Large-Scale Asset Purchases by the Federal Reserve: Did They Work?
Gagnon, Joseph, Raskin, Matthew, Remache, Julie, Sack, Brian, Federal Reserve Bank of New York Economic Policy Review
In December 2008, the Federal Open Market Committee (FOMC) lowered the target for the federal funds rate to a range of 0 to 25 basis points. With its traditional policy instrument set as low as possible, the Federal Reserve faced the challenge of how to further ease the stance of monetary policy as the economic outlook deteriorated. The Federal Reserve responded in part by purchasing substantial quantities of assets with medium and long maturities in an effort to drive down private borrowing rates, particularly at longer maturities. These large-scale asset purchases (LSAPs) have greatly increased the size of the Federal Reserve's balance sheet, and the additional assets may remain in place for years to come.
To be sure, the Federal Reserve undertook other important initiatives to combat the financial crisis. It launched a number of facilities to relieve financial strains at specific types of institutions and in specific markets. In addition, in an attempt to provide even more stimulus, it used public communications about its policy intentions to lower market expectations of the federal funds rate in the future. All of these strategies were designed to ease financial conditions and to support a sustained economic recovery. Over time, though, the credit extended by the liquidity facilities has declined, and the dominant component of the Federal Reserve's balance sheet has become the assets accumulated through the LSAP programs.
The decision to purchase large volumes of assets through March 2010 came in two steps. In November 2008, the Federal Reserve announced purchases of housing agency debt and agency mortgage-backed securities (MBS) of up to $600 billion. In March 2009, the FOMC decided to substantially expand its purchases of agency-related securities and to purchase longer term Treasury securities as well, with total asset purchases of up to $1.75 trillion, an amount twice the magnitude of total Federal Reserve assets prior to 2008. (1) The FOMC stated that the increased purchases of agency-related securities should "provide greater support to mortgage lending and housing markets" and that purchases of longer term Treasury securities should "help improve conditions in private credit markets."
In this paper, we review the Federal Reserve's experience with implementing the LSAPs through March 2010 and describe some of the challenges raised by such large purchases in a relatively short time. In addition, we discuss the economic mechanisms through which LSAPs may be expected to stimulate the economy and present some empirical evidence on those effects. In particular, LSAPs reduce the supply to the private sector of assets with long duration (and, in the case of mortgage securities, highly negative convexity) and increase the supply of assets (bank reserves) with zero duration and convexity. (2) To the extent that private investors do not view these assets as perfect substitutes, the reduction in supply of the riskier longer term assets reduces the risk premiums required to hold them and thus reduces their yields. We assess the extent to which LSAPs had the desired effects on market interest rates using two different approaches and find that the purchases resulted in economically meaningful and long-lasting reductions in longer term interest rates on a range of securities, including securities that were not included in the purchase programs. We show that these reductions in interest rates primarily reflect lower risk premiums rather than lower expectations of future short-term interest rates. (3) We conclude with a discussion of issues raised by these policies and potential lessons for implementing monetary policy at the zero bound in the future.
2. HOW LSAPS AFFECT THE ECONOMY
The primary channel through which LSAPs appear to work is by affecting the risk premium on the asset being purchased. By purchasing a particular asset, a central bank reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others, while simultaneously increasing the amount of short-term, risk-free bank reserves held by the private sector. …