In popular terms, the ECB's purchase programme is often referred to as “printing extra money”, but central bankers prefer to use the official term, quantitative easing or QE. The reason for launching this programme is the outlook of persistently too low inflation in the euro area. The ECB's usual response would be to lower the policy interest rate in order to meet the inflation target of just under 2% in the medium term. However, as the policy interest rate has already reached the lower bound, purchasing financial assets is an alternative way of giving a monetary stimulus to the economy.
Operational details of the purchase programme
Since 9 March 2015, the Eurosystem central banks have been purchasing government bonds and debt securities from a number of national agencies and European institutions. Because of the prohibition of monetary financing of sovereigns, the bonds are not purchased directly from the issuer but from the parties holding them, such as banks, pension funds, insurance companies and other investment funds.
The public sector purchase programme supplements the purchase programmes for asset-backed securities (ABS) and covered bonds issued by banks, which have been running since the autumn of 2014. The combined monthly purchases of the three programmes amount to EUR 60 billion. Every Monday, the ECB publishes the total amount of purchases for each of these programmes (see the ECB website). The ECB intends to continue the purchases until September 2016, and in any case until the ECB's Governing Council sees a sustainable adjustment in the path of inflation that is consistent with its target. The amount of government bonds purchased of individual countries will be determined based on the ECB's capital key. This means that Dutch treasury bonds will account for approximately 5.7% of the total amount of government paper purchased. Most of these will be purchased by DNB and the remainder by the ECB.
The Eurosystem attaches several conditions for the bonds to be eligible for purchases. For example, the bonds must comply with the same credit rating requirements that apply to the collateral pledged by the banks in applying for ECB loans, in order to limit the risks to the central banks. This means that, for the time being, no Greek government paper will be purchased. In order not to disturb market liquidity too much and to maintain the market price discovery mechanism, the Eurosystem spreads the purchases over a broad maturity spectrum varying from two to thirty years, and purchases only a limited share of each bonds issue.
Purchases by DNB
In the dealing room, a monetary operations team executes the purchase of government bonds and covered bonds and monitors the effects of the purchase programme on the markets on a daily basis. They can draw on their experiences with other purchase programmes that were launched in the past few years, such as the Securities Markets Programme. The dealers negotiate with their banking counterparties using a dedicated electronic trading platform or by telephone. They compare the prices that are offered and subsequently select a number of counterparties to negotiate prices and quantities. These contacts also provide them with information about the holders of the bonds, i.e. pension funds, insurance companies or parties from outside the euro area. As soon as the deal is closed, the back office is informed. The back office then contacts the selling party's back office to arrange the settlement: the transfer of the bonds and their payment. As of that moment, the bonds are added to DNB's balance sheet.
The purchase programme creates new money
The process of quantitative easing is illustrated in the figure below using simplified balance sheets of three parties involved. In this example, the central bank purchases government bonds from a pension funds through a banking counterparty. The central bank credits the payment to the bank's cash reserves. This is electronic cash held by the banks with the central bank that they may only use for interbank transfers. The bank then credits the payment to the pension fund’s deposit account. As a result of these transactions, the government bonds are transferred to the central bank's balance sheet and the pension fund now holds a deposit with the bank instead of tradable bonds. At the same time, the cash reserves and deposits on the bank's balance sheet have increased. This means that the quantity of money in the economy has also increased, as pension fund deposits held by banks are counted towards the broad money aggregate M3. This is where the impact of quantitative easing on the economy actually starts. It is expected that the institutional investors will use part of these increased deposits to purchase other financial assets, causing a wider fall in interest rates. This should improve the funding conditions for businesses and households, encouraging them to spend more. The effects of the purchase programme are already evident from the decline in government bond interest rates and the euro exchange rate.