Asset Purchase Programme (APP)

The Asset Purchase Programme (APP) assists the European Central Bank in its objective of maintaining inflation below, yet close to, 2% over the medium term.

Asset purchases can stimulate the economy when traditional monetary policy measures are ineffective, particularly when the central bank is lending to commercial banks at interest rates near zero or even at negative rates for long-term refinancing operations.

By purchasing assets, euro area central banks can reduce bond yields, prompting investors to seek alternative investments, which should enhance financing options for businesses and households.

This, in turn, is expected to boost investment and consumption in the euro area, helping to align inflation with the target set by the Governing Council of the European Central Bank.

Why do we need an asset purchase program?

In typical economic conditions, the ECB influences broader financial conditions and, ultimately, macroeconomic trends and inflation by adjusting short-term key interest rates.

However, following the global financial crisis, key interest rates approached their effective lower bound, where further reductions would have minimal impact.

Consequently, the ECB resorted to non-standard measures to mitigate the risks of prolonged low inflation and to restore inflation to levels below, but close to, 2% over the medium term, which aligns with the Governing Council’s definition of price stability.

The asset purchase program is one of the non-standard measures employed by the ECB to achieve this goal. Although net purchases under this program concluded in December 2018, it continues as principal payments from maturing securities purchased under it are fully reinvested.

How does the asset purchase programme work?

Under the expanded asset purchase programme (APP), the ECB acquired a variety of assets, including government bonds, securities issued by European supranational institutions, corporate bonds, asset-backed securities, and covered bonds, at a rate ranging from €15 billion to €80 billion per month.

These asset purchases affect broader financial conditions and, ultimately, economic growth and inflation through three primary channels:

Direct Pass-Through

When the ECB purchases private sector assets, such as asset-backed securities and covered bonds linked to loans provided by banks to households and firms, the heightened demand for these assets raises their prices.

This incentivizes banks to issue more loans, which they can then use to create and sell additional asset-backed securities or covered bonds.

The increased availability of loans typically lowers bank lending rates for businesses and households, enhancing overall financing conditions.

Portfolio Rebalancing

The ECB has acquired both private and public sector assets from investors like pension funds, banks, and households.

These investors may opt to reinvest the funds received from selling assets to the ECB into other investments.

By boosting demand for assets more broadly, this portfolio rebalancing mechanism drives prices up and yields down, even for assets not directly targeted by the APP.

This leads to reduced costs (the effective market interest rate) for companies seeking financing in capital markets.

Simultaneously, the compression of yields on securities encourages banks to lend to businesses or households.

The increased availability of bank lending to the real economy generally lowers borrowing costs for households and firms.

If investors instead use the additional funds to purchase higher-yielding assets outside the euro area, this may also result in a lower euro exchange rate, which tends to exert upward pressure on inflation.

Both the direct pass-through and portfolio rebalancing channels enhance broader financial conditions for businesses and households in the euro area.

By reducing funding costs, asset purchases can stimulate investment and consumption.

More vigorous demand from both firms and consumers will ultimately help return inflation to below, but close to, 2% over the medium term.

Signaling Effect

Finally, asset purchases convey to the market that the central bank intends to maintain low key interest rates for an extended duration.

This signaling effect diminishes volatility and uncertainty in the market regarding future interest rate trends.

This is crucial as it influences various investment decisions. For instance, interest rates on long-term loans are likely to remain lower as banks anticipate a prolonged period of low-interest rates.

The ECB’s asset purchase program highlights its commitment to fulfilling its mandate by utilizing these channels to actively address the risks of an extended period of low inflation.

This reassures investors that inflation will remain around levels that are below, but close to, 2% over the medium term—a prerequisite for sustained growth in a stable price environment.