Bond purchases

What Are Bond Purchases?

Bond purchases refer to the acquisition of debt securities, such as government bonds or corporate bonds, by an investor. While any entity can engage in bond purchases, the term most frequently refers to large-scale acquisitions by a central bank as a key component of its monetary policy. These actions are designed to influence overall credit conditions, manage the money supply, and achieve specific economic objectives. Such operations fall under the broader category of macroeconomic policy.

When a central bank makes bond purchases, it effectively injects liquidity into the financial system. This action aims to lower interest rates across the economy, encouraging borrowing and investment, and ultimately stimulating economic growth. The most well-known form of large-scale central bank bond purchases is quantitative easing (QE).

History and Origin

The practice of central banks engaging in bond purchases, particularly on a large scale, gained significant prominence following the 2008 global financial crisis. Before this period, central banks primarily influenced the economy through adjusting short-term interest rates via traditional open market operations. However, when benchmark interest rates approached zero, limiting the effectiveness of conventional tools, central banks turned to unconventional measures like large-scale asset purchases.¹⁵

One notable historical instance of central bank asset purchases, albeit on a smaller scale than modern quantitative easing, was the Federal Open Market Committee's (FOMC) "Operation Twist" in 1961. This operation involved the Federal Reserve selling short-term Treasury securities and buying long-term government bonds to flatten the yield curve and stimulate the economy. However, the scale and scope of bond purchases expanded dramatically after 2008. For instance, the U.S. Federal Reserve implemented multiple rounds of quantitative easing, starting in December 2008 with purchases of agency mortgage-backed securities (MBSs) and agency debt. By March 2020, in response to the COVID-19 pandemic, the Federal Reserve's balance sheet surged from $4.2 trillion in February to $7 trillion by July 2020 due to extensive bond buying programs.

Key Takeaways

• Bond purchases are the acquisition of debt securities, often carried out by central banks to manage economic conditions.
• Central bank bond purchases, particularly through quantitative easing, aim to lower interest rates and increase the money supply.
• These operations influence bond prices, which move inversely to interest rates.
• The goal of such bond purchases is typically to stimulate economic growth, combat deflation, or stabilize financial markets.
• While effective in certain circumstances, bond purchases can carry risks, including potential impacts on market functioning and inflation.

Interpreting Bond Purchases

When a central bank engages in bond purchases, the primary interpretation is that it is pursuing an expansionary monetary policy. By buying bonds from commercial banks and other financial institutions, the central bank increases the amount of reserves held by these banks. This influx of cash makes it easier and cheaper for banks to extend loans to businesses and households, thereby stimulating credit growth and economic activity.

The scale and type of bond purchases provide further insight. For example, large-scale purchases of longer-term government bonds or mortgage-backed securities, as seen during quantitative easing programs, signal an intent to exert downward pressure on long-term interest rates.¹⁴ This aims to encourage significant investment and borrowing by making long-term financing more affordable. Conversely, a reduction or cessation of bond purchases (known as tapering or quantitative tightening) indicates a shift towards a less accommodative monetary policy, often in response to rising inflation or strong economic growth.¹³

Hypothetical Example

Imagine a scenario where the economy is experiencing sluggish growth and low inflation, leading the central bank to consider intervention. The central bank decides to undertake a program of bond purchases.

Let's say the central bank announces it will purchase $100 billion worth of long-term government bonds from commercial banks over the next six months.

1. Central Bank Action: The central bank initiates these bond purchases. It electronically credits the reserve accounts of the commercial banks from which it buys the bonds.
2. Increased Bank Reserves: Commercial Bank A, for instance, sells $1 billion in government bonds to the central bank. In return, its reserves held at the central bank increase by $1 billion.
3. Impact on Lending: With more reserves, Commercial Bank A has greater capacity and incentive to lend money. This increased supply of available funds in the banking system leads to a decrease in the federal funds rate, which is the interest rate at which banks lend reserves to each other overnight.
4. Broader Interest Rate Impact: The lower federal funds rate, in turn, influences other interest rates across the economy, such as mortgage rates and business loan rates, pushing them downward.
5. Economic Stimulus: Lower borrowing costs encourage consumers to take out loans for purchases like homes and cars, and businesses to borrow for expansion and investment. This increased spending and investment contribute to overall economic activity and potentially higher employment.

This hypothetical example illustrates how bond purchases by a central bank aim to ease financial conditions and stimulate the economy through various channels, ultimately affecting borrowing costs and aggregate demand.

Practical Applications

Bond purchases by central banks are primarily applied as a tool for implementing monetary policy, especially in unconventional circumstances. Their practical applications include:

• Stimulating Economic Growth: During periods of recession or slow economic activity, central banks use bond purchases to lower long-term interest rates, making it cheaper for businesses to invest and consumers to borrow, thereby boosting aggregate demand. This was a significant application during the 2008 financial crisis and the COVID-19 pandemic.¹²
• Combating Deflation: When an economy faces the risk of sustained price declines, bond purchases can help increase the money supply and encourage spending, countering deflationary pressures.
• Stabilizing Financial Markets: In times of market stress or illiquidity, central banks may step in as a "market maker of last resort" through bond purchases to ensure the smooth functioning of financial markets. This helps prevent systemic crises and restore confidence.¹¹
• Influencing Currency Value: While not always the primary goal, large-scale bond purchases can sometimes lead to a devaluation of the domestic currency due to an increased money supply, potentially making exports more competitive.

For example, from late 2008 through October 2014, the Federal Reserve substantially expanded its holdings of longer-term securities through open market purchases with the explicit objective of putting downward pressure on longer-term interest rates, thereby supporting economic activity and job creation.¹⁰ More recently, in November 2021, the Federal Reserve announced it would begin to "taper" its bond-buying program, which had been set at $120 billion a month since March 2020. This move signaled the central bank's response to signs of a strengthening U.S. economy and elevated inflation, indicating a shift away from emergency support measures.⁹

Limitations and Criticisms

While bond purchases can be an effective monetary policy tool, they are not without limitations and criticisms. One concern is their potential impact on market liquidity. Some research suggests that central bank asset purchases, particularly of corporate bonds or mortgage-backed securities, can lead to a deterioration in market functioning, such as reduced trade sizes and trading volumes.⁸

Another criticism revolves around the effectiveness of bond purchases in stimulating the "real economy." While they demonstrably lower interest rates and can boost asset prices, their broader impact on consumption, investment, and employment can be less clear or even temporary.⁷ For instance, some argue that quantitative easing primarily benefits borrowers over savers and investors over non-investors, potentially exacerbating wealth and consumption inequality.⁶ Furthermore, excessive or prolonged bond purchases could lead to unintended consequences, such as mispricing of assets or a weakening of market discipline by reducing incentives for governments and corporations to manage debt responsibly.⁵

There are also debates about the "exit strategy" from large-scale bond purchases, meaning how central banks can unwind these positions without disrupting markets or triggering unwanted inflation. Reversing quantitative easing through "quantitative tightening" (selling off bonds) can lead to higher bond yields and increased borrowing costs, posing fiscal challenges for governments.⁴ Some economists also raise concerns about the politicization of central banks, arguing that extensive bond purchases can blur the lines between monetary and fiscal policy.³

Bond Purchases vs. Quantitative Tightening

Bond purchases and quantitative tightening represent opposite actions within the realm of central bank monetary policy. Both involve a central bank's activity in the bond market, but their objectives and effects are distinct.

The confusion between these two terms often arises because they both involve the central bank interacting with the bond market. However, bond purchases are an expansionary measure designed to ease financial conditions, while quantitative tightening is a contractionary measure aimed at tightening them. For example, during the COVID-19 pandemic, the Federal Reserve undertook massive bond purchases to support the economy. In contrast, in more recent years, with inflation accelerating, central banks globally have begun to implement quantitative tightening to rein in price increases.²

FAQs

What types of bonds do central banks typically buy?

Central banks primarily buy government bonds (like U.S. Treasuries) and, especially during periods of crisis, may also purchase other assets such as agency mortgage-backed securities or even corporate bonds. The specific types depend on the central bank's mandate and the economic conditions it aims to address.

How do bond purchases affect the average person?

When a central bank makes bond purchases, it generally leads to lower interest rates on loans, including mortgages, car loans, and business loans. This can make borrowing cheaper for consumers and businesses, potentially stimulating spending and job creation. However, lower interest rates can also reduce returns on savings accounts and fixed-income investments.

Are bond purchases the same as printing money?

While bond purchases do increase the overall supply of money in the financial system by crediting commercial banks' reserve accounts, it's not the same as physically printing currency. The increased money is primarily in the form of electronic reserves, which banks can then lend out, thereby expanding the broader money supply.

Why do central banks sometimes stop or reverse bond purchases?

Central banks may stop or reverse bond purchases when the economy shows signs of strengthening or when inflation rises above their target. The goal is to prevent the economy from overheating and to keep prices stable. This process of reducing or ending bond purchases is often referred to as "tapering," while actively selling off bonds is known as "quantitative tightening."

Do bond purchases always lead to inflation?

Not necessarily. While increasing the money supply through bond purchases can contribute to inflationary pressures, other economic factors also play a significant role. If the economy is operating below its full potential, bond purchases might stimulate demand without causing high inflation. However, if the economy is robust, large-scale bond purchases could lead to unwanted inflation.¹