Central bank purchasing programs – their benefits and their side effects

When central banks buy bonds, borrowers and investors in high-risk asset classes such as shares both benefit. As borrowers, companies naturally also benefit from such programs: they make it easier and cheaper to finance takeovers, and the size of the takeovers increases. In addition, less profitable companies are subsidized by the low interest rates they have to pay. Such extremely low yields in the corporate sector thus result in a gradual process of concentration, average company size tends to increase in individual sectors and market forces are sapped accordingly.

But the greatest beneficiary of such programs is the state. States are the biggest borrowers and they accordingly also enjoy the biggest interest-rate savings. In addition, it also becomes very easy for countries to place their bonds as the central bank is always there to act as backstop buyer. These two effects reduce countries’ incentive to implement reforms. Accordingly, it comes as no surprise that the euro area’s member states’ readiness to implement reforms has dwindled again in the last few years.

Bond purchasing programs can be a very effective central bank policy instrument when used at the right time and in the correct dosage and can prevent or mitigate severe crises. On the other hand, the side-effects are very considerable and depend mainly on the volume and duration of the programs. In addition, that central banks fail to halt the purchasing programs in due time is inherent to the programs’ incentive mechanisms. Those responsible should be aware of all these dangers, otherwise the risks of such instruments are greater than their benefits.

In an interview Bundesbank president Weidmann drew attention to the fact that the central banks’ bond purchasing programs are overestimated. The purchasing programs are not able to generate inflation directly. The liquidity they generate remains largely in the banking sector and only a small part of it flows into the real economy. The inflationary effects of such instruments are accordingly relatively small.

But when central banks buy bonds yields are affected directly. The yields of government bonds and of other instruments on which the central bank focuses its attention, such as, for example, Pfandbriefe or corporate bonds, fall. As a rule low bond yields lead to a relatively stable economy. In the medium term this can also contribute to higher inflation. However, this also depends on a few other factors, such as the development of commodity prices. At the moment, we are seeing only slight effects on inflation as wages are rising only modestly despite the positive development of the employment market.

But falling yields also have direct effects. Generally speaking, borrowers and investors in high-risk asset classes, such as shares or corporate bonds, benefit. Purchasing programs for sovereign bonds or for other segments of the bond market push up the prices of the bonds concerned. As a result, yields fall and further investment in these bonds is no longer lucrative or no longer makes much sense as of a certain price level. The prices for these bonds have simply become too rich and also have little potential to rise further even if the central banks prolong their programs or increase their volume. The consequence is that investors move their capital, with the equity markets benefiting most. Shares become relatively attractive in such an environment as the companies benefit directly from falling financing costs and the stable economy. In addition, the valuation of the equity markets is relatively attractive. The property markets are naturally also a beneficiary of low interest rates. If the purchasing programs go on too long, these asset classes may become overvalued and the liquidity bubble that then builds up may burst for relatively little reason.

Naturally, companies also benefit as borrowers from such programs. Takeovers can be financed more easily and more cheaply and the size of the takeovers increases. In addition, less profitable companies are subsidized by the low interest rates. Such extremely low yields in the corporate sector thus result in a gradual process of concentration, average company size tends to increase in individual sectors and market forces weaken accordingly.

But the greatest beneficiary is the state. States are the biggest borrowers and they accordingly also enjoy the biggest interest-rate savings. In addition, it also becomes very easy for countries to place their bonds as the central bank is always there to act as backstop buyer. These two effects reduce countries’ readiness to implement reforms. Generally speaking, structural reforms are not highly attractive for a government as the positive effects of such reforms become only partly manifest within a legislative period. So the likelihood of being voted out of office on account of reform programs that are usually unpopular with voters is relatively great. But when a country loses competitiveness and attractiveness yields usually rise and it becomes more difficult to finance the budget. Due to this effect, financial market developments may lend governments a decisive incentive to implement structural reforms. But it is precisely this effect which is undermined by sovereign bond purchasing programs. It therefore comes as no surprise that the euro area states’ readiness to implement reforms has diminished in the last few years.

What is left after a long period of central bank bond purchases?
A very stable economy, substantial liquidity in the banking sector, a corporate sector that may have lost some of its efficiency, relatively expensive equity and property markets, misallocations in the government bond segment with the corresponding misdirected incentives for governments. The strength of these effects depends on the program’s volume, duration and aim. As regards the ECB’s program, so far the corresponding effects are particularly notable with respect to Pfandbriefe, corporate bonds and government bonds.

Another systemic risk is that central banks fail to taper and terminate their programs in due time on account of these beneficial effects. Their concern is that the positive effects on the economy probably outweigh the negative effects. In addition, the central bankers naturally also like to bask in the sun of their successes. But if the purchasing programs go on too long, the liquidity bubbles described above may build up and under certain circumstances may unleash another crisis. Another risk lies in the fact that governments may become accustomed to such accommodative central bank policy and may not be very pleased to see such programs throttled back. Admittedly, such government influence should actually be ruled out by the independence of the central banks. But politicians can also be very imaginative when necessary.

Bond purchasing programs can be a very effective central bank policy instrument when used at the right time and in the correct dosage and can prevent or mitigate severe crises. But their side-effects are also very considerable, depending mainly on the volume and duration of the programs. In addition, that central banks fail to halt the purchasing programs in due time is inherent to the nature of the programs themselves. Those responsible should be aware of all these dangers, otherwise the risks of such instruments are just as great as their benefits.

 

 

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