Academic journal article ABA Banking Journal

To QE3 or Not to QE3? Impact on Rates

Academic journal article ABA Banking Journal

To QE3 or Not to QE3? Impact on Rates

Article excerpt

The markets have reacted to variations in the perceived odds of additional-asset purchases by the Federal Reserve (Quantitative Easing 3)--rallying if perceived as more likely and selling off if less likely. Fed officials suggest QE3 is on the table, but the odds are relatively low. Additional-asset purchases, likely centered on mortgage-backed securities, would depend on a significant deterioration in the economic outlook. QE3's goal: push long-term interest rates down. But they are already low. Why take action now?

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Investors may be concerned about what will happen to long-term interest rates when the Fed ends Operation Twist in June. Probably very little. Fed officials view Operation Twist a lot like they viewed QE2: It's the stock of bonds purchased that matters, not the flow. There was no significant rise in long-term rates when QE2 ended. There is unlikely to be much of a difference when Operation Twist ends. However, the bond market will be sensitive to whether the Fed undertakes QE3--and some small, positive probability of additional-asset purchases is now factored in.

Long-term interest rates normally rise as the economy recovers. However, long-term interest rates can be viewed as a combination of current and future short-term interest rates. The current ten-year Treasury yield is consistent with the expected path of short-term interest rates. That assumes the Fed will maintain its current target range for the federal-funds rate into late 2014, and then begin to raise rates. …

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