Monday 22 October 2018

ECB lifts Irish bond purchases as debate on ending QE rages on

Piotr Skolimowski and Donal O'Donovan

Central bankers across the globe have lauded quantitative easing (QE), the crisis tool that sees central banks buying vast quantities of traded debt in order to drive down lending returns and therefore encourage riskier investments. QE is credited with averted outright deflation in the period after the crash, but policymakers are still feeling their way to reversing out of the scheme.

A new Bank of England staff blog suggests policymakers should be less worried about the need to keep the bloated balance sheets they've acquired.

Economist Richard Harrison's study finds that QE's stimulus comes from buying assets, rather than from owning them. In a post on the BoE's Bank Underground blog he says that the stimulus effect is due to an "expectations channel", whereby bond investors recognise a central bank will start purchases when it runs out of room to cut rates. The investors react accordingly, pushing down yields.

That means simply holding large quantities of bonds won't have the same kind of effect.

"'Active' QE improves welfare precisely because it is active," writes Harrison, who works in the BoE's Monetary Assessment and Strategy Division. "If the central bank merely holds a fixed proportion of long-term debt on its balance sheet, then it will not replicate this feature of an active QE policy."

Harrison's findings go to the heart of the debate that the European Central Bank (ECB) is having on whether to stop adding to bond purchases after September next year.

Growth in the euro area economy is now running at the best level in a decade and the ECB has already said it will scale back its monthly bond purchases.

Some policymakers argue that the stock of holdings on the books is the primary source of stimulus, others say the monthly flow of purchases is what impacts the market.

Harrison sidesteps his European colleagues' conundrum, his model does not support the idea of permanently large central bank balance sheets - something equally relevant to the Bank of England too, which has said it plans to maintain bond holdings built up under a QE programme there until interest rates reach a level where they could be cut "materially" in case of a negative shock to the economy.

Regarded as a extreme even five years ago, Harrison suggests QE could become a more familiar tool in the future.

"If real interest rates remain low for a prolonged period, perhaps because of secular factors, then we would expect the lower bound on policy rates to be encountered more often. During these more frequent lower bound episodes, the model predicts that QE should be used to help support spending and inflation."

In a signal that the ECB's decision to scale back purchases doesn't mean the scheme is in retreat, new data shows the bank increased purchases of Irish bonds in November. In fact acquisitions of the Irish debt were above the monthly total mandated by its so-called capital key last month.

The key capital formula means the ECB in effect buys the bonds of euro area governments in proportion to the size of each country.

Up to now the ECB has struggled in some months to find enough of the Irish debt to buy to meet that target, so was able to over-purchase in November to compensate.

This "confirms that while the ECB is deviating from its preferred allotment method, due to scarcity or any other reason, it will use that same flexibility to fill any gaps when possible," said Kim Liu, a strategist at ABN Amro. (Additional reporting Bloomberg)

Irish Independent

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