ECB explains the transmission of asset purchases to the real economy

Economic Developments in the Euro Area

Excerpts from Speech by Peter Praet, Member of the Executive Board of the ECB, at the FT Debt Capital Markets Outlook Conference in London, 12 February 2015

"How does the asset purchase programme add extra monetary stimulus to the euro area economy? It does so along five dimensions.

The first is the overall size of our interventions, which will be substantial.

The second is the pace, which will accelerate to €60 billion per month.

The third is the composition of purchases, which will include securities issued by euro area sovereigns and EU institutions.

The fourth is the maturity, which extends from 2 to 30 years.

And the fifth dimension is the horizon of our new measures, which will last until end-September 2016 or until we see a sustained adjustment in the path of inflation consistent with our aim of achieving inflation rates close to 2% over the medium term."

"... it will work through several transmission channels, we expect it to be particularly powerful in terms of portfolio rebalancing effects. Put simply, the displacement of investors’ portfolios will be larger, faster and take place across more market segments. This should also help reduce market segmentation arising from excess risk aversion, improve confidence and lead to a generalised easing of financing conditions for euro area firms and households."

..." Indeed, I expect that an important transmission channel for our new measures will be via banks.

·         Banks may tend to follow a pecking order strategy in their response to large-scale asset purchases. In the first instance, those that sell their securities to the central bank, and thus have an excess reserve position, may react by paying down market debt. This would create scarcity in bond markets, thus inducing a portfolio rebalancing effect and leading in turn to a compression of yields.

·         When this liability management reaches its limit, we would then expect that those more favourable market funding conditions to translate into lower lending rates for borrowers in the real economy – which is a key aim of our measures. This should be aided by the effect of portfolio rebalancing on the returns on securities and its implication for banks’ decisions to grant loans.

·         Specifically, as expected returns on securities will be compressed, maintaining net interest income will require banks to shift their portfolios away from securities and towards loans to firms and households. Indeed, one reason that credit growth has been weak, especially in peripheral countries, is that the risk adjusted returns for banks on loans have been very subdued relative to returns on securities portfolios – especially domestic government bonds.

·         Moreover, as credit conditions further ease and the macroeconomic outlook improves, there should be an endogenous effect on borrowing conditions. Insofar as banks expect lower delinquencies thanks to improving macroeconomic conditions, they should require lower credit risk premia from firms and households, implying lower lending rates. And insofar as asset prices are boosted by our measures, collateral values will rise in tandem, implying higher lending volumes.

·         Finally, we expect all these effects to be reinforced by the way we have calibrated our programme, in particular the open-ended commitment to return inflation back close to 2%. This strengthens the signal emanating from our decisions, which is visible in price movements at the longer end of the yield curve. And it should also support the firm anchoring of inflation expectations, which is crucial to avoid the self-reinforcing dynamics associated with a too long period of low inflation that I mentioned above."

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