The Federal Reserve: Monetary Policy

Introduction

Monetary policy is the key tool used by Federal Reserve to monitor and control US economy. According to Vance Roley and Gordon H. Selon, in their article “Monetary Policy Actions and Long-Term Interest Rates”:

“It is generally believed that monetary policy actions are transmitted to the economy through their effect on market interest rates. According to this standard view, a restrictive monetary policy by the Federal Reserve pushes up both short-term and long-term interest rates, leading to less spending by in interest-sensitive sectors of the economy such as housing, consumer durable good, and business fixed investment. Conversely, an easier policy results in lower interest rates that stimulate economic activity”

How interest rate change and the level of interest rate actively reflect the economy of US. While it is generally accepted that short-term interest rates are determined primarily by Fed monetary policy (via the Fed Funds rate), long-term interest rates are often thought to be influenced by other factors, such as long-term inflationary expectations and the long-term outlook for the Federal budget deficit (Duke, 2006) Also, economists and policy makers are believe in expectation models, which states the relationship between short term (FFR) and long term interest rate: long-term rates are determined primarily by short-term rates through market expectations of future short-term rates.

Under expectation theory, the nominal long tern interest rate should be close to the average of current and expected nominal short - term interest rate when we make them to have same maturity, say, the yield on a 10-year Treasury note should be comparable to the yield on a 1-year Treasury bill that is rolled over each year for ten years. However, the short term and long term interest rate does not always goes along in real life. Since the middle of 2004, the Federal Reserve has increased its key Fed funds rate eight times by a total of 200 basis points, or two percentage points. Over this same period, the yield on the 10- year Treasury note has remained essentially unchanged. And to further control the influence of housing bubble and financial crisis since 2008, the short-term rate almost fall close to zero.

When interest rates are close to zero, there is another way of affecting the price of money: Quantitative Easing (QE). The aim is still to bring down interest rates faced by companies and households and the most important step in QE is that the central bank creates new money for use in an economy to stimulate economy and create new investment opportunity. Between November 2008 and March 2010, the Federal Reserve conducted massive asset purchases known as quantities easing (QE1). In QE1 the Fed purchased approximately $1.75 trillion of assets consisting of $1.25 trillion mortgage-backed securities (MBS), $300 billion Treasury securities, and $200 billion federal agency debt. Between November 2010 and June 2011, another phase of quantitative easing known as QE2 was implemented, consisting of an additional purchase of $600 billion long-term Treasuries. Moreover, in September 2013, Fed expanded its holding of long-term securities with open-ended purchased of $40 billion of mortgage debt to boost growth and reduce unemployment. This paper examines how federal funds rate will affect the term structure in US and the relationship between long-term and short-term interest rate (federal fund rate).

Literature Review

The literature contains many studies that analyze the impact of QE, monetary policy and short-term rates on long-term interest rates. Cook-Hahn and Cohen-Wenninger both found that the Federal funds rate had a significant impact on long-term rates. Cook-Hahn found (using daily data) that between 9/74 and 9/79, a one percentage point (100 basis points) increase in the Funds rate target results, on the day of the target change, in a 13 basis point movement in the 10-Year Treasury Bond Rate and a 10 basis point movement in the 20-Year Treasury Bond rate. The Cohen-Wenninger study found that between 1982 and 1993 (using quarterly data) a one-percentage point change in the Fed funds rate resulted in an approximately 65 basis point change in the 10- year bond rate. Moreover, Roush in his paper concludes that exogenous changes in short rates do produce changes in long rates that are consistent with the expectations theory. Friedman (1980), Shiller-Campbell-Schoenholtz (1983) and Blanchard (1984), also found that short-term rates had a significant independent impact on long-term rates.

However, other economists do not believe that short-term rates are related to long-term rate, especially when business cycle pattern change. Demiralp and Jorda (2004) and Jorda (2005) found that difficulties in generating long-term forecasts of the Fed funds rate were an important reason that empirical tests of the expectations theory have often failed. When market participants fully anticipate a change in Fed policy and short-term rates, it is possible that changes in monetary policy will not impact long-rates, since long rates already reflect the changes before they occur. Also, as the financial crisis of 2008, no one is seeing the FFR will fall close to zero, which cannot be used to predict the long-term interest rate. According to the data in this paper, the expectation and term structure theory does not always hold, as the business cycle change. That’s also the reason why QE is invited to boost the economy as another way to lower the interest rate when the interest rate is as close to zero and cannot be further reduced.

Both Hamilton and Wu (2012), Krishna-murthy and Vissing-Jorgensen (2011) assert that QE1 and QE2 were effective in lowering long term Treasury yields. Moreover, Bernanke and Reinhart (2004) and Klyuev et al. (2009) demonstrate that QE can enable the monetary authorities to stimulate economic activity even after the zero lower bound is reached. This asset purchases in large volume by a central bank would be able to affect the price or yield of the targeted asset, change the market expectation, which can be viewed as an important communication with central bank.

How QE affect the economy and term structure

The stated objective of this quantitative easing (QE) is to reduce long-term interest rates in order to spur economic activity (Dudley 2010). The large reductions in mortgage rates due to QE1 appear to be driven by the fact that QE1 involved large purchases of agency MBS. For QE2, which involved only Treasury purchases, we find a substantial impact on Treasury rates, but almost no impact on MBS rates (Krishnamurthy and Vissing-Jorgensen 2011)

QE1:
Gagnon, et. al., (2010) provide an event study of QE1 based on the purchase of mortgage-backed securities, Treasury securities and Agency securities by Federal Reserve in the late 2008 to 2009. And Gagnon, et. al.,(2010) ppinted out eight important dates to focus beginning with the 11/25/08 announcement of the Fed’s intent to purchase $500 billion of Agency MBS and $100 billion of Agency debt, and running into the summer of 2009. Krishnamurthy and Vissing-Jorgensen (2011) in their finding detailed examine five of these eight dates when major yield changes occurred. Figure 1 presents graphs of intraday movements in Treasury yields and trading volume for each of the event dates. These graphs show that the events identify significant movements in Treasury yields and Treasury trading volume and that the announcements do appear to be the main piece of news coming out on the event days, especially on 12/1/2008, 12/16/2008 and 3/18/2009. For 11/25/2008 and 1/28/2009, the trading volume graphs also suggests that the announcements are the main events, with more mixed evidence from the yield graphs for those days. (Krishnamurthy and Vissing-Jorgensen 2011).

Figure 1. Intra-day Yields and Trading Volume on QE1 Event Days
Yields

Volume

(Source: Krishnamurthy and Vissing-Jorgensen (2011))
Figure 2 graphs the yields on the monthly Federal Funds futures contract, for contract maturities from March 2009 to October 2010. The pre-announcement average yield curves are computed 12 on the day before each event and then averaged across event dates. The post-announcement average yield curve is computed likewise for the day after the event dates. The graph shows that, on average, each QE announcement “shifts” an anticipated rate hike cycle by the Fed later by a little over one month. For the March 2010 contract, the total effect of the five QE announcements is to shift anticipated rate increases later by 6.3 months. This further tells Fed’s signal to keep the FFR low.

Figure 2. Yield Curve from Fed Funds Futures, pre and post QE1 Event.

(Source: Bloomberg)

The period of QE1 is very particular, which is the unusual financial crisis period. Demand for safety assets was vey high and people are afraid of investing in very risky assets. QE1 significantly reduced yields on safe assets, including Treasuries, Agencies and highly rated corporate bonds, which can be seen from Table 1.

Table 1. Treasury, Agency and Agency MBS yields on QE1 Event Dates
Two-day changes (in basis points)

QE2

We are using similar approaches to see the effect of QE2 compare to QE1. August 10, 2010, FOMC state that “the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.'' September 21, 2010 FOMC want to “maintain its existing policy of reinvesting principal payments”. November 3, 2010, FOMC add an additional statement that “the committee intends to purchase $600 billion of longer-term treasury securities. ” Thus, the announcement of the Fed’s intent to continue QE revised market expectations. Moreover, the announcement indicated that the QE would shift towards longer-term Treasuries, and not Agencies or Agency MBS as in QE1.

Figure 3 presents intraday data on the 10-year Treasury bond yield around the announcements times of the FOMC statements. The 8/10 announcement appears to be significant news for the Treasury market, reducing the yield in a manner that suggest that market expectations over QE were revised up. The 9/21 announcement is qualitatively similar. At the 11/3 announcement, Treasury yields increased by then fell some. The reaction suggests that markets may have priced in more than a $600bn QE announcement. (Krishnamurthy and Vissing-Jorgensen 2011) And we collect same data and found out that QE2 also cause Treasury, Agency and highly-rated corporate bond yields to decline.

Figure 3. Intra-day Yields and Trading Volume on QE2 Event Days
Yields

Volume

Table 2. Treasury, Agency and Agency MBS yields on QE2 Event Dates
Two-day changes (in basis points)

Both QE1 and QE2 QE1 and QE2 significantly lower nominal interest rates on Treasuries, Agencies and highly rated corporate bonds, driven mainly by an increase in the safety price premium of assets with near-zero default. (Gagon, Joseph and Sack 2010)
In QE1, the Fed purchased agency securities and mortgage-backed securities rather than Treasury securities as it did in QE2. This is significant as Fed Chairman Ben Bernanke was at pains to stress that QE1 was “credit easing”, focused on the asset side of the balance sheet. As Brian P, the Executive Vice President of Federal Reserve Bank of New York put about QE1:

By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield.

For QE1, the Federal Reserve worked to support the functioning of credit markets by providing liquidity to the private sector. Without this easing, the US and the global economy would have had a depression of indescribable severity with unknown attendant geopolitical and military consequences. (Edward 2011)

Most analysts criticize QE2 was not as successful as QE1, the Fed’s QE2 raised inflation expectations, causing interest rates to actually rise and working at cross-purposes with the lowered risk premium. Thus, QE2 was only successful insofar as it has increased business credit and raised asset prices, as Marshall put in 2010.

QE3

The Federal Reserve said it will expand its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt a month in a third round of quantitative easing as it seeks to boost growth and reduce unemployment. The FOMC also said it would probably hold the federal funds rate near zero “at least through mid-2015.” Since January, the Fed had said the rate was likely to stay low at least through late 2014. The Fed said, “a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” As the interest rate keep low and economy began to recover, people believe in the effectiveness of quantitative easing. However, John (2012) put that the effectiveness of quantitative easing has been temporary and are evidently psychological: people think the money supply will inflate, providing more money to invest, inflating stock prices, so investors jump in and buy. The psychological effect eventually wears off, requiring a new round of QE to keep the game going. If we check with what happens before, we can see QE1 and QE2 indeed not reduce unemployment, the alleged target. But they also did not drive up the overall price level. The rate of inflation has actually been lower after QE than before the program began.

Overall, to be sure, QE as an unconventional monetary policy do have important short-term benefits. But if such policies remain in place for too long, their side effects could be severe—and the longer-term costs very high (Nouriel, 2013)

Conclusion

This paper examines the policy interest rates and the long-term interest rates by collecting recent ears data and using statistical analysis. It presents evidence that the Fed funds rate directly influences other short-term interest rates, but indirectly related to long-term interest rates. Moreover, Hasan (2012) presents evidence supporting the argument that there was a gradual decoupling between the Fed interest rate and long-term interest rates even before the recent crisis. After financial crisis, the short -term interest rates keeps low and almost fail to zero especially after QE comes out. The relationship between policy and long-term interest rates appears to be much looser. Moreover, the influence of the Fed on long-term interest rates had decreased. As interest rates close to zero, the Federal Reserve conduct QE 1 2 and 3 to further boost the economy and keep bond yields at a very low level. But QE only gives temporary effect and cannot last long.

Reference:

Arvind Krishnamurthy, Annette Vissing-Jorgensen, The Effects of Quatntatitave Easing on Interest. May 2011. http://www.chicagofed.org/digital_assets/others/events/2011/bsc/vissing_350_0505.pdf

Edward Harrison, What are the differences between QE1, QE2 and QE3. 20 juNE, 2011. http://www.creditwritedowns.com/2011/06/qe1-versus-qe2-versus-q3.html

John P. Swift, QE2 and other Troublesome signs. October 1, 2012. http://www.gentryfinancialcorporation.com/downloads/private-wealth-management/perspectives/Swift-Quarterly-4Q2012.pdf

Hasan Comert, Decoupling between the Federal Funds Rate and Long Term Interest rates: Decreasing Effectiveness of Monetary Policy in the US. October, 2012. http://www.peri.umass.edu/fileadmin/pdf/working_papers/working_papers_251-300/WP295.pdf Gagnon, Joseph, Matthew Raskin, Julie Remache, and Brian Sack, "Large-Scale Asset Purchases by the Federal Reserve: Did They Work?" Federal Reserve Bank of New York Staff Report no. 441, March 2010.

Robert Jarrow and Hao Li, The Impact of Quantities Easing on the U.S. Term Structure of Interest Rates. January 23, 2013.

Noriel Roubini, All of Your Quantitative Easing Questions, Answered. When is it ineffective? When is it justified? And what about unintended consequences? March, 3 2013. http://www.slate.com/articles/business/project_syndicate/2013/03/quantitative_easing_all_your_questions_answered.html

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