LSAPs affect yields or liquidity based on central bank intent
A new working paper reveals that central bank large-scale asset purchases (LSAPs) have distinct effects depending on their primary objective. Purchases for monetary accommodation strongly affect yields, while those for market functioning primarily enhance liquidity.
Two faces of asset purchases
The study empirically demonstrates that central bank asset purchases, while operationally similar, yield markedly different outcomes based on their intent.
Purchases aimed at monetary accommodation, such as those during QE1, QE2, and QE3, are found to strongly affect longer-term yields, driving them down significantly upon announcement.
These effects are persistent but show little impact on market liquidity metrics.
Conversely, purchases executed for market functioning, like those initiated in March 2020 to address severe market dysfunction, lead to significant improvements in liquidity measures, compressing bid-ask spreads.
Crucially, these market functioning purchases have minimal effect on yields, even as they increase duration risk on the central bank's balance sheet.
This distinction is identified using a duration-adjusted measure of the Federal Reserve's System Open Market Account (SOMA) portfolio, combining security-level data with narrative event-based identification in a structural vector autoregressive (VAR) model.
Intermediation shapes impact
To reconcile these empirical findings, the paper advances a partial equilibrium model of an intermediated bond market, incorporating the role of market makers.
The model distinguishes between orderly and disorderly trading flows.
When order flow is balanced, LSAPs affect yields by reducing the expected supply of duration, with minimal impact on liquidity.
Conversely, when order flow is disorderly and market makers accumulate elevated inventories, LSAPs reduce these inventories, improving liquidity and compressing bid-ask spreads.
In this state, LSAPs have no effect on yields.
The model emphasizes that the state of intermediaries' balance sheets is a crucial determinant for the transmission of LSAPs, explaining how similar operations can have divergent effects.
Beyond a single-purpose tool
This research provides a crucial theoretical and empirical distinction between types of LSAPs, moving beyond a one-size-fits-all view of central bank asset purchases.
It highlights that central banks possess a more nuanced toolkit than often assumed, allowing for targeted interventions in either price stability or financial stability.
For policymakers, this implies that the clear communication of LSAP objectives is paramount for achieving desired outcomes and managing market expectations effectively.