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ECB Bond Purchases: Fiscal or Monetary Policy?

Summary:
In an NBER working paper, Arvind Krishnamurthy, Stefan Nagel, and Annette Vissing-Jorgensen analyze which components of bond yields were affected by the European Central Bank’s government bond purchasing programs. Given the institutional restrictions on monetary policy in the Euro area, the ECB had to carefully argue why it intervened in the first place. (To many, the case was obvious; the ECB intervention amounted to quasi-fiscal policy. But an intervention with this objective would not be covered by the rules of the Euro area.) It gave two reasons for the SMP, OMT, and LTRO: The ECB has publicly stated that these policies reduce redenomination risk, i.e., the risk that the Eurozone might break up and countries redenominate domestic debt into new domestic currencies, and financial

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In an NBER working paper, Arvind Krishnamurthy, Stefan Nagel, and Annette Vissing-Jorgensen analyze which components of bond yields were affected by the European Central Bank’s government bond purchasing programs.

Given the institutional restrictions on monetary policy in the Euro area, the ECB had to carefully argue why it intervened in the first place. (To many, the case was obvious; the ECB intervention amounted to quasi-fiscal policy. But an intervention with this objective would not be covered by the rules of the Euro area.) It gave two reasons for the SMP, OMT, and LTRO:

The ECB has publicly stated that these policies reduce redenomination risk, i.e., the risk that the Eurozone might break up and countries redenominate domestic debt into new domestic currencies, and financial market “dysfunctionality,” i.e., segmentation- and illiquidity-induced pricing anomalies.

The authors decompose bond yields into five components: an expectations hypothesis component; a euro-rate term premium; a default risk premium; a redenomination risk premium; and a component due to sovereign bond market segmentation. To identify the non-observable, country-specific components (reflecting default risk, redenomination risk, and sovereign bond market segmentation), the authors use information from asset prices that are differentially exposed to these components.

Specifically, they use the fact that

foreign-law sovereign bonds denominated in US dollars cannot be redenominated through domestic law changes … and redenomination into a new currency should affect all securities issued in a given country under the country’s local law equally.

The authors find that

the default risk premium and sovereign bond segmentation effect appear to have been the dominant channels through which the SMP and the OMT affected sovereign bond yields of Italy and Spain. Redenomination risk may have been present at times and it may have been a third policy channel for the SMP and OMT in the case of Spain and Portugal, but not for Italy. … default risk accounts for 30% of the fall in yields across SMP and OMT for Italy. Segmentation accounts for the other 70%. For Spain, the numbers are 42% (default risk), 15% (redenomination risk) and 43% (segmentation). For Portugal, the numbers are 40% (default risk), 24% (redenomination risk) and 36% (segmentation). For the LTROs, we find that their effect on Spanish bond yields worked almost entirely via the sovereign segmentation channel. We show that the more substantial impact of the LTROs on Spanish sovereign yields than on Italian and Portuguese sovereign yields is consistent with Spanish banks purchasing a larger fraction of outstanding sovereign debt in the months following the introduction of the LTROs.

Dirk Niepelt
Dirk Niepelt is Director of the Study Center Gerzensee and Professor at the University of Bern. A research fellow at the Centre for Economic Policy Research (CEPR, London), CESifo (Munich) research network member and member of the macroeconomic committee of the Verein für Socialpolitik, he served on the board of the Swiss Society of Economics and Statistics and was an invited professor at the University of Lausanne as well as a visiting professor at the Institute for International Economic Studies (IIES) at Stockholm University.

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