Bad Medicine? The Side Effects of Central Bank Mispricing

Big medical problems often require significant doses of strong pharmaceuticals. Unfortunately, the medicines often come hand-in-glove with unwanted side effects.

The same is true in economics. 

An Anemic Economy

In response to the conditions produced by the 2007–09 financial crisis and the eurozone sovereign debt crisis that persisted, one of the world’s central banks doled out some strong medicine — and it caused considerable problems. 

In an attempt to resuscitate the weak European economy, European Central Bank (ECB) policies distorted Europe’s bond market and effectively transferred hundreds of millions of dollars from taxpayers to financiers, according to “Central Bank-Driven Mispricing,” a paper co-authored by Davide Tomio, a professor in Darden’s Finance area. Moreover, the distortions reduced the market’s usefulness as a measure of the ECB’s policy effectiveness.

“[These findings] should concern central banks in particular and policymakers in general,” states the report.

Strong Medicine

Here’s how the distortion came to pass: In 2015, in the context of abiding near-deflationary conditions, the ECB decided to buy the bonds issued by those governments that participated in Europe’s single currency area, the eurozone. The idea was to hold down long-term borrowing costs and to jump-start the European economy. 

To see if the ECB’s strategy altered the markets in unintended ways, Tomio and his fellow researchers used data from 2013 and 2014 — the two years just before the ECB announced the new bond-buying program — as control years. They studied the period of March 2015 through April 2017, when the ECB made monthly bond purchases of between €50 billion and €80 billion. 

In the history of central banking, this level of quantitative easing was unprecedented in both scope and duration.

Adverse Effects

The ECB’s bond-buying binge caused a variety of effects, direct and indirect. 

With reduced availability of the government securities, it naturally became more difficult for commercial banks to acquire bonds for use as collateral. And without the ability to support their loan operations — vital for lending institutions — bond scarcity likely stymied loan growth.

Importantly, the availability of bonds typically helps maintain market liquidity, and a more liquid market tends to be a more efficient market. Likewise the inverse: Fewer available bonds can mean lower liquidity, and the corresponding less efficient market means the prices of securities don’t necessarily reflect their true values. 

In this case, the bond market became so distorted that financial institutions could make money easily through trading between the futures market and the bond market. 

An Expensive Prescription

In an efficient market, bond interest rates should be more-or-less identical to those indicated by the futures contracts for the same bonds. When there is a significant difference, then traders can sell one (a bond) and buy the other (a futures contract) to make a risk-free profit — such opportunities exceedingly rare or nonexistent in an efficient market. 

During the period of the ECB’s market efforts, there were larger-than-usual gaps between the interest rates in the bond and futures markets. These differences allowed “traders to profit from selling the more expensive security — and contemporaneously perfectly hedging it by buying the cheaper security,” the report states. 

Such trades, possible due to the ECB’s intervention, were “tantamount to a direct transfer from taxpayers to arbitrageurs” — the latter a type of trader who profits from price differences across separate markets.

Though determining the exact figure would be a challenge, as the ECB doesn’t provide that data, Tomio notes that “what is certain is that the ECB paid too much for the securities.” 

Using data from other sources, the researchers estimate that the total transfer of wealth to speculators was as high as €1.46 billion.

Further Complications

Not only did the wide difference between the prices of bonds and futures contracts give speculators the opportunity to make money with zero risk — at the expense of taxpayers — it undermined the ECB’s ability to measure what its own policies did or didn’t achieve. Central bankers use the financial markets as indicators of how effectively their policies are working; when two markets don’t show the same interest rate (in this case, the futures and bond markets), it gives them conflicting information.

“The market for interest rates should be informative for monetary policy to be effective, and it is in the policymakers’ interests that the market participants agree on what the ‘correct’ interest rate is,” the researchers note.

Although the research by Tomio and his colleagues specifically addressed the actions of the ECB, there are clear implications for other central banks, including the Federal Reserve, which conducted a similar bond-buying program in the U.S. markets.

When conducting outright asset purchases, central banks would be well-advised to carefully monitor markets connected by arbitrage, and market neutrality is more likely if they purchase a broader set of assets. 

Davide Tomio co-authored “Central Bank-Driven Mispricing,” a Sustainable Architecture for Finance in Europe working paper, with Loriana Pelizzon of Goethe University Frankfurt and Ca’ Foscari University of Venice, Marti G. Subrahmanyam of New York University’s Stern School of Business and Jun Uno of Waseda University.