This shows us that sometimes market forces (i.e. fear, flight to security, yield-seeking) that are beyond the control of the Federal Reserve can have a greater impact on interest rates than billions of dollars worth of non-conventional monetary policy.
Tuesday, April 1, 2014
Now that Janet Yellen and her fellow American central bankers have signalled that the Fed's long experiment with quantitative easing is soon to end, it is important to look back and see what impact unconventional monetary policy and the bloating of the Federal Reserve's balance sheet had on longer term interest rates once the Fed had pushed the Fed Funds rate to zero, since it is through the manipulation of interest rates that the Federal Reserve hopes to impact the economy.
A fascinating paper "Measuring the Change in Effectiveness of Quantitative Easing" by Daniel Nellis at Grinnell College in Iowa takes an empirical look at the effectiveness of QE 1, QE 2 and QE 3 and whether each round was as effective as the round that preceded it.
Let's open by looking at the key events in the life of the Fed since 2008:
1.) November 25, 2008 - QE 1 is announced - Federal Reserve purchases $500 billion of government agency mortgage-backed securities and $100 billion of agency debt. The intent of QE 1 was to reduce the cost and increase the availability of credit for the purchase of housing and was completely unanticipated by the market, catching investors completely off guard.
2.) November 3, 2010 - QE 2 is announced - Federal Reserve purchases $600 billion in Treasury bonds at a pace of about $75 billion per month. Note that a speech by Ben Bernanke on August 27, 2010 telegraphed that additional purchases of longer-term securities might be required to further ease financial conditions so the announcement of QE 2 was hardly a surprise to the markets. In fact, a survey by CNBC showed that in October 2010, 93 percent of respondents believed that QE 2 would be announced.
3.) September 12, 2012 - QE 3 is announced - Federal Reserve announces an open policy to buy $40 billion of agency mortgage-backed securities each month ad infinitum. This move was telegraphed in the August 22, 2012 release of the FOMC minutes from the July 2012 meeting. Again, most investors expected an expansion of QE with the only uncertainty being the size of the program.
As you can see from this summary, once the Federal Reserve announced QE 1, the surprise element was completely gone and investors anticipated that further asset purchases would be required based on the weak U.S. economy as 2010, 2011 and 2012 passed.
When the Fed purchases long-term securities like 10- and 30-year Treasuries, the demand for these securities is artificially increased and the supply is decreased which pushes up the price and pushes down the yield since the two work in opposition to each other. In addition to affecting the price and yield of the particular security that is purchased by the Fed, the prices and yields on other similar securities are impacted in the same direction, pushing yields down on those assets.
The study looked at various key events around the announcement of QE 1, QE 2 and QE 3, looking at both single day and longer-term impacts to see whether the effect of the announcements were permanent or temporary.
Here is a chart showing key dates for QE 1 and how the yield on 10- and 30-year Treasuries was impacted:
After a year, the yield on 10-year Treasuries had fallen by 0.96 percent and 30-year Treasuries had fallen by 1.04 percent.
This graph shows that the impact of QE 1 on 10- and 30- year yields was not long-lasting, possibly because other influences on bond yields had overtaken the impact of QE 1:
Here is a chart showing key dates for QE 2 and how the yield on 10- and 30-year Treasuries was impacted:
Basically, there was no immediate impact on yields when QE 2 was announced, likely because, as I noted above, the market was anticipating the Fed's moves. From the time that the Fed started to telegraph that QE 2 was on its way until the date of the announcement, yields on 10-year Treasuries rose by 0.14 percent and yields on 30-year Treasuries rose by 0.07 percent rather than falling as was the Fed's intent.
Here is a chart showing key dates for QE 3 and how the yield on 10- and 30-year Treasuries was impacted:
Again, between the day when the Fed telegraphed that QE 3 was a possibility and the day of the announcement, 10-year yields rose by 0.13 percent, however, in contrast to QE 2, 30-year yields dropped by 0.46 percent.
From this analysis, we can clearly see that QE 1 was far more effective at lowering long-term interest rates than either QE 2 or QE 3, largely because the "surprise factor" was absent, particularly in the case of QE 2 where the amount of asset purchases was publicly announced. Basically, even though the Fed added trillions of dollars to its balance sheet, a situation that could lead to future inflationary pressures, the overall reward (of lower interest rates) for the risk involved has been minimal. In the words of the author:
"The Federal Reserve has employed the successful monetary policy of maintaining a stable rate of inflation during the past few decades, so loosening the control of inflation for the sake of attempting an unproven monetary policy to lower interest rates and stimulate the economy seems unwise. Based on the above factors, the risks associated with QE are not worth the rewards, and the Federal Reserve should utilize other monetary policies to target interest rates in the future."
I couldn't have said it better.