Two Federal Reserve System economists have looked at the recent quantitative easing programs of the Federal Reserve to determine whether a central bank's monetary policy could retain potency when short-term rates reach zero.  The two, Diana Hancock and Wayne Passmore, were testing their theory that because the banks could purchase a wide variety of assets, not just short-term government securities the purchases could be used to enforce explicit ceilings for yields on longer-term securities, including longer-dated Treasury securities, agency debt, or agency mortgage-backed securities   

If such a long-term asset purchase program were successful they say, not only would yields on such securities fall, but yields on private debt (such as mortgages) would probably fall as well and the increase in the monetary base would lead to an increase in asset prices in general and a subsequent impact on spending.  Thus, even a central bank whose accustomed policy rate has been forced down to zero would not "run out of ammunition."

To test these assumptions they two looked at the impact the Fed's large-sale asset purchases (LSAPs) or quantitative easing (QE) programs had on agency mortgage-backed security (MBS) yields and thus on conforming mortgage interest rates.  They selected periods when the financial markets were functioning well rather than being in turmoil because the prevailing view is that LSAP's would have no effects on asset prices in normal times.  They tested the countervailing opinion is that such purchases can potentially influence all components of MBS yields to some extent by (1) signaling Federal Reserve intentions to financial markets (2) portfolio rebalancing effects, and (3) liquidity effects.  

The purchase of long-term assets may make more credible the Feds commitment to keep interest rates low even after the economy recovers, particularly if the central bank weighs potential losses on its asset holdings in its objective function.  This signaling affects all bond market interest rates, since lower future federal funds rates can be expected to affect all interest rates.  And, as market participants anticipate the announcement of LSAPs, their effects can be reflected in market prices even before they are announced.

These purchases can also potentially affect MBS yields through a portfolio rebalancing channel where the Fed purchases reduce private sector holdings while increasing short-term, risk-free, private sector bank deposits.   The private sector finds it holds more of these deposits than they desire because of receipts from selling securities so they bid up prices of remaining long-term securities and thus lower the yields.  This "scarcity" effect is primarily focused on the current coupon yield MBS.

For longer-term securities, this portfolio rebalancing effect is often expected from duration and convexity risk.  Duration refers to the length of time that the bonds will likely provide an income stream.  Convexity refers to "duration's sensitivity to rates"--i.e. a pool of mortgages that might normally last for about 7 years could quickly change to lasting half that time if rates fall quickly enough, prompting more refinances out of that pool. 

When MBS are withdrawn from the market the private sector finds they must meet their demands for duration and convexity by bidding more aggressively for MBS. The portfolio rebalancing in this case has two components:  (1) a willingness to take less compensation for hedging the interest rate risks of financial assets, or a "duration effect," that applies to both Treasury securities and MBS; and (2) a willingness to take less compensation for hedging the prepayment and volatility risks that are associated with holding MBS, i.e. a "convexity effect." When purchasing Treasury securities, the Federal Reserve was quite aware of the duration effect and specifically targeted its purchases of Treasury securities toward those with a maturity of 4 to 7 years, so that it would withdraw more duration from the market.   MBS typically have a duration that is in the 4 to 7 year range.

At the same time, LSAPs by the Federal Reserve could potentially operate through a liquidity channel.    Investors are willing to pay a premium for a security that remains liquid when other securities do not or when market returns overall are low. The effect of Federal Reserve asset purchases on liquidity is unclear.  They may increase the liquidity in the future, particularly during "bad" markets, because of a belief that the Fed will remain a large and persistent buyer in those markets.  On the other hand, as the Fed's holdings of a security increases during "normal" times, the private sector holdings of the security may diminish, leading to a thinner market in the future with fewer seller opportunities.  Withdrawal of securities from the private sector by the Fed might diminish future liquidity if there is uncertainty about the Fed buying in a bad market of the future.

LSAPs can change the expectations held by market participants about future interest rates because they communicate the intentions of the Federal Reserve.  However, information about the effects of new quantitative easing programs, or about long-term asset purchases, is often learned over time; consequently asset prices may adjust more slowly.  Moreover, the liquidity effects associated with asset purchase programs may be difficult to understand, or to predict, at the time when asset purchase programs are announced.  Finally, investors anticipate both the announcements and the effects of LSAP programs, which may lead to underestimating the effect of a given announcement.

The authors conclude that assessing the effects of the Federal Reserve's open market operations is difficult because of the way monetary policy accommodation operates through so many transmission channels.

The decline in the MBS yields after the initial announcement of a large-scale asset program may generally reflect a shift of market expectations, but may not fully capture the actual effects of the large-scale security purchases as portfolio rebalancing actually commences.  They found that the Fed's market share variables were significant determinants of MBS yields, even after accounting for changes in expectations about future rates by market participants.

They say their estimates also suggest that the Federal Reserve must hold a substantial market share of agency MBS or of Treasury securities to significantly lower MBS yields and in turn significantly lower mortgage rates.  The liquidity or portfolio rebalancing effects of LSAPs, as well as markets' expectations of future interest rates, are important considerations for monetary policy.  Finally, their findings suggest that such LSAPs achieved the Open Market Committee's goal to "put downward pressure on longer-term interest rates, support mortgage markets, and help make broader financial conditions more accommodative."