Large scale asset purchase

What Is Large Scale Asset Purchase?

A large scale asset purchase (LSAP) is an unconventional monetary policy tool employed by central banks to stimulate an economy, particularly when conventional tools like lowering interest rates become ineffective. It falls under the broader umbrella of monetary policy. In a large scale asset purchase program, the central bank buys substantial quantities of financial assets, such as government bonds and mortgage-backed securities, from commercial banks and other financial institutions. This action aims to inject liquidity into the financial system, lower long-term interest rates, and increase the money supply. Ultimately, the goal of a large scale asset purchase is to encourage lending, investment, and consumption, thereby fostering economic growth and stability.

History and Origin

Large scale asset purchases gained prominence as a monetary policy tool in the wake of the 2008 Global Financial Crisis. Prior to this period, central banks primarily relied on adjusting short-term interest rates to manage economic conditions. However, as interest rates approached zero during the crisis—a situation often referred to as the "zero lower bound"—central banks needed alternative measures to provide further economic stimulus. Central bank policies like LSAPs became necessary to combat the severe recession and prevent deflation.

The Federal Reserve was among the first to implement such programs, launching its first round of large scale asset purchases in November 2008. These initial purchases focused on agency debt and mortgage-backed securities, with a stated goal of supporting housing markets and improving overall financial conditions. The program was later expanded to include longer-term U.S. Treasury securities. The Federal Reserve Bank of New York provides detailed information on the various rounds of large-scale asset purchases undertaken by the U.S. central bank. Fol⁶lowing the Federal Reserve's lead, the European Central Bank (ECB) and other major central banks also initiated similar programs, known as Asset Purchase Programmes (APPs), to address economic challenges in their respective regions. The ECB's asset purchase programmes, for instance, began in mid-2014 to support price stability and the monetary policy transmission mechanism.

##⁵ Key Takeaways

• A large scale asset purchase (LSAP) is an unconventional monetary policy where a central bank buys vast quantities of financial assets.
• The primary objective of LSAPs is to lower long-term interest rates, increase the money supply, and improve financial market conditions.
• LSAPs are typically deployed when conventional monetary policy tools, such as interest rate adjustments, are no longer effective due to rates nearing the zero lower bound.
• These programs aim to stimulate economic activity by encouraging borrowing, investment, and consumer spending.
• LSAPs played a crucial role in combating the financial crisis of 2008 and the economic fallout from the COVID-19 pandemic.

Interpreting the Large Scale Asset Purchase

When a central bank announces or conducts a large scale asset purchase program, it signals its commitment to maintaining accommodative financial conditions. The scale of these purchases, often measured in billions or trillions of dollars or euros, reflects the central bank's intent to significantly impact market yields and liquidity. A larger purchase program suggests a stronger commitment to stimulating the economy.

Market participants interpret LSAPs as an attempt to lower long-term borrowing costs for businesses and consumers. By increasing demand for specific assets like government bonds or mortgage-backed securities, the central bank drives up their prices and, consequently, pushes down their yields. This reduction in yields on safe assets can prompt investors to engage in portfolio rebalancing, shifting their investments towards riskier, higher-yielding assets, which can further stimulate the economy.

Hypothetical Example

Consider a hypothetical country, "Econoland," facing a prolonged economic downturn with its central bank, the "Econobank," having already reduced its benchmark interest rate to near zero. Despite this, credit markets remain tight, and businesses are reluctant to invest.

To address this, the Econobank announces a large scale asset purchase program. It commits to buying $500 billion worth of long-term government bonds from commercial banks over the next six months.

1. Increased Bank Reserves: As the Econobank buys bonds from commercial banks, it credits their reserve accounts at the central bank. This increases the total bank reserves in the financial system.
2. Lower Long-Term Rates: The increased demand for government bonds drives up their prices, causing their yields to fall. This decline in long-term government bond yields serves as a benchmark for other long-term borrowing rates, such as those for mortgages and corporate loans, making borrowing cheaper across the economy.
3. Encouraging Lending: With more reserves and lower funding costs, commercial banks are incentivized to lend more to businesses and consumers. This increased availability of credit, coupled with lower borrowing costs, encourages new investments by businesses and larger purchases (like homes or cars) by consumers.
4. Economic Stimulus: The resulting boost in investment and consumption spending helps stimulate aggregate demand, pulling Econoland out of its economic stagnation.

Practical Applications

Large scale asset purchases are primarily a tool of central banks, particularly during periods of severe economic distress or when conventional monetary policy is constrained. Their practical applications include:

• Combating Recession and Deflation: As seen during the 2008 financial crisis and the COVID-19 pandemic, LSAPs were deployed by major central banks to prevent deep recession and counter the threat of deflation when inflation was very low or negative.
• Lowering Long-Term Interest Rates: By directly purchasing long-term securities, central banks aim to lower the borrowing costs for households and businesses, stimulating investment and spending. The Federal Reserve, for instance, specifically targeted U.S. Treasury securities and agency mortgage-backed securities to put downward pressure on long-term interest rates and support mortgage markets.
• ⁴ Enhancing Liquidity: LSAPs inject vast amounts of liquidity into the financial system, ensuring that banks have ample reserves, which can facilitate lending and improve the functioning of financial markets.
• Signaling Policy Intent: A large scale asset purchase program serves as a strong signal from the central bank about its commitment to an accommodative monetary stance, influencing market expectations about future interest rates and economic conditions. The European Central Bank's Asset Purchase Programmes (APP) were designed to support the monetary policy transmission mechanism and provide necessary policy accommodation.

##³ Limitations and Criticisms

Despite their intended benefits, large scale asset purchase programs are not without limitations and criticisms.

One major criticism is the potential for LSAPs to inflate asset prices, leading to concerns about wealth inequality. Critics argue that by driving up the prices of bonds and stocks, LSAPs disproportionately benefit those who own financial assets, while having less direct benefit for those with fewer assets. Another concern is that while LSAPs increase bank reserves, they do not guarantee that banks will lend these funds. If banks are risk-averse or if there is insufficient demand for loans, the increased liquidity might simply sit as excess reserves, limiting the intended economic stimulus.

Furthermore, some economists question the effectiveness of quantitative easing (the term often used interchangeably with large scale asset purchase) in significantly reducing long-term yields via the channels identified by central banks. There's also debate about the long-term consequences, such as the potential for future inflation if the accumulated reserves are rapidly unleashed into the economy, or the challenge of unwinding these large balance sheets. The Cato Institute, for example, has published analyses questioning the theoretical foundations and empirical evidence for the effectiveness of quantitative easing in persistently reducing long-term yields. Aca²demic research also scrutinizes central banks' own assessments of QE effectiveness, suggesting that central bankers might be more optimistic in their findings compared to independent academics.

##¹ Large Scale Asset Purchase vs. Quantitative Tightening

While a large scale asset purchase involves a central bank expanding its balance sheet by buying assets, quantitative tightening (QT) is its direct opposite. Quantitative tightening refers to a monetary policy where a central bank reduces its holdings of financial assets, typically by allowing maturing bonds to roll off its balance sheet without reinvesting the proceeds, or by actively selling assets.

LSAPs are a form of monetary easing, designed to inject money and liquidity into the financial system to support economic activity. Conversely, quantitative tightening is a form of monetary tightening, aimed at withdrawing money from the system and raising interest rates to combat high inflation or to normalize monetary policy after a period of extreme accommodation.

FAQs

Why do central banks conduct large scale asset purchases?

Central banks conduct large scale asset purchases primarily to stimulate the economy when traditional monetary policy tools, such as lowering short-term interest rates, are no longer effective. They aim to lower long-term interest rates, increase liquidity in the financial system, and encourage lending and investment to boost economic growth.

What types of assets are typically purchased in an LSAP?

The most common assets purchased in a large scale asset purchase program are government bonds (like U.S. Treasury securities) and mortgage-backed securities (MBS). Some central banks may also purchase corporate bonds or other private sector assets, depending on their specific mandates and market conditions.

Is large scale asset purchase the same as quantitative easing?

Yes, "large scale asset purchase" is often used interchangeably with "quantitative easing" (quantitative easing), particularly in the context of central bank policy. Both terms refer to the practice of a central bank buying large quantities of financial assets to stimulate the economy, especially when short-term interest rates are near zero.

What are the potential risks of LSAPs?

Potential risks include inflation if the increased money supply leads to overheating of the economy, the creation of asset bubbles due to inflated asset prices, and concerns about wealth inequality as those who own financial assets benefit disproportionately. There are also debates about the effectiveness and the long-term implications of central banks holding such large balance sheets.

How do large scale asset purchases affect the average person?

While the direct effects are primarily on financial markets and institutions, large scale asset purchases can indirectly affect the average person by lowering borrowing costs for mortgages and other loans, potentially making it cheaper to buy a home or finance a business. However, they can also contribute to higher prices for assets like stocks and real estate, and some critics argue they can worsen wealth disparities.