The Financial Market Effects of the Federal Reserve's Large-Scale Asset Purchases

This 2011 International Journal of Central Banking paper by Gagnon, Raskin, Remache, and Sack provides the founding empirical assessment of the Federal Reserve’s first large-scale asset purchase program (LSAP1, later known as QE1): between December 2008 and March 2010 the Fed bought more than $1.7 trillion of longer-term Treasury, agency debt, and agency mortgage-backed securities, roughly 22% of the $7.7 trillion stock of those securities outstanding (about $850 billion, or over 20% of the $3.7 trillion stock, measured in duration-equivalent “ten-year equivalents”). The authors argue the purchases worked mainly through a portfolio-balance channel — removing duration from the market forces the private sector to hold less of that duration risk, bidding up prices and compressing term premiums across asset classes, including on securities the Fed never bought — rather than through a signaling channel that would work by lowering expected future short-term rates; MBS purchases additionally reduced prepayment/negative-convexity risk, and an early market-functioning/liquidity channel narrowed unusually wide agency and MBS spreads. Two independent empirical strategies are used. An event study of cumulative one-day changes around an eight-announcement “baseline event set” (November 2008 through November 2009) finds the 10-year Treasury yield fell 91 basis points, the 10-year agency debt yield fell 156 bp, agency MBS yields fell 113 bp, the 10-year Kim-Wright term premium fell 71 bp, the 10-year swap rate fell 101 bp, and the Baa corporate index fell 67 bp, while the 2-year Treasury yield fell only 34 bp — a pattern the authors read as showing the effect worked mainly through the term premium rather than expected future policy rates, since the two announcements that also carried forward-guidance language moved the Kim-Wright one-year-ahead instantaneous rate by only about 4 bp each. A separate time-series regression of the 10-year Kim-Wright term premium (monthly, January 1985-June 2008) on cyclical, uncertainty, and net public debt-supply variables, estimated by OLS and dynamic OLS exploiting a cointegrating relationship, implies the full $1.725 trillion LSAP program (about 12% of 2009 GDP) lowered the 10-year term premium by roughly 38-82 basis points depending on specification — a range the authors emphasize “overlaps considerably” with the event-study estimates despite using entirely different data and methods. The net 10-year Treasury yield did not actually fall over the full program window (it rose over 100 bp on non-event days), which the authors attribute to a rising expected fiscal deficit and a strengthening outlook rather than to any reversal of the LSAP effect. International comparisons show the UK’s 2009-10 gilt purchases produced a “strikingly similar” roughly 100 bp decline in 5-25-year yields, while Japan’s smaller and shorter-duration 2001-06 purchases had little effect on longer-term yields.

Matthew Raskin | Macro Paper Warehouse

The Financial Market Effects of the Federal Reserve's Large-Scale Asset Purchases