Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Buying Government Bonds Again
Transcript
- Lucas: If you thought the era of central bank bond buying was over, you might want to look at what's happening right now in Tokyo and Frankfurt. Luna: Wait — I thought we were in the age of quantitative tightening. The Fed has been shrinking its balance sheet for years. Lucas: The Fed still is, yes. But several other major central banks have quietly resumed net purchases of government bonds in 2026. Not the crisis-scale QE we saw in 2020 — smaller, more targeted buying. But it's happening. Luna: So the narrative that 'central banks are exiting unconventional policy' isn't universal? Lucas: Exactly. The Bank of Japan is the clearest example. They've been buying government bonds for decades, but in 2024 they moved to a new framework — yield curve control 2.0. Under that, they cap the ten-year Japanese government bond yield at 1.5 percent. And to enforce that cap, they have to buy whenever the yield pushes above it. Luna: Which they have been doing regularly this year because global yields are up. Lucas: Right. Since January 2026, the Bank of Japan has purchased roughly 15 trillion yen in government bonds — that's about $100 billion — to keep the ten-year at or below that 1.5 percent ceiling. It's essentially active bond buying, even if they call it yield curve management rather than QE. Luna: And what about the European Central Bank? I thought they ended net purchases under the Pandemic Emergency Purchase Programme in 2022. Lucas: They did end PEPP reinvestments in 2024. But the ECB has a newer facility — the Transmission Protection Instrument, or TPI. It's designed to prevent bond market fragmentation in the euro zone. If yields in, say, Italy spike relative to Germany, the ECB can buy Italian bonds to cap the spread. And in 2026, they've used it more aggressively than expected. Luna: How much are we talking about? Lucas: As of May 2026, the ECB's TPI holdings have reached about 60 billion euros. That's net new purchases — bonds they didn't hold before. It's not huge relative to the 5-trillion-euro PEPP portfolio, but it's a clear reversal from the idea that central banks should only sell, not buy. Luna: So the Fed is the outlier here, sticking with quantitative tightening while others are adding. Lucas: The Fed is continuing its passive runoff — letting Treasuries and mortgage-backed securities mature without reinvesting. As of May 2026, the Fed's balance sheet is down to about $6.8 trillion from a peak of $8.9 trillion in 2022. But there's a debate inside the Fed about when to stop. Some are worried about money market stress. Luna: Because shrinking reserves too much can cause repo market spikes, like we saw in 2019. Lucas: Exactly. The Fed doesn't want to repeat September 2019, when overnight repo rates surged to 10 percent. So they're watching reserve levels closely. The current thinking is they'll stop quantitative tightening once reserves fall to around $3 trillion — that's about 10 percent of GDP. We're at roughly $3.2 trillion now, so maybe by early 2027. Luna: If the Fed stops, and the Bank of Japan and ECB are buying, then globally we're moving toward central banks being net buyers of government bonds again. That's a big shift. Lucas: It is. And it matters for bond markets. When central banks buy bonds, they push down yields and compress term premiums — the extra compensation investors demand for holding long-term debt. That affects everything from mortgage rates to corporate borrowing costs. Luna: Let's talk about the Bank of Japan specifically for a moment. Their purchases are huge relative to the size of their economy. How sustainable is that? Lucas: The Bank of Japan already owns more than half of all outstanding Japanese government bonds — about 53 percent as of March 2026. At some point, they run into market functioning issues. If the central bank owns everything, there's no price discovery. Luna: Right, but they've been doing this for so long that the market has adapted. There's still trading, just mostly among foreign investors and banks. Lucas: True, and the yield curve control 2.0 is actually more flexible than the old 0.25 percent cap. It allows yields to float more, which gives the market a bit more room. But the fundamental dynamic remains: the central bank is a dominant buyer, and that shapes the entire yield curve. Luna: Let me ask what might sound like a naive question, but I think it's on listeners' minds: if central banks buy bonds, aren't they just printing money and risking inflation? Lucas: It's a fair question. When a central bank buys a bond, it credits the seller's bank account with reserves — that's new money. In theory, that could fuel inflation if banks lend it out. But the link between reserves and inflation is not mechanical. Banks can hold excess reserves without lending them. Since 2008, we've seen huge reserve expansions without corresponding inflation — until the pandemic. Luna: So the 2021-2022 inflation spike was partly because those reserves got into the real economy through fiscal stimulus, not just QE. Lucas: That's the consensus. QE alone didn't cause inflation; it was the combination of QE and large fiscal transfers that increased aggregate demand. Today, with central banks buying bonds but governments tightening fiscal policy, the inflation risk is lower. The Bank of Japan's purchases haven't pushed core inflation above 2 percent — it's running at around 1.8 percent. Luna: So they can keep buying without overheating? Lucas: For now, yes. But there's another risk: if central banks become too dominant, they distort the bond market's signaling function. A rising yield curve normally signals expectations of stronger growth or inflation. If the central bank is capping yields, that signal gets muted. Luna: And that can lead to misallocation of capital. Companies might borrow more cheaply than they should, thinking the economy is stronger than it is. Lucas: Exactly. There's also the exit problem. Once you start buying, it's hard to stop without causing a tantrum — like the 2013 taper tantrum when the Fed hinted at reducing purchases. The Bank of Japan and ECB are both aware of this. They try to be gradual and transparent. Luna: Let's bring it back to the global picture. If the Fed stops quantitative tightening in 2027, and the ECB and Bank of Japan keep buying, what does that mean for global bond yields? Lucas: It suggests that the natural rate of interest — the rate consistent with full employment and stable inflation — might be lower than many think. Central bank purchases artificially lower yields, so if they're buying, yields would be lower than in a free market. Some economists argue that the 'neutral rate' has fallen because of demographic trends and low productivity growth, and central bank buying is just adjusting to that. Luna: But others would say central banks are interfering with market signals and creating bubbles. Lucas: That's the perennial debate. I think the key takeaway for today is that the era of central bank balance sheet expansion is not over. It's just become more selective and targeted. For investors, that means paying close attention to which central banks are buying and which are selling — because that flows directly into bond yields, currency values, and asset prices. Luna: Speaking of which, if today's episode helped clarify some of these dynamics — you know, made something click — we want to mention something briefly. Lucas: Yeah, we get a lot of messages from listeners saying these deep dives are hard to find without ads or fluff. And honestly, that's by design. The way this stays sustainable is through listener support. If you found value here, you can help keep it going. Luna: It's buy me a coffee dot com slash fexingo. No pressure at all — just a way for those who can to chip in and keep the show ad-free. Lucas: We appreciate every bit of support, and it lets us keep bringing episodes like this one. Now, back to bond buying — one thing we haven't covered is the impact on currency markets. When the Bank of Japan buys bonds, it pushes yen lower relative to dollars, because they're effectively printing more yen. Luna: Right, and that's been a big story this year. The yen has weakened to around 160 to the dollar, partly because of the BoJ's continued easing stance. Lucas: That creates a headache for the Bank of Japan because a weak yen raises import prices and hurts consumers. So they're in a bind: they want to control yields, but that weakens the yen, and they have to balance that against inflation concerns. It's a classic central bank trade-off. Luna: And the ECB doesn't have that same currency pressure because the euro is floating freely and isn't as directly affected. Lucas: Correct. The ECB's TPI purchases are mainly about bond market stability within the euro zone, not about managing the exchange rate. But still, any bond buying by a major central bank has spillover effects — it lowers yields globally, which pushes capital toward higher-yielding markets like emerging economies. Luna: So we might see more capital flows into places like India or Brazil if the Fed stops shrinking and the BoJ and ECB keep buying. Lucas: That's the scenario. And that would strengthen emerging market currencies and potentially help them manage their own inflation. But it also creates vulnerability if those capital flows reverse suddenly. Luna: So to wrap it up: central banks are still in the bond-buying business, just in a quieter, more targeted way. The Bank of Japan is the most active, the ECB is selective, and the Fed is stepping back. But the overall direction is not a clean exit from QE. Lucas: Exactly. And I think the lesson is that central banks have found these tools too useful to abandon completely. They'll keep using them for specific purposes — yield curve control, market functioning, financial stability. The era of large-scale, crisis-driven QE may be over, but targeted bond buying is here to stay.