International Channels of the Fed’s Unconventional Monetary Policy

TLDR: In this paper, the authors used dynamic term structure models to uncover to what extent signaling and portfolio balance channels caused international bond yields, and found that signaling effects were large for countries with strong yield responses to conventional U.S. monetary policy surprises.

Abstract: Previous research has established that the Federal Reserve’s large scale asset purchases (LSAPs) significantly influenced international bond yields. We use dynamic term structure models to uncover to what extent signaling and portfolio balance channels caused these declines. For the U.S. and Canada, the evidence supports the view that LSAPs had substantial signaling effects. For Australian and German yields, signaling effects were present but likely more moderate, and portfolio balance effects appear to have played a relatively larger role than in the U.S. and Canada. Portfolio balance effects were small for Japanese yields and signaling effects basically nonexistent. These findings about LSAP channels are consistent with predictions based on interest rate dynamics during normal times: Signaling effects tend to be large for countries with strong yield responses to conventional U.S. monetary policy surprises, and portfolio balance effects are consistent with the degree of substitutability across nternational bonds, as measured by the covariance between foreign and U.S. bond returns.

Figures

Table 2: Conventional U.S. monetary policy and foreign interest rates

Table 5: Summary of event study results

Table 1: LSAP announcements

Figure 1: QE1 — decomposition of changes in the ten-year yield

Table 3: Model summary statistics

Figure 3: QE3 — decomposition of changes in the ten-year yield

Full text

International Channels of the Fed’s Unconventional Monetary
Policy,
ECONOMIC RESEARCH
FEDERAL RESERVE BANK OF ST. LOUIS
WORKING PAPER SERIES
Authors Michael D. Bauer, and Christopher J. Neely
Working Paper Number 2012-028D
Revision Date December 2013
Citable Link
https://doi.org/10.20955/wp.2012.028
Suggested Citation
Bauer, M.D., Neely, C.J., 2013; International Channels of the Fed’s Unconventional
Monetary Policy,, Federal Reserve Bank of St. Louis Working Paper 2012-028. URL
https://doi.org/10.20955/wp.2012.028
Published In Journal of International Money and Finance
Publisher Link
https://doi.org/10.1016/j.jimonfin.2013.12.007
Federal Reserve Bank of St. Louis, Research Division, P.O. Box 442, St. Louis, MO 63166
The views expressed in this paper are those of the author(s) and do not necessarily reflect the views of the Federal Reserve
System, the Board of Governors, or the regional Federal Reserve Banks. Federal Reserve Bank of St. Louis Working Papers
are preliminary materials circulated to stimulate discussion and critical comment.

International Channels of the Fed’s Unconventional
Monetary Policy
∗
Michael D. Bauer
†
, Christopher J. Neely
‡
December 12, 2013
Abstract
Previous research has established that the Federal Reserve’s large scale asset purchases
(LSAPs) significantly influenced international bond yields. We use dynamic term struc-
ture models to uncover to what extent signaling and portfolio balance channels caused
these declines. For the U.S. and Canada, the evidence supports the view that LSAPs
had substantial signaling effects. For Australian and German yields, signaling effects
were present but likely more moderate, and portfolio balance effects appear to have
played a relatively larger role than in the U.S. and Canada. Portfolio balance effects
were small for Japanese yields and signaling effects basically nonexistent. These findings
about LSAP chan nels are consistent with predictions based on interest rate dynamics
during normal times: Signaling effects tend to be large for countries with strong yield
responses to conventional U.S. monetary policy surprises, and portfolio balance effects
are consistent with the degree of substitutability across international bonds, as measured
by the covariance between foreign and U.S. bond returns.
Keywords: monetary policy, zero lower bound, LSAP, signaling, portfolio b alance, dy-
namic term structure model
JEL Classifications: E43, E52
∗
The views expressed in this paper are those of the authors and do not necessar ily reflect those o f Federal
Reserve Banks of San Francisco or St. Louis or the Fede ral Reserve System.
†
Federal Rese rve Bank of San Francisco , 101 Market St. MS 1130, San Francisco, CA 94105, USA; e-mail:
michael.bauer@ sf.frb.org.
‡
Federal Rese rve Bank of St. Louis, Box 442, St. Louis, MO 63166-0442, USA; e-mail: neely@stls.frb.org.

1 Introduction
In response to the extreme credit market disturbances in the fall of 2008, the Federal Reserve
lowered the Federal funds rate target to near-zero, announced unprecedented bond purchases,
and offered forward guidance to markets to reduce expectations of future short rates. Eventu-
ally, the Fed would announce three rounds of asset purchases that would total over $3 trillion
from November 2008 through 2013. Federal Open Market Committee (FOMC) statements
and speeches describ ed t he motives for these asset purchases in several ways but repeatedly
returned to the themes of directly supp orting credit markets—especially for housing—to re-
duce medium- and long-term U.S. interest rates in o r der to ultimately stimulate r eal activity.
Other central banks, that is, the Bank of Japan, the Bank of England and the European
Central Bank, would later initiate or expand similar prog r ams. A growing literature studies
the empirical effects of these unconventional policies. For the United States, the event study
estimates of
Gagnon et al. (2011) and Krishnamurthy and Vissing-Jorgensen (2011) establish
that the Fed’s asset purchases strongly affected domestic bond yields.
Neely (20 13) finds that
the purchases had substant ial international effects on bond and foreign exchange markets.
Announcements of large scale asset purchases (LSAPs) can affect government bond yields
through bo t h signaling and portfolio balance channels. The signaling channel implies that
investors interpret asset purchase announcements as implying a lower path for future short-
term interest rat es, which reduces the expectations component of long-term interest rates.
1
On the ot her hand, asset purchases can also affect prices of imperfectly substitutable assets
through the portfolio ba lance channel. A purchase of U.S. bonds can reduce the term premia
in bot h U.S. long-term yields and in international substitutes.
A crucial question is how important signaling and portfolio balance channels are empiri-
cally for the effects of these asset purchases on government bond yields. For the U.S., the term
1
The announcements can contain both direct (explicit) and indirect (implicit) signals about the future short-
rate path (Woodford, 2012). The event study approach chosen here and in other papers cannot distinguish
between these.
1

structure estimates of Ga gnon et al. (2011) appear to indicate that por tfolio balance effects
dominate, and these authors conclude that the signaling effects are negligible. On the other
hand,
Bauer and Rudebusch (2013b) and Christensen and Rudebusch (2012) find a substan-
tially larger role f or the signaling channel of asset purchase announcements.
2
Neely (2013)
argues that the large impact of the Fed’s LSAP a nno uncements on international yields are
consistent with a portfolio balance effect but he does not directly evaluate the relative impor-
tance of signaling/portfolio balance effects. There has b een no serious analysis of the cha nnels
through which t he Fed’s LSAP a nno uncements affected international b ond yields. This paper
aims to fill that gap by using term structure models to evaluate the relative importance of
LSAP channels in mediating the impact of the Fed’s asset purchases on international bond
yields. In addition to U.S. yields, we study the effects on interest rates in Canada, Germany,
Australia, and Japan.
3
We consider announcements associated with the three LSAP programs
during the period from 2008 to 2012: QE1, QE2, and QE3.
Before presenting our results on the relative importance of L SAP channels of unconven-
tional policy, we investigate what past data would lead us to expect f or each count r y. We
predict the impact of U.S. LSAPs on expectations of foreign short-term interest rates by ana-
lyzing how conventional U.S. monetary policy surprises affect foreign yields. For example, the
strong reaction of Canadian yields to conventional U.S. monetary shocks implies a significant
signaling effect for that country’s markets. Analysis of the covariances between real foreign
and U.S. bond returns predict that Australia and Germany would show the strongest portfolio
balance channel effects.
Using dynamic term structure models (DTSMs) we estimate changes in short-rate expec-
tations and term premia around key LSAP a nno uncements. Their respective contribution to
2
Joyce et al. (2011) cite swap rates to argue that the Bank of E ngland’s purchases worked mainly through
the portfolio balance channel. Christensen and Rudebusch (2012) confirm the importance of portfolio balance
effects on domestic g overnment yields.
3
We omit the U.K. from our analys is because news unrelated to U.S. policies significantly influenced
U.K. shor t- term interest rate movements during the policy event w indows. These movements distorted mea-
surement of the effect of U.S. unconventional policies on the U.K., but not other bond markets.
2

the observed decreases in long-term yields is a measure of the importance of the signaling
and portf olio ba lance channels. Importantly, chang es in short-rate exp ectations should be
viewed as conservative estimates of the impor tance of the signaling channel for two reasons:
First, a successful monetary po licy a ctio n aimed at easing financial conditions stimulates fu-
ture growth and would raise short-rate expectations for the more distant future, counteracting
the decreases in expectations due to signaling effects. Second, signaling near-zero p olicy rat es
would tend to lower interest ra t e risk and the term premium, even without any portfolio
balance effects.
4
The resulting inference can be quite sensitive to model choice. To guard ag ainst model-
dependent conclusions and to obtain robust evidence, we estimate six alternative models f or
each country. In addition to a conventional maximally-flexible model, we correct for small-
sample bias and restrict model pa r ameters to obtain more reliable results. We evaluate the
term structure models using criteria that include out-of-sample forecast accuracy. Models tha t
impose greater peristence on the expected short rate or that restrict the dynamic evo lution
of the risk factors (as in Duffee, 2011) have the best forecasting perfo rmance. Based on the
forecast accuracy, we can weight well-performing models mor e heavily, a nd can pa r tly address
the issue of model uncertainty.
We find that the unconventional policy announcements had the most substantia l signaling
effects for t he U.S. and Canada. In both countries, changes in expected future policy rates
contributed significantly to lower long-term yields in those two countries. This finding holds
for all three LSAP programs. The strong signaling effects on Canadian rates is consistent with
the sensitivity of Canadian interest rates to signals from conventional U.S. monetary policy
surprises. Overall, signaling effects likely accounted for a very substantial part of the sizable
effects of the Fed’s LSAP announcement s on U.S. and Canadian long rates.
For Australia and Germany, we also find strong signaling effects. They appear slightly
more moderate than for the U.S. and Canada, however, and these estimates entail model
4
See also Bauer and Rudebusch (2013b) and Woodford (2012) for similar arguments.
3

Frequently asked questions

Q1. What are the advantages of affine Gaussian models?

The affine models the authors use have the advantages that they (i) parsimoniously model the entire yield curve with a small number of risk factors, (ii) impose absence of arbitrage, enforcing consistency on the cross-sectional and time series behavior of yields, and (iii) are very tractable to estimate. 

Q2. How do the authors address the downward bias in estimated VAR persistence?

The authors address this downward bias in estimated VAR persistence in three ways: first, by directly correcting for the bias, as in Bauer et al. (2012); second, by imposing parameter constraints that increase persistence, as in Duffee (2011); and third, by restricting the risk pricing in the model, as in Cochrane and Piazzesi24The authors have also estimated the models using four risk factors. 

Q3. What other central banks would later initiate or expand similar programs?

Other central banks, that is, the Bank of Japan, the Bank of England and the European Central Bank, would later initiate or expand similar programs. 

Q4. How do the authors estimate the importance of the signaling channel?

The authors estimate the importance of the signaling channel by the changes in short-rate expectations around LSAP events, as is common in event studies of LSAPs. 

Q5. How do the authors estimate the impact of LSAPs on international yields?

Using dynamic term structure models (DTSMs) the authors estimate changes in short-rate expectations and term premia around key LSAP announcements. 

Q6. How can the authors weigh well-performing models more heavily?

Based on the forecast accuracy, the authors can weight well-performing models more heavily, and can partly address the issue of model uncertainty. 

Q7. What is the advantage of the event study approach?

An advantage of the event study approach is that5Most event studies seek to determine the effect of the unexpected component of some event—e.g. a monetary policy announcement or macroeconomic release—on prices. 

Q8. How do the authors estimate the importance of the portfolio balance channel?

The authors will estimate the importance of the portfolio balance channel from the magnitude of changes in the term premium (see equation (1)) in long-term yields around LSAP announcements. 

Q9. How does Neely illustrate the effects of a domestic and international portfolio?

Neely (2013) illustrates international portfolio balance effects through the portfolio choice of a budget-constrained, mean-variance investor who represents all agents except the Federal Reserve/U.S. government. 

Q10. What is the main alternative approach to quantitative easing?

The main alternative approach is a time series analysis of interest rates and variables measuring the supply of the targeted securities—see, for example, Li and Wei (2013) and Hamilton and Wu (2012)—which, however, by construction can only provide estimates of portfolio balance effects and does not capture signaling effects. 

Q11. What are the covariances of the monthly excess bond returns for the U.S.?

The covariances of these monthly excess bond returns for the U.S. versus Australia, Canada, Japan and Germany are 3.16, 2.62, 2.38 and 3.18, respectively. 

Q12. What is the effect of a LSAP announcement on Japanese yields?

For Japan, signaling effects are negligibly small and portfolio balance effects can entirely explain the modest LSAP announcement effects.