How Does QE Lower Interest Rates?

At each quarterly meeting, FOMC members are asked to state what they think would be an appropriate forward path for the Fed Funds Rate, given their present expectations about future inflation and unemployment.  The following table and chart show how the averages of these estimates have evolved over the last three meetings:



Suppose that FOMC projections turn out to be accurate.  Rates rise through 2015, and then stabilize at long run levels.  For each of the different future path estimates, we can ask, how much would $100 of cash earn over the next 10 years under that estimate? If we assume that the interest on the outstanding cash balance is paid on the first of the year, at the prior year’s interest rate, and that the transition from ~1% to the long run interest rate occurs over two years, consistent with the 2003 – 2007 cycle, we get the following result: 

pathestimatecashCash under the June path estimate would earn slightly more than cash under the March path estimate, and cash under the September path estimate, released today, would earn less than both.

Now, to get an idea of what sort of effect on long-term bond yields the differences between the path estimates might be able to justify, we can ask, what would a brand new $100 face value 10 year risk-free bond–a symmetric alternative to holding $100 of cash for 10 years–need to yield to match the cash return under each rate path?  If we assume that the coupon is held as cash and reinvested at the Fed Funds rate, we get the following result.


So the yield on a 10 year risk free bond that would be necessary to match the yield on cash is about 20 bps higher on the June path estimate than the March path estimate.  Did the market respond to the March-June Fed shift by increasing the 10 year bond yield by 20 bps?  Hardly.  On May 1st, a little less than a month and a half after the March meeting, the 10 year treasury yield was trading at a ridiculous 1.64%.  On August 1st, a little less than a month and a half after the June meeting (which all but cemented the Fed’s “taper” plan), it was trading at 2.72%.  The market adjusted to the news of the Fed’s plan by increasing the 10 year yield 108 bps, when only 20 bps was necessary (assuming anyone had taken the path guidance seriously).

This result helps to illustrate the mechanism through which QE lowers long-term interest rates.  Surely, there are stock and flow effects.  If you reduce the supply of bonds that investors can invest in, and increase the supply of zero-interest money that they must hold, you are going to push bond yields lower.  Similarly, if you enter a market as a dominant player and promise to buy a large number of securities, you are going to push the prices of those securities higher.  But far more powerful than either of these effects is the behavioral impact of QE, the way it influences investors’ perceptions of the Fed’s intentions and their expectations about likely future Fed policy.  Bond yields rose in May and June because of that effect.  

The Fed’s perceived insistence on “tapering” in the presence of a still-weak economy created doubts in the investment community about its commitment to a dovish, pro-cyclical policy stance.  The selling in the bond market and consequent rises in yields–that the Fed seemed to be OK with–made the shift feel acutely real to investors.  A reflexive feedback loop then took hold.  More and more investors began to question whether bonds were a smart place to be invested, which led to more doubts, more selling, lower prices, more discomfort, more questioning, more doubts, more selling and so on.  

Some have proposed that the Fed should counteract this process by telling the market that it intends to keep rates lower for a longer period of time.  But talking is easy to do, and can be taken back in the future on a moment’s notice.  QE, in contrast, is an overt action.  It cannot be feigned or faked, nor can it be easily taken back.  For all practical purposes, once the Fed’s balance sheet is increased, it has to stay increased until the securities roll off (to try to sell them would create chaos).  Thus, when the Fed aggressively expands its balance sheet, when it steps into what the market views as “uncharted territory” and exposes itself to controversy and criticism, it demonstrates its commitment to an easy policy, its willingness to stay true to such a policy despite the risks.  It puts its money where its mouth is–quite literally.

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