How Should We Measure Success?
In the nearly two and a half years since the onset of the financial crisis, the Fed has purchased over $2 trillion in long-term assets. Determining the effectiveness of such a policy is challenging for a number of reasons, including the lack of prior experience with this monetary policy tool. One approach is to examine changes in interest rates to assess how financial markets react to announcements related to and preceding policy decisions. A second approach is to look broadly at the overall effect that the purchases have had on macroeconomic conditions. This article uses both approaches to judge the effectiveness of the Federal Reserve’s large-scale asset purchases.
A simple plot of the 10-year Treasury yield suggests that the Federal Reserve’s asset purchases were effective in lowering bond yields. For example, yields declined sharply with the announcements of the first round of asset purchases in late 2008 and the most recent round in November 2010.
However, judging the effectiveness of asset purchases from broad movements in Treasury yields is complicated by several factors. First, compared to other financial assets such as mortgage-backed securities, Treasury bonds have a special function for investors as a highly liquid and safe investment. Times of stress in financial markets can induce what is known as a flight to safety, in which investors sell other assets and buy Treasuries. This rush to safe securities pushes the price of Treasuries up and yields down. For example, some portion of the fall in 10-year Treasury yields in late 2008 is almost certainly attributable to the rush to safe securities by foreign and domestic investors.
Because of this complexity in the Treasury market, other rates might provide a clearer picture about the effects of the purchases. The bulk of the first round of asset purchases was made in mortgage-backed securities, so the 30-year mortgage rate and the yield on a 30-year mortgage bond should reflect an impact if there was one, as might AAA-rated agency debt. Due to the general lack of liquidity in these securities during the financial crisis, their prices should have incorporated fewer market events. In the graphs for these rates, it is easier to see that the announcements on policy decisions and the announcements on policy direction seemed to help ease conditions. The interest rates associated with these securities all fell significantly on the initial announcement, and they also experienced smaller drops following later events.
Some other aspects of financial markets also complicate determining the effects of monetary policy changes on the yields of both Treasury bonds and mortgage-related securities. First, financial markets can anticipate some asset purchases before a formal announcement, particularly if policymakers use speeches to signal the possibility of a coming policy decision. For example, many observers believe that public comments by Federal Reserve Chairman Ben Bernanke in August 2010 led to some anticipation of the Treasury bond purchases—and a decline in Treasury bond rates—that the FOMC announced in November 2010.
Second, bond yields quickly react to news on the economy. Many of the ups and downs in Treasury yields reflect good (resulting in upward moves in yields) or bad (declines in yields) news on the economy. For example, as the outlook for the economy seemed to improve in late 2010 and early 2011, Treasury yields rose. This sensitivity can make it difficult to separate the influence of monetary policy from the effects of the economic outlook on bond yields, particularly since a monetary policy action can be seen as revealing information on the economic outlook.
To address these complications and carefully assess the effects of the Federal Reserve’s asset purchases on bond yields, some researchers have used an approach known as an event study. This methodology involves assessing changes in bond yields over very short periods of time surrounding the announcements of asset purchases and controlling for other influences on bond yields.
In theory, because financial market participants are forward looking, markets should be able to immediately incorporate information into the prices of securities such as bonds. However, the immediate response to information requires that a market have high liquidity and trading volumes. Because of this condition, most studies of the effects of asset purchases have examined yields on Treasury securities rather than mortgage-backed securities or agency debt. Using this approach, several studies have all shown that the first round of security purchases by the Federal Reserve was successful in lowering bond yields (Gagnon et al. , D’Amico and King , and Hamilton and Wu ).
So why do we care if the interest rates on Treasury bonds or mortgage-backed securities are lower? We care because reductions in these yields can help lower a broader array of interest rates. The effects of asset purchases on interest rates arise through what is known as the portfolio balance channel.
To understand this channel, it is easiest to think on a very large scale. Start by thinking about the entire supply of long-term securities, including all of the assets charted above, plus bonds backing all long-term investments in small businesses, car loans, student loans, and so on. With a given supply in the market, each of these types of bonds will have its own equilibrium price and its own equilibrium interest rate. This supply isn’t necessarily fixed at any one amount, but it exists at any one point in time. When the Fed makes its asset purchases of government-backed securities, it removes a part of this supply. With less supply in the market for the government-backed assets, but presumably the same amount of demand, the market prices for these securities will rise and the rates will fall.
However, when the rates are falling, some investors will no longer find the reward large enough for taking on the risk of that particular security. This may lead some investors who had been demanding government-backed securities to shift their investments over to other long-term assets that back the previously mentioned sectors of the economy, like small business or car loans. This should in turn boost the prices of these other long-term assets and push down the associated interest rates.
If this portfolio balance channel is truly functioning, a number of interest rates other than those on Treasury bonds and mortgage-backed securities should have declined with the Federal Reserve’s asset purchases. In particular, interest rates on private credit instruments should have dropped, and the value of other asset prices should generally be higher. Both of these events have occurred.
Over time, these easier financial conditions should translate into stronger macroeconomic conditions and growth in economic output. Lower rates on long-term assets should encourage parts of the real economy to expand by making cars, equipment, houses, and other business and household investments more affordable.
Unlike in the financial markets, however, it takes time for the effects of monetary policy changes to be evident in consumer spending, business investment, and employment. As one example, it takes time for consumers and businesses to regain confidence in the economy and to rebalance their finances. As another, it takes time for businesses to change their plans for investment in plant and equipment in response to changes in interest rates. Generally, economic theory and empirical evidence suggest the lag is approximately six months from the time policy is enacted to the time policy effects can be seen. As highlighted in the chart above, movements in the target federal funds rate are correlated with corresponding changes in GDP growth about two quarters later. For example, drops in the target interest rate are normally associated with subsequent increases in GDP growth.
The chart below suggests that the same lag has applied with the Federal Reserve’s large-scale asset purchases. When the Fed made its asset purchases, which were meant to lower long-term interest rates, the rate at which the economy grew increased after a six-month period. There are clearly other factors that have impacted the path of gross domestic product, but the current trends in the data thus far are supportive of a successful monetary policy.