Under non-conventional monetary policy central banks influence financial markets through the “portfolio rebalancing channel”. The purchase of assets changes the structure of prices. A particularly powerful portfolio rebalancing effect arises from duration extraction, i.e. the combined size expansion and duration extension of the assets that have been absorbed onto the central bank’s balance sheet. Duration extraction has a significant and persistent impact on the yield curve and the exchange rate. Importantly, the effect arises from hints or announcements of new parameters for the future stock of assets. Given the large size of central bank balance sheets, this explains why changes in expected asset purchases, re-investments or redemption plans have a profound impact on financial markets.
Titzck, Stephanie and van den End, Jan Willem, The Impact of Size, Composition, and Duration of the Central Bank Balance Sheet on Inflation Expectations and Market Prices (March 8, 2019). De Nederlandsche Bank Working Paper No. 627 (2019).
The post ties in with SRSV’s summary lecture on non-conventional monetary policy.
The below are quotes from the paper. Emphasis and cursive text have been added.
Understanding the duration extraction channel
“By engaging in unconventional monetary policy the central bank actively uses its balance sheet to influence financial market outcomes, the real economy, inflation expectations, and ultimately inflation…On the asset purchase side, transmission channels include the signalling channel [and] the portfolio rebalancing channel…For refinancing operations, liquidity effects play a role.”
“Asset purchases may affect the economy through the portfolio rebalancing channel, which is often cited as the main channel through which quantitative easing affects financial markets and the economy… The portfolio rebalancing channel works in the context of imperfect asset substitutability, which means that central bank purchases of long-term bonds in exchange for central bank reserves or deposits induce a change in asset prices or consumption.”
“An important form of portfolio rebalancing is the duration extraction channel… Through this channel the central bank can alter the yield curve, particularly reducing long-maturity bond yields relative to short-maturity yields (reflected in the term premium), by taking out duration risk from the market. Inflation expectations may increase if lower interest rates relax borrowing and spending constraints and raise the value of assets.”
Evidence for the importance of the duration extraction effect
“First, balance sheet policies seem effective in influencing the bond yield and exchange rate.”
“We analyse the effects of announcements of changes in the Eurosystem’s balance sheet size, duration and composition on inflation expectations, the exchange rate and the 10-year euro area government bond yield…The main innovation of this paper is the use of multiple balance sheet dimensions as monetary policy surprises…in particular, the interaction between size and duration is of interest, as it reflects the duration extraction channel.”
“We first construct metrics of announcements of changes to three balance sheet dimensions, i.e. size, duration and composition. We then use these metrics to construct monetary policy surprise series for the empirical analysis…for the period 2008:4 to 2017:6 [for the euro area]… Size is measured by total assets related to monetary policy instruments on the Eurosystem balance sheet scaled by euro area GDP for each month in the sample… Duration is measured by the weighted average maturity of long-term repo operations and asset purchases.”
“The size measure shows three expansions: a smaller one in 2008, a large one in 2011-2013 and an even larger one since the beginning of 2015… The duration evolves in two large waves over the sample period. First, it increased sharply in 2010, owing to the purchases of bonds…Second, duration has increased even more from mid-2014 onwards, when ECB introduced measures to provide additional monetary policy accommodation to support lending to the real economy.”
“We find evidence for the importance of the duration extraction channel (the interaction of size and duration as measured by the weighted average maturity balance sheet) for monetary policy transmission… The interaction of size and duration and of size and composition have significant effects on the bond yield and exchange rate. This suggests that both financial market variables are particularly sensitive to the combined impact of shocks to the balance sheet dimensions and not so much to isolated shocks…It implies a larger negative effect of an increasing balance sheet size on the bond yield and exchange rate when the central bank takes more duration from the market, while increasing its balance sheet and vice versa. These effects are found to be quite persistent.”
Evidence of the importance of the stock effect
“Stock effects seem to matter for the transmission of balance sheet policies.”
“By focussing on announcements of balance sheet policies, not their implementation..in the sense of flow effects..we analyse the importance of stock effects, i.e. effects of changes in market expectations on the future central bank portfolio (e.g. regarding size, duration or composition) induced by new information, in the transmission of monetary policy.”
“The cumulative sum of the announcements is constructed by adding up the nominal amounts of long-term refinancing operations (LTROs) and asset purchases on the balance sheet over the announced horizon at the date of the announcement.”
“We construct measures of unexpected balance sheet shocks across the three dimensions (size, duration, composition). Specifically, we identify innovations to the balance sheet dimensions, purged of anticipatory effects as reflected in market prices.”
“The combined effect of size and duration and the fact that the empirical analysis is based on announcements of policy measures, not their implementation, underline the importance of stock effects of central bank balance sheet policies.”