.

Question 2

When did the ECB start using bond purchases to counter downside risks to the inflation outlook, and what was the program called?

Answer 2

The ECB started using bond purchases in 2015 under the Asset Purchase Programme (APP).

Question 3

How did central banks, including the ECB, use asset purchases after the outbreak of COVID-19 in 2020?

Answer 3

Central banks used asset purchases to (1) stabilize financial markets and (2) ease financing conditions in pursuit of price stability.

The PEPP embodied both objectives in one program.

Question 4

What did Ben Bernanke mean by saying, “the problem with quantitative easing is that it works in practice, but it doesn’t work in theory”?

Answer 4

He highlighted the discrepancy between the practical effectiveness of quantitative easing and the theoretical challenges in explaining how it works.

Question 5

What is Wallace neutrality, and how does it relate to asset purchases?

As a consequence, how do asset purchases function as a signaling channel according to the text?

Answer 5

Wallace neutrality suggests that changes in the size and composition of a central bank balance sheet should have no effect on asset prices, output, or inflation, implying asset purchases may predominantly work through a signaling channel.

As a consequence, they would be similar to forward guidance in that they signal a commitment to an extended period of low short-term interest rates. They show the central bank’s commitment through its exposure to duration risk.

Question 6

What is the “Delphic” way of central banks communicating about monetary policy?

Answer 6

Central banks communicate about the likely future direction of monetary policy based on how the economy evolves, rather than making fixed commitments.

Question 7

How do asset purchases through the liquidity channel work, particularly in the context of non-bank financial intermediaries?

Answer 7

Asset purchases are effective in addressing liquidity shortages outside the banking sector, where non-bank financial intermediaries do not have direct access to the central bank balance sheet.

Question 8

How did the operational details of the PEPP in 2020 help stabilize financial markets?

Answer 8

The flexible allocation of purchases across time, asset classes, and countries removed concerns about policy space and stopped price spirals.

Question 9

What are the potential risks of market interventions or announcements by central banks?

Answer 9

Market interventions can create risks of moral hazard, especially in less exceptional circumstances compared to exogenous shocks like the pandemic.

Question 10

What is the Transmission Protection Instrument (TPI) announced by the ECB in 2022, and what are its eligibility criteria?

Answer 10

The TPI is designed to counter unwarranted market dynamics to ensure smooth monetary policy transmission, requiring governments to pursue sound fiscal and macroeconomic policies.

Question 11

What example illustrates a successful exit strategy from an asset purchase program?

Answer 11

The Bank of England’s response to the LDI crisis showed how an exit strategy can be designed successfully to balance market stabilization with price stability.

Question 12

What is the portfolio rebalancing channel, and how does it function in the context of quantitative easing?

Answer 12

The portfolio rebalancing channel aims to reduce long-term government bond yields and encourage risk-taking by banks and investors to stimulate aggregate demand and inflation.

Question 13

What evidence suggests that the impact of asset purchases is smaller outside crisis periods?

Answer 13

Studies indicate that QE announcements lower bond yields and raise asset prices more significantly during crises, with effects being up to 40% smaller in non-crisis periods.

Question 14

What was the peak level of Eurosystem bond holdings under the APP and the PEPP, and how does this compare to GDP?

Answer 14

At the peak, Eurosystem bond holdings reached more than €5 trillion, or around 35% of euro area nominal GDP, similar to levels in the United Kingdom and the United States.

Question 15

What are the notable benefits of using asset purchases near the effective lower bound?

Answer 15

Asset purchases have lifted growth, generated upward pressure on inflation, and helped prevent inflation expectations from falling further during periods of low inflation.

Question 16

What was the economic context during the ECB’s first QE between 2015 and 2018, and how did it affect QE’s effectiveness?

Answer 16

• Governments were consolidating public finances,
• banks were building capital buffers,
• and non-performing loans were high,

leading to moderate boosts in credit creation and sluggish inflation response.

Question 17

How did the economic context during and after the pandemic differ from the earlier QE period?

Answer 17

Fiscal deficits soared, lending to households and firms increased significantly, reflecting solid balance sheets and a strong common policy response, which made QE more effective.

Question 18

What key takeaway does the text highlight about the economy’s response to QE?

Answer 18

QE is most effective when banks, households, firms, and governments are able and willing to respond to low interest rates, boosting economic activity and lifting inflation closer to the target.

Question 19

What are the side effects of QE mentioned in the text, and how does the ECB assess them?

Answer 19

Side effects include interest rate risk and potential central bank losses, which can impact reputation and credibility. The ECB takes a comprehensive approach to assessing these side effects as part of its proportionality assessment.

Question 20

How can long periods of QE adversely affect market functioning?

Answer 20

Sustained QE can lead to a scarcity of government bonds, which may adversely affect financial market conditions and impair the steering of short-term interest rates.

Question 21

How can QE pose financial stability risks and exacerbate inequality?

Answer 21

Portfolio rebalancing effects may result in excessive risk-taking, increased asset valuations, and surging asset prices, which can pose risks to financial stability and exacerbate wealth inequality.

Question 22

What role did QE play in the rise of asset valuations and price-earnings ratios in stock markets?

Answer 22

QE contributed to the rise in asset valuations and record-high price-earnings ratios as it was designed to lower yields and encourage risk-taking.

Question 23

How did residential property prices in the euro area change from the start of QE in 2015 to 2022?

Answer 23

Residential property prices in the euro area increased by nearly 50% from the start of QE in 2015 to their peak in 2022.

Question 24

How does portfolio rebalancing from QE amplify wealth inequality?

Answer 24

Since wealthier households hold more long-duration assets, they benefit more from central banks purchasing longer-dated assets, while low-wealth households hold fewer such assets.

Question 25

What evidence suggests that portfolio rebalancing effects might be highly persistent?

Answer 25

Despite sharp rises in interest rates, stock market valuations remain high, and house prices have shown broad resilience due to supply constraints, strong demand, and gradual unwinding of central bank assets.

Question 26

Why do central banks typically take a cautious approach to reducing the size of their balance sheets?

Answer 26

A cautious and gradual approach is taken to avoid causing congestion effects in financial markets and to allow banks time to adjust to the fall in excess liquidity.

Question 27

What is the stock effect, and how does it relate to quantitative tightening (QT)?

Answer 27

The stock effect refers to the impact on financial markets of the total amount of assets held by central banks. This effect matters when reducing portfolios, as bonds mature gradually and future redemptions are heavily discounted by investors.