The Asset Purchase Programme (APP) helps the European Central Bank in its task of keeping inflation below but close to 2% over the medium term.
Asset purchases can provide a stimulus to an economy if the traditional monetary policy measures of a central bank are not working as planned and it is lending to commercial banks at interest rates close to zero, or even at negative rates for long-term refinancing operations.
Asset purchases let euro area central banks lower the yield on bonds and this leads investors to put their money elsewhere, which should improve the financing options available to companies and households.
This should encourage investment and consumption in the euro area and help keep inflation in line with the target of the Governing Council of the European Central Bank.
Why do we need an asset purchase program?
In normal economic times, the ECB steers broader financial conditions and, ultimately, macroeconomic developments and inflation by setting the short-term key interest rates.
But, as a result of the global financial crisis, key interest rates have come close to their effective lower bound – the point at which lowering them further would have little to no effect.
Therefore, the ECB turned to non-standard measures to address the risks of a period of low inflation lasting for too long, and to bring inflation back to levels below, but close to, 2% over the medium term, which is the Governing Council’s definition of price stability.
The asset purchase program is one of the non-standard measures the ECB is using to achieve this. Net purchases under this program ended in December 2018, but the program is ongoing as principal payments from maturing securities purchased under it are being reinvested in full.
How does the asset purchase programme work?
Under the expanded asset purchase programme (APP), the ECB bought a range of assets including government bonds, securities issued by European supranational institutions, corporate bonds, asset-backed securities, and covered bonds at a pace ranging from €15 billion to €80 billion per month.
Such asset purchases influence broader financial conditions and, eventually, economic growth and inflation, through three main channels:
When the ECB buys private sector assets, such as asset-backed securities and covered bonds, which are linked to loans that banks grant to households and firms in the real economy, the increased demand for these assets drives up their prices.
This encourages banks to make more loans, which they can then use to create and sell more asset-backed securities or covered bonds.
The increased supply of loans tends to lower bank lending rates for companies and households, improving broader financing conditions.
The ECB has purchased private and public sector assets from investors such as pension funds, banks, and households.
These investors may choose to take the funds they receive in exchange for assets sold to the ECB and invest them in other assets.
By increasing demand for assets more broadly, this mechanism of portfolio rebalancing pushes prices up and yields down, even for assets that are not directly targeted by the APP.
This results in reduced costs (the effective market interest rate) for companies seeking to obtain financing on the capital markets.
At the same time, the compression of yields on securities encourages banks to lend to companies or households.
The increased supply of bank lending to the real economy tends to lower the costs of borrowing for households and firms.
If, on the other hand, investors use the extra funds to buy higher-yielding assets outside the euro area, this may also lead to a lower euro exchange rate, which tends to put upward pressure on inflation.
Both the direct pass-through and the portfolio rebalancing channel improve broader financial conditions for companies and households in the euro area.
By lowering funding costs, asset purchases can stimulate investment and consumption.
More dynamic demand from both firms and consumers will eventually contribute to returning inflation to below, but close to, 2% over the medium term.
Finally, asset purchases signal to the market that the central bank will keep key interest rates low for an extended period of time.
This signaling effect reduces volatility and uncertainty in the market regarding future interest rate developments.
This is important because it guides various investment decisions. Interest rates charged on long-term loans, for example, will remain lower as banks anticipate a protracted period of low-interest rates.
The ECB’s asset purchase program underscores its commitment to fulfilling its mandate by using these channels to actively address the risks of a period of low inflation that lasts for too long.
This serves to reassure investors that inflation will be around levels that are below, but close to, 2% over the medium term – a precondition for sustained growth in an environment of price stability.
Vincent Nyagaka is a Professional Trader, Analyst &. He has been actively engaged in market analysis for the past 7 years. He has a monthly readership of 100,000+ traders and has taught over 1,000 students since 2014. Vincent is also an experienced instructor and public speaker. Checkout Vincent’s Professional Trading Course here.