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ARVIND KRISHNAMURTHY
Northwestern University
ANNETTE VISSING-JORGENSEN
Northwestern University
The Effects of Quantitative Easing
on Interest Rates: Channels
and Implications for Policy
ABSTRACT We evaluate the effect of the Federal Reserve’s purchase of
long-term Treasuries and other long-term bonds (QE1 in 2008–09 and QE2 in
2010–11) on interest rates. Using an event-study methodology, we reach two
main conclusions. First, it is inappropriate to focus only on Treasury rates as a
policy target, because quantitative easing works through several channels that
affect particular assets differently. We find evidence for a signaling channel,
a unique demand for long-term safe assets, and an inflation channel for both
QE1 and QE2, and a mortgage-backed securities (MBS) prepayment channel
and a corporate bond default risk channel for QE1 only. Second, effects on par-
ticular assets depend critically on which assets are purchased. The event study
suggests that MBS purchases in QE1 were crucial for lowering MBS yields as
well as corporate credit risk and thus corporate yields for QE1, and Treasuries-
only purchases in QE2 had a disproportionate effect on Treasuries and agency
bonds relative to MBSs and corporate bonds, with yields on the latter falling
primarily through the market’s anticipation of lower future federal funds rates.
T
he Federal Reserve has recently pursued the unconventional policy of
purchasing large quantities of long-term securities, including Trea-
sury securities, agency securities, and agency mortgage-backed securities
(MBS). The stated objective of this quantitative easing (QE) is to reduce
long-term interest rates in order to spur economic activity (Dudley 2010).
There is significant evidence that QE policies can alter long-term interest
rates. For example, Joseph Gagnon and others (2010) present an event
study of QE1 that documents large reductions in interest rates on dates
216 Brookings Papers on Economic Activity, Fall 2011
associated with positive QE announcements. Eric Swanson (2011) pre-
sents confirming event-study evidence from the 1961 Operation Twist,
where the Federal Reserve purchased a substantial quantity of long-term
Treasuries. Apart from the event-study evidence, there are papers that
look at lower-frequency variation in the supply of long-term Treasuries
and document its effects on interest rates (see, for example, Krishnamurthy
and Vissing-Jorgensen 2010).
1
Although it is clear from this body of work that QE lowers medium- and
long-term interest rates, the channels through which this reduction occurs
are less clear. The main objective of this paper is to evaluate these chan-
nels and their implications for policy. We review the principal theoretical
channels through which QE may operate. We then examine the event-study
evidence with an eye toward distinguishing among these channels, study-
ing a range of interest rates and drawing in additional facts from various
derivatives prices to help separate the channels. We furthermore supple-
ment previous work by adding evidence from QE2 and evidence based on
intraday data. Studying intraday data allows us to document price reac-
tions and trading volume in the minutes after the main announcements,
thus increasing confidence that any effects documented in daily data are
due to these announcements.
It is necessary to understand the channels of operation in order to evalu-
ate whether a given QE policy was successful. Here is an illustration of
this point: Using annual data back to 1919, Krishnamurthy and Vissing-
Jorgensen (2010) present evidence for a channel whereby changes in long-
term Treasury supply drive the safety premiums on long-term assets with
near-zero default risk. Our findings in that paper suggest that QE policy
that purchases very safe assets such as Treasuries or agency bonds should
work particularly to lower the yields of bonds that are extremely safe, such
as Treasuries, agency bonds, and high-grade corporate bonds. But even
if a policy affects Treasury interest rates, such rates may not be the most
policy-relevant ones. A lot of economic activity is funded by debt that is
not as free of credit risk as Treasuries or other triple-A bonds. For example,
about 40 percent of corporate bonds are rated Baa or lower (for which our
earlier work suggests that the demand for assets with near-zero default
risk does not apply). Similarly, MBSs issued to fund household mortgages
are less safe than Treasuries because of the substantial prepayment risk
1. Other papers in the literature that have examined Treasury supply and bond yields
include Bernanke, Reinhart, and Sack (2004), Greenwood and Vayanos (2010), D’Amico and
King (2010), Hamilton and Wu (2010), and Wright (2011).
ARVIND KRISHNAMURTHY and ANNETTE VISSING-JORGENSEN 217
involved. Whether yields on these less safe assets fall as much as those on
very safe assets depends on whether QE succeeds in lowering default risk
or the default risk premium (for corporate bonds) and the prepayment risk
premium (for MBSs).
One of the principal findings of this paper is that the large reductions in
mortgage rates due to QE1 appear to be driven partly by the fact that QE1
involved large purchases of agency-backed MBSs (thus reducing the price
of mortgage-specific risk). In contrast, for QE2, which involved only Trea-
sury purchases, we find a substantial impact on Treasury and agency bond
rates, but smaller effects on MBS and corporate rates. Furthermore, we find
a substantial reduction in default risk or the default risk premium for corpo-
rate bonds only for QE1, suggesting that the MBS purchases in QE1 may
also have helped drive down corporate credit risk and thus corporate yields
(possibly via the resulting mortgage refinancing boom and its impact on
the housing market and consumer spending). The main effect on corporate
bonds and MBSs in QE2 appears to have been through a signaling channel,
whereby financial markets interpreted QE as signaling lower federal funds
rates going forward. This finding for QE2 raises the question of whether
the main impact of a Treasuries-only QE may have been achievable with a
statement by the Federal Reserve committing to lower federal funds rates,
that is, without the Fed putting its balance sheet at risk in order to signal
lower future rates.
The next section of the paper lays out the channels through which QE
may be expected to operate. We then, in sections II and III, present results
of event studies of QE1 and QE2 to evaluate the channels. We document that
QE worked through several channels. First, a signaling channel (reflecting
the market inferring information from QE announcements about future fed-
eral funds rates) significantly lowered yields on all bonds, with the effects
depending on bond maturity. Second, the impact of QE on MBS rates was
large when QE involved MBS purchases, but not when it involved only
Treasury purchases, indicating that another main channel for QE1 was to
affect the equilibrium price of mortgage-specific risk. Third, default risk
or the default risk premium for corporate bonds fell for QE1 but not for
QE2, contributing to lower corporate rates. Fourth, yields on medium-
and long-maturity safe bonds fell because of a unique clientele for safe
nominal assets, and Federal Reserve purchases reduced the supply of such
assets and hence increased the equilibrium safety premium. Fifth, evidence
from inflation swap rates and Treasury inflation-protected securities (TIPS)
shows that expected inflation increased as a result of both QE1 and QE2,
implying larger reductions in real than in nominal rates. Section IV presents
218 Brookings Papers on Economic Activity, Fall 2011
regression analysis building on our previous work in Krishnamurthy and
Vissing-Jorgensen (2010) to provide estimates of the expected effects of
QE on interest rates via the safety channel. Section V concludes.
I. Channels
We begin by identifying and describing the various channels through which
QE might operate.
I.A. Signaling Channel
Gauti Eggertsson and Michael Woodford (2003) argue that nontradi-
tional monetary policy can have a beneficial effect in lowering long-term
bond yields only if such policy serves as a credible commitment by the
central bank to keep interest rates low even after the economy recovers
(that is, lower than what a Taylor rule may call for). James Clouse and oth-
ers (2000) argue that such a commitment can be achieved when the central
bank purchases a large quantity of long-duration assets in QE. If the central
bank later raises rates, it takes a loss on these assets. To the extent that the
central bank weighs such losses in its objective function, purchasing long-
term assets in QE serves as a credible commitment to keep interest rates
low. Furthermore, some of the Federal Reserve’s announcements regarding
QE explicitly contain discussion of its policy on future federal funds rates.
Markets may also infer that the Federal Reserve’s willingness to undertake
an unconventional policy like QE indicates that it will be willing to hold its
policy rate low for an extended period.
The signaling channel affects all bond market interest rates (with effects
depending on bond maturity), since lower future federal funds rates, via
the expectations hypothesis, can be expected to affect all interest rates. We
examine this channel by measuring changes in the prices of federal funds
futures contracts, as a guide to market expectations of future federal funds
rates.
2
The signaling channel should have a larger impact on intermediate-
maturity than on long-maturity rates, since the commitment to keep rates
low lasts only until the economy recovers and the Federal Reserve can sell
the accumulated assets.
2. Piazzesi and Swanson (2008) show that these futures prices reflect a risk premium, in
addition to such expectations. If short-term rates are low and employment growth is strong,
the risk premium is smaller. To the extent that this risk premium is reduced by QE, our
estimates of the signaling effect are too large. It is difficult to assess whether changes in
short-term rates or employment growth due to QE have the same effect as non-policy-related
changes in these variables, so we do not attempt to quantify any such bias.
ARVIND KRISHNAMURTHY and ANNETTE VISSING-JORGENSEN 219
I.B. Duration Risk Channel
Dimitri Vayanos and Jean-Luc Vila (2009) offer a theoretical model for
a duration risk channel. Their one-factor model produces a risk premium
that is approximately the product of the duration of the bond and the price
of duration risk, which in turn is a function of the amount of duration risk
borne by the marginal bond market investor and this investor’s risk aver-
sion. By purchasing long-term Treasuries, agency debt, or agency MBSs,
policy can reduce the duration risk in the hands of investors and thereby
alter the yield curve, particularly reducing long-maturity bond yields rela-
tive to short-maturity yields. To deliver these results, the model departs
from a frictionless asset pricing model. The principal departures are the
assumptions that there is a subset of investors who have preferences for
bonds of specific maturities (“preferred-habitat demand”) and another sub-
set who are arbitrageurs and who become the marginal investors for pricing
duration risk.
An important but subtle issue in using the model to think about QE is
whether the preferred-habitat demand applies narrowly to a particular asset
class (for example, only to the Treasury market) or broadly to all fixed-
income instruments. For example, if some investors have a special demand
for 10-year Treasuries, but not for 10-year corporate bonds (or mortgages
or bank loans), then the Federal Reserve’s purchase of 10-year Treasur-
ies can be expected to affect Treasury yields more than corporate bond
yields. Vayanos and Vila (2009) do not take a stand on this issue. Robin
Greenwood and Vayanos (2010) offer evidence for how a change in the
relative supply of long-term versus short-term Treasuries affects the yield
spread between them. This evidence also does not settle the issue, because
it focuses only on Treasury data.
Recent studies of QE have interpreted the model as being about the
broad fixed-income market (see Gagnon and others 2010), and that is how
we proceed. Under this interpretation, the duration risk channel makes two
principal predictions:
—QE decreases the yield on all long-term nominal assets, including
Treasuries, agency bonds, corporate bonds, and MBSs.
—The effects are larger for longer-duration assets.
I.C. Liquidity Channel
The QE strategy involves purchasing long-term securities and paying for
them by increasing reserve balances. Reserve balances are a more liquid
asset than long-term securities. Thus, QE increases the liquidity in the hands
