Academic journal article Economic Perspectives

A History of Large-Scale Asset Purchases before the Federal Reserve

Academic journal article Economic Perspectives

A History of Large-Scale Asset Purchases before the Federal Reserve

Article excerpt

Introduction and summary

The Federal Reserve's preferred policy instrument--the overnight federal funds rate--approached zero at year-end 2008. With the zero lower bound constraining additional policy accommodation through traditional channels, the Federal Reserve began a series of large-scale asset purchases (LSAPs). The goal of the Fed's LSAP strategy is to place downward pressure on yields of a wide range of longer-term securities, foster mortgage markets, and encourage a stronger economic recovery. (1) While a consensus has emerged that LSAPs have lowered yields on U.S. Treasury bonds and other long-maturity, high-duration assets (thus increasing their prices), (2) considerable uncertainty remains as to the magnitude of these yield changes and the exact channels by which central bank purchases influence yields. (3) Much of this uncertainty stems from the fact that researchers have only a few examples of large open market purchases of government-guaranteed bonds to study. Central banks have traditionally preferred to implement monetary policy by altering short-term interest rate targets rather than utilize their balance sheets as a policy tool. Most of what we know about the effectiveness of LSAPs and the magnitude of their effects, therefore, come from evaluations of the small number of episodes when central banks wished to stimulate their economies but the traditional tool--the short-term policy rate--was constrained by the zero lower bound of nominal interest rates. (4)

In this article, we assemble a new historical database of monthly U.S. Treasury bond prices, contract terms, and amounts outstanding between 1870 and 1913. These new data allow us to look beyond the traditional empirical sample of LSAPs by examining the numerous large open market operations conducted by the U.S. Department of the Treasury during this pre-Fed era. During this period, the Treasury engaged in many refundings and open market sinking fund purchases (5) that resulted in dramatic changes in the quantity and duration of aggregate Treasury bonds outstanding. These refundings and sinking fund purchases provide us with an opportunity to measure the effects of changes in the amount and duration of Treasury bonds on equilibrium yields. (6) We compare the price response of high- and low-duration bonds to changes in the amount and aggregate duration of Treasury bonds outstanding, and find purchases of Treasury securities made by the U.S. Treasury Department narrowed the yield spread between Treasury bonds with high interest rate risk (the risk of an investment's value changing on account of interest rate changes) (7) and those with low interest rate risk.

LSAP channels

Theory suggests LSAPs can lower equilibrium bond yields through three channels, which we label scarcity, duration, and signaling. The scarcity channel, which is sometimes referred to as the portfolio-balance channel, is associated with the preferred habitat literature pioneered by James Tobin, Franco Modigliani, and Richard Sutch. (8) Because of differences in asset risk characteristics or regulation, some investors prefer to hold certain assets and are reluctant or unable to hold alternative assets. For example, regulatory restrictions force money market funds to hold short-maturity assets, while insurance companies may prefer to hold long-maturity assets that match the duration of their liabilities; moreover, a bank that wishes to hedge the duration and negative convexity (9) embedded in its mortgage portfolio will prefer to short sell (10) long-maturity Treasury securities. Therefore, different classes of financial assets are not perfectly substitutable in investors' portfolios and changes in the relative supply of preferred assets may alter their equilibrium prices and yields.

There is every reason to believe that pre-1913 investors also preferred to hold certain bonds because of differences in asset risk characteristics or regulatory restrictions. …

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