Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Efficacy of Large-Scale Asset Purchases at the Zero Lower Bound

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Efficacy of Large-Scale Asset Purchases at the Zero Lower Bound

Article excerpt

(ProQuest: ... denotes formulae omitted.)

During the recent financial crisis, the Federal Reserve took unprecedented actions to prevent the economy from collapsing. First, the Federal Open Market Committee (FOMC) lowered the short-term federal funds rate nearly to its zero lower bound. Then, several months later, the FOMC began making large-scale purchases of long-term Treasury bonds to lower long-term interest rates by reducing the supply of long-term assets. The FOMCs announcement of its intent led to immediate and substantial declines in the yields of long-term Treasury bonds.

While these results suggest that changing the supplies of bonds available to the private sector brought about the changes in prices and, in turn, long-term interest rates, some economists disagree. Most economic models of the term structure of interest rates, including the widely known expectations theory, assume that supply shifts of bonds do not matter in determining prices.

In various speeches, however, policymakers have suggested that a different economic model motivated the asset purchases. One such model, the preferred-habitat theory, assumes that some investors have preferences for bonds of specific maturities. If this assumption is valid, the supplies of bonds would directly affect their prices and, in turn, their yields.

The preferred-habitat model was proposed in the 1950s. It was widely accepted through the 1960s when it was challenged by the lack of empirical evidence. New empirical findings for impacts of supply shifts on bond yields renewed interest in the model, but the existing literature has never considered how ir might be affected by the zero lower bound.

Interest in the theory increased when the short-term policy rate approached the zero lower bound and policymakers used asset purchases as a policy alternative. But some observers have questioned whether asset purchases could really lower long-term interest rates.

To answer this question, this article uses a preferred-habitat model that explicitly considers the zero bound for nominal interest rates. The analysis suggests that purchasing assets on a large scale can effectively lower long-term interest rates. Furthermore, when heightened risk aversion disrupts the activities of arbitrageurs, policymakers may lower long-term rates more effectively through asset purchases than through communicating their intentions to lower the expected path of future short-term rates.

The first section of this article reviews economic theories of the terni structure of interest rates and identifies the effects of supply shifts on bond yields. The second section describes a baseline model in which relative supplies of bonds of different maturities determine bond yields. The third section extends the baseline model by explicitly incorporating the zero bound for nominal interest rates and discusses when asset purchases can be a more effective policy tool than other policy alternatives.

I. TERM STRUCTURE THEORIES AND PRICE IMPACTS OF BOND SUPPLY SHIFTS

When the Federal Reserve purchased long-term Treasury bonds as a policy tool, the rationale was that, by causing the supplies of bonds to contract, bond prices would rise. The higher prices, in turn, would cause long-term interest rates to fall. The downward shift of rhe yield curve of Treasury bonds after the announcement of asset purchases supports such a view (Chart 1). However, widely known rerm structure models, such as the expectations model, imply that supplies do not matter in determining prices. The preferred-habitat model, by contrast, supports the idea that supplies matter. This section examines the two theories and reviews the empirical evidence supporting the opposing views.

Relative supplies do not matter

The expectations hypothesis of the term structure of interest rates assumes that current and expected yields of short-term bonds determine yields of long-term bonds, while the supplies of the bonds do not affect yields. …

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