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Underestimated effects of the termination of QE and forward guidance

It is evident that non-conventional Fed policy has contributed to long-term yield compression. It is less evident how this exactly worked and what will happen when the Fed tries to terminate QE and forward guidance. A new IMF paper supports evidence for two underestimated effects. First, to maintain existing stimulus the Fed must constantly announce new asset purchases or holding period extensions. Second, the stimulus from asset purchases depends on forward rate guidance and hence may decrease when the latter ceases.

Wu, Tao (2014), “Unconventional Monetary Policy and Long-Term Interest Rates”, IMF Working Paper, 14/89, September 2014

The below are excerpts from the paper. Emphasis and cursive text have been added.

The two types of yield compression policies

“As any long-term interest rate can be decomposed into an expectations component which equals the average of expected future short-term interest rates, and a term premium component, the central bank can aim at lowering either component, or both, to achieve its goal…In the United States, the unconventional monetary policy measures conducted by the Federal Reserve since late 2008 can be described as follows…

  • ‘Forward guidance’ practices…reflect a continuing effort to lower the market expectations of future short-term interest rates…by first announcing that the federal funds rate would remain at ‘exceptionally low levels’ for ‘some time’ (January 28, 2009) and later ‘an extended period’ (March 18, 2009), followed by a switch to a more specific calendar date of ‘at least through mid-2013’ (August 9, 2011), and further extending the date to ‘at least through late 2014’ (January 25, 2012) and then again ‘at least through mid-2015’ (September 13, 2012). Finally, the FOMC changed the guidance format from the date-based approach to a threshold-based approach, linking the “lift-off” or the first increase of the federal funds target rate to specific economic indicators such as the unemployment rate and inflation expectations.
  • The Federal Reserve initiated a Large Scale Asset Purchase (LSAP) program, under which the Federal Reserve has cumulatively purchased about USD4 trillion’s worth of long-term Treasury securities and Mortgage-backed securities (MBS), and is still continuing such purchases. This program, usually referred to as quantitative easing (QE), is clearly not aiming at further stabilizing financial markets…but rather…at lowering the term premium component of long-term interest rates through affecting the supply-demand balance.”

Measuring the impact of asset purchases

“Recent studies have generally agreed that such large-scale purchases of QE assets have helped to reduce the long-term interest rates… However, the estimated magnitude of such effects differs greatly (view IMF summary report here, p.42-43)…Literature has explored two possible channels for the LSAP to affect long-term interest rates: one is a portfolio balance channel due to market segmentation…and the other, a signalling channel, which suggests that such purchases may signal to market participants that the central bank has changed either its views on the economic outlook or its policy preference.”

“To measure the magnitude of the LSAP program…I construct a quantitative measure based on the market’s expectations of the future path of the Federal Reserve’s balance sheet…Specifically, at any given point in time, in particular following each major policy announcement from the FOMC or each major revision to the economic outlook since late 2008, I trace the market participants’ projections of the future path of the Federal Reserve’s SOMA (System Open Market Account) balance using survey data, and calculate the present discounted value of the current and future balance…By construction a 100 percentage point increase in the LSAP measure is equivalent to an immediate increase of the SOMA balance in the amount of 20 percent of nominal potential GDP (about USD3.4 trillion as of 2013), and the purchased assets are projected to stay on the Fed’s balance sheet for about five years before immediately disappearing…Such a purchase would reduce the 10-year term premium by 1.12 percentage points, and this effect is statistically significant.”

[From September 2008 to May 2013] changes in the constructed LSAP measure alone had reduced the [10-year treasury] term premium by 113 basis points…Specifically, changes in the LSAP measure have helped reduce the term premium by 35 basis points in the QE I phase (November 2008 to March 2010), 9 basis points in QE II (September 2011 to August 2012), and 19 and 26 basis points in the “Operation Twist” (September 2011 to August 2012) and QE III phases (September 2012 to May 2013), respectively…Both the pure bond purchases and a gradual extension of the length of holding period of the purchased assets as projected by market have contributed substantially to the declines in term premiums.”

“An LSAP announcement will immediately generate an upward revision to the market’s projections of the future SOMA balance path and thus an increase in the LSAP measure. However, without any further actions, this measure tends to gradually decline over time, as the market anticipates the LSAP program to gradually approach its termination. Therefore, to maintain the same amount of policy stimulus, the Fed needs to either conduct new purchases, or signal an extension of the length of time that the purchased assets will stay on its balance sheet.”

“The effectiveness of LSAP…in lowering the term premium exhibits substantial variations over time, in particular, the effects become much weaker during the QE III phase, and such differences are statistically significant.”

Mutual reinforcement of forward guidance and asset purchases

“The LSAP policy and the “forward guidance” policy on short-term interest rates are intimately intertwined…In addition to the conventional view that ‘forward guidance’ alters the public’s expectation of future short rates and thus the expectations component of long-term interest rates, and that LSAPs lower the term premiums, there is strong evidence [based on a market survey indicator explained below] suggesting two spillover effects:

  • On the one hand, ‘forward guidance’ also leads to a gradual extension of market’s projected length of the holding period of the LSAP assets,…As soon as the FOMC extends its guidance on how long the federal funds rate would be kept close to zero, investors would also revise their expectations of the LSAP unwinding schedule as well as the entire future path of the SOMA balance accordingly… in early August 2011, a pure FOMC announcement of its intention to keep the federal funds rate at exceptionally low levels ‘at least through mid-2013’ caused market participants to anticipate a later unloading of the LSAP assets that the Fed had already purchased, and resulted in a 20 basis point decline in the 10-year term premium according to the model estimate… Decomposition…reveals that a substantial part of the LSAP-related policy stimulus since early 2010 is related to the ‘forward guidance’ policy. For instance, at the height of the constructed LSAP measure at 104 percent of GDP in early 2013 over 45 percentage points come from gradual extensions of length of the holding period of LSAP assets, which is primarily affected by forward guidance.
  • On the other hand, the continuing LSAPs also help to enhance the credibility of the ‘forward guidance’ and guide the market’s expectations of future short-term interest rates.”

“When the market participants speculated on an earlier “tapering” in mid-2013, it is quite likely that they also revised their projections of the federal funds rate ‘lift-off’, as well as the unloading schedule of the LSAP assets. Indeed, various surveys have suggested that market participants substantially changed their projections of the federal funds rate ‘lift-off’ date, moving it forward from the third quarter of 2015 to the first quarter of 2015.”


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