A Central Bank can decide to purchase government bonds. For example, the ECB has recently been buying bonds from members of the Eurozone. The impact of buying bonds depends upon whether it is ‘sterilised’ or unsterlised.
- Sterlised Bond Purchases. This occurs when the Central Bank purchase government bonds without affecting the money supply, i.e there will be no inflationary impact of buying bonds from commercial banks.
- Unsterlised Bond purchases. This occurs when the Central Bank purchases government bonds and allows the money supply to increase. (see also: Quantitative easing)
How to Sterilise Bond Purchases
When the Central bank buys government bonds from commercial banks, the banks see an increase in their liquid bank balances. (they get money from Central Bank from selling bonds). This increase in reserves could lead to an increase in bank lending. However, the Central bank can offset these purchases by taking deposits from commercial banks. Therefore, in theory, the extra money the banks gain from selling bonds, they then deposit in fund accounts at the Central Bank.
For example, after ECB bond purchases, the ECB then offered commercial banks 1% interest rate for weekly fund deposits (above 0.25% for daily deposits). Therefore commercial banks have an incentive to deposit money in these weekly accounts. (ECB Bond sterilisation)
- Banks sell bonds to ECB and gain money.
- This money is then deposited back at the Central Bank.
- Net money supply stays the same.
- In practise ‘sterilising’ bond purchases is not straightforward. The Central bank may wish to encourage banks to deposit, but they may not be able to encourage banks to deposit sufficient funds. Some say ‘sterilised bond purchases’ can still be a slippery slope to ‘unsterilised bond purchases’
- Also, in the case of the ECB, banks are actually allowed to use these ‘weekly deposit funds’ as collateral in lending. In other words, the weekly deposit funds (aimed at sterilising bond purchases) is more liquid than the government bonds and could lead to higher bank lending.
- In a liquidity trap, even if excess reserves were created as a result of bond purchases, the fall in the willingness of banks to lend means that it is non-inflationary anyway. Unsterilised quantitative easing in UK and US, didn’t cause a jump in inflation.
Importance of Sterilisation
The difference between sterilised and unsterilised bond purchases may seem a little technical but it has a big impact on policy. For example, the ECB are very keen to insist that their bond purchases are not going to be ‘unsterilised’ and risk the potential of inflation.