The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy

This 2011 Brookings Papers on Economic Activity paper by Arvind Krishnamurthy and Annette Vissing-Jorgensen evaluates the effect of the Federal Reserve’s large-scale purchases of long-term Treasuries and other long-term bonds – QE1 in 2008-09 and QE2 in 2010-11 – on interest rates, and argues that quantitative easing works through several distinct channels that affect different assets differently, so it is inappropriate to focus only on Treasury rates as a policy target and effects depend critically on which assets are purchased. The authors decompose the yield on a long-term risky, illiquid asset into the expected safe short rate, expected inflation, and premia for duration risk, illiquidity, lack of safety, default risk, and prepayment risk, and identify seven candidate channels (signaling, duration risk, liquidity, safety, prepayment risk, default risk, and inflation), each tied to instruments that should load on it (federal funds futures for signaling, CDS for default risk, inflation swaps/TIPS/swaption volatility for inflation). Identification comes from an event study around the QE1 announcement dates (Nov 25, Dec 1, Dec 16, 2008; Jan 28, Mar 18, 2009) and the QE2 announcement dates (Aug 10, Sep 21, Nov 3, 2010), combined with difference-in-differences comparisons across pairs of assets that share most characteristics but differ in one dimension (e.g., agency versus Treasury bonds isolating liquidity), and a 2SLS regression of the Baa-Treasury and Baa-Aaa spreads on the log ratio of ten-year-equivalent long-term Treasury supply to GDP using 1949-2008 annual data. For QE1, summed two-day yield changes around the five event dates were sizable and pervasive: Treasury yields fell 73 bp (30-year), 107 bp (10-year), 74 bp (5-year); Fannie Mae agency yields fell 144-200 bp across maturities; agency MBS yields fell 88-107 bp; the signaling channel alone (a roughly 6.3-month delay in anticipated rate hikes, a 40 bp drop in 24-month fed funds futures) is estimated to account for about 20-40 bp of the declines out to ten years, while duration effects only partly explain the pattern (they cannot account for agency bonds falling the most or for the absence of a within-rating maturity effect in corporates), and safety, MBS prepayment, default, and inflation channels are all found to be operative, with MBS purchases described as crucial to the fall in MBS yields and corporate credit risk. For QE2, which purchased only Treasuries, the results look different: signaling lowered 5-year yields by 11-16 bp and 10-year yields by 7-11 bp, safety lowered 10-year low-default-risk yields by a further 6-11 bp, and inflation expectations rose (implied 10-year inflation expectations up 14-16 bp), but the authors find no evidence of duration, liquidity, prepayment, or default channels for QE2, and conclude that its effect on the mortgage and lower-grade corporate rates most relevant to households worked mainly through signaling and inflation rather than a portfolio-balance effect. The safety-channel regression estimates an elasticity of -0.83 (Baa-Treasury) and -0.32 (Baa-Aaa) on log relative Treasury supply, implying safety effects of roughly 4-11 bp for QE1 and 8-20 bp for QE2 under “normal” demand conditions – substantially smaller than the safety effect the event study attributes to QE1, which the authors suggest reflects unusually elevated crisis-period demand for safety rather than an average relationship. The paper’s central mechanism claim is that the portfolio-balance channel operating in both QE1 and QE2 works through a preferred-habitat safety channel – a clientele demand for long-term assets with little or no default risk – rather than through the duration-risk channel emphasized in some contemporaneous work, a conclusion the authors state directly: they “do not find support for the operation of the duration risk channel.”

Annette Vissing-Jorgensen | Macro Paper Warehouse

The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy