The impact of Federal Reserve asset purchase programmes: another twist 1

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1 Jack Meaning eng Zhu The impac of ederal Reserve asse purchase programmes: anoher wis 1 This aricle examines he effeciveness of recen ederal Reserve asse purchase programmes. We esimae ha once we conrol for facors such as he size and he mauriy profile of Treasury issuance, he new Mauriy Exension Program (MEP) could have an impac comparable o he one we esimae for he Large-Scale Asse Purchase (LSAP) programme. The effeciveness of such programmes is limied by Treasury deb managemen policy. Indeed, he Treasury s exension of he average mauriy of ousanding deb during LSAP is likely o have pushed up he 1-year bond yield significanly. JEL classificaion: E52, E63. Jus before making is mos recen policy rae cu in December 28, he ederal Reserve sared a series of asse purchase programmes ha focus on longer-erm securiies including governmen bonds (Graph 1). How effecive will he recen programmes, especially he Mauriy Exension Program (MEP), be in lowering ineres raes? We seek o answer his quesion using esimaes from a simple model of US Treasury bond yield dynamics. We find, firs, ha he likely impac of he MEP on he 1-year governmen bond yield is sizeable. Second, he esimaed impac on yields is comparable o ha of he previous asse purchase programmes. And he effeciveness of ederal Reserve asse purchases is limied by he Treasury s deb managemen policy. Indeed, we esimae ha he Treasury s exension of he average mauriy of ousanding deb during he Large-Scale Asse Purchase (LSAP) programme pushed he 1-year bond yield up by 27 basis poins during he firs sage of he programme (LSAP1) and by 14 basis poins during he second sage (LSAP2). 1 The views expressed in his aricle are hose of he auhors and do no necessarily reflec hose of he BIS. We are graeful o Claudio Borio, Jagji Chadha, Sephen Cecchei, Bob McCauley, Bill Nelson and Chrisian Upper for useful commens on earlier drafs of his aricle, and o Jakub Demski for exper assisance wih daa and graphs. BIS Quarerly Review, March

2 ederal Reserve asse purchase programmes On 21 Sepember 211, he ederal Open Marke Commiee (OMC) announced he new MEP, which seeks o increase he average mauriy of he ederal Reserve porfolio of Treasury securiies by 25 monhs o abou 1 monhs by he end of 212. To do so, he OMC planned o buy $4 billion in Treasury securiies wih remaining mauriies of 72 o 36 monhs and o sell an equal amoun of Treasuries wih remaining mauriies of hree o 36 monhs. Abou 64% of he purchases were allocaed o he six- o 1-year segmen, and anoher 29% o he 2- o 3-year segmen. The MEP differs from he previous LSAP programme. When LSAP was esablished in November 28, he OMC inended o acquire up o $6 billion in agency morgage-backed securiies and agency deb. rom March 29 o March 21, i commied an addiional $85 billion o purchases of agency securiies, and a furher $3 billion o acquiring longererm Treasury securiies (LSAP1). As he recovery falered, in November 21 he OMC pu in place LSAP2, which consised of furher purchases of $6 billion in longer-erm Treasury securiies unil mid-211. The ederal Reserve s asse holdings expanded rapidly as a consequence of hese purchases, reaching abou 17% of Treasury securiies ousanding by mid-211 (Graph 1). Unlike he LSAP programme, he MEP explicily aims a exending he average mauriy of he ed s Treasury holdings wihou changing he overall size of he cenral bank s balance shee. In his regard i is essenially a new version of Operaion Twis, implemened in he early 196s, which sough o wis he yield curve by nudging he longer-erm yields lower while keeping he shor raes a exising levels. Under ha programme, he ed bough abou $8.8 billion of longer-erm Treasury securiies and reduced is holdings of shor-erm Treasury bills by $7.4 billion. The size of purchases was comparable A new Operaion Twis focuses on he composiion of ed asse holdings ederal Reserve moneary policy measures In per cen Ineres raes ederal funds arge rae Ten-year Treasury yield 6 Asse holdings Asses 1 Treasury holdings by he ed The shaded areas represen LSAP1: March 29 November 29; LSAP2: November 21 June 211; and MEP: Sepember 211 June ederal Reserve oal asses as a share of GDP. ousanding, excluding inragovernmenal holdings. 2 ederal Reserve Treasury securiies holdings as a share of Treasury securiies Sources: ederal Reserve Board; US Deparmen of he Treasury; Bloomberg; naional daa. Graph 1 24 BIS Quarerly Review, March 212

3 o he LSAP programmes, relaive o GDP and o Treasury deb ousanding. Early sudies, such as Modigliani and Such (1966, 1967), find ha Operaion Twis had lile impac on long-erm bond yields. However, based on even sudies wih high-frequency daa, Swanson (211) esimaes ha i could have lowered he US 1-year Treasury bond yield by abou 15 basis poins. The likely impac of he MEP How effecive will he MEP be? Will i have a greaer impac on Treasury bond yields han ourigh asse purchases under he LSAP programme? We evaluae he likely effecs of he programme by esimaing he impac on 1-year Treasury bond yields of he argeed 25-monh mauriy exension of he ed porfolio of Treasury securiies. The effeciveness of he MEP ed mauriy exension reduces bond yields Cenral banks can affec governmen bond yields by changing eiher he size or he composiion of heir bond holdings, or boh. The mauriy srucure of he ederal Reserve s Treasury holdings is a good indicaor of he porfolio s composiion. We esimae a dynamic model of yield deerminaion o gauge he impac on he 1-year Treasury bond yield of changes in he average mauriies of he ed holdings of Treasury securiies and of Treasury securiies ousanding (see box). We conrol for he size of he ed Treasury holdings relaive o Treasury deb ousanding, he effecive federal funds rae and a number of oher facors reflecing macroeconomic and marke condiions. Our esimaes indicae, firs, ha he mauriy srucure of ed Treasury holdings maers for Treasury bond yields. 2 Lenghening he average mauriy of he ed holdings by one monh lowers he 1-year bond yield by 3.4 basis poins, all oher hings being equal (Table 1). Assuming ha he relaionship is linear and ceeris paribus, he planned 25-monh exension of he average Esimaed long-run coefficiens from error correcion model 1 Impac on 1-year Treasury bond yield Sample period Average mauriy of ed Treasury holdings Average mauriy of Treasuries ousanding ed holdings relaive o Treasuries ousanding ed funds rae Jan Jun 211 (.4) (.7) (.12) (.24) Jan Jun 27 (.18) (.13) (.35) (.27) 1 Sandard errors are repored in parenheses. Source: Meaning and Zhu (212). Table 1 2 Kuner (26) finds ha ed purchases of long-erm bonds have a significan impac on he erm premia, bu he effecs of changes in he ousanding publicly held Treasury deb are insignifican. BIS Quarerly Review, March

4 Esimaing he yield impac of ed bond purchases Using monhly US daa from January 199 o June 211, we apply he Engle-Granger (1987) wo-sep procedure o esimae an error correcion model of he dynamics of he 1-year Treasury bond yield. In he firs sep, we esimae a co-inegraing vecor, inerpreed as he long-run equilibrium relaionship, of he following form: y 1Y = α + β M + β T M T + δ + κi + γc + ε (1) y 1 Y where is he yield for a bond of 1 years remaining mauriy a ime, M is he average T mauriy of he ed holdings of Treasury securiies, M is he average mauriy of ousanding Treasury securiies, is he size of he ed Treasury holdings relaive o oal Treasury deb ousanding, and i is he effecive federal funds rae. The coefficiens on hese variables capure he individual impac on yields of ed mauriy ransformaion, Treasury deb mauriy ransformaion, he relaive size of ed holdings of Treasury securiies, and convenional ineres rae policy. Model (1) is similar o hose of Kuner (26) and Greenwood and Vayanos (28), and shares heir limiaions. irs, changes in he mauriy srucure and size of ed asse holdings and Treasury deb ousanding are no independen from each oher. The overall effec of MEP will be smaller han he parial effec indicaed by he coefficien β if he Treasury exends he mauriy or increases he size of is ousanding deb. Unlike Kuner (26), we include o conrol for effecs arising from changes in he size of ed holdings relaive o he amoun ousanding of Treasuries. I is imporan o bear in mind ha depends on boh ed and Treasury acions. T In addiion, M, M and may be correlaed wih some omied variables. We consider a se of conrol variables C which include he consensus forecass of one-year-ahead inflaion and real GDP growh raes, he VIX (an index of implied volailiy), and he Cochrane-Piazzesi (25) forward rae facor. irs, a rise in expeced inflaion can increase long yields by raising he expeced level of fuure shor ineres raes. Second, higher growh expecaions could be associaed wih a rise in expeced inflaion, igher moneary policy and higher ineres raes. There is also evidence ha expeced real oupu growh plays a significan role in explaining ime variaion in bond risk premia. Third, implied volailiy capures a fligh o safey facor, as rising marke srains may drive invesors o shif o safe haven asses such as Treasury securiies, depressing heir yields. ourh, ama and Bliss (1987) and Cochrane and Piazzesi (25) show ha forward raes implied from he yield curve have significan predicive power for bond erm or risk premia. Implied forward raes, along wih lagged 1-year yields and lagged federal funds raes, convey informaion on he fuure pah of he policy rae. We find ha hese variables are saisically significan and have signs in line wih our priors, bu hey do no significanly affec he coefficien T esimaes on M, M and. Mos of he included variables are esed o be non-saionary. In he second sep, we formulae an error correcion model ha capures he dynamics of heir ineracions: Δy + 1Y f = θ ΔC f = σ + f I i = 1 ρ Δy + φ εˆ i g 1Y i 1 + ξ + J K L T T β j ΔM j + βk ΔM k + j = k = l = δ Δ l l + M m= κ m Δi m (2) where εˆ s are he regression residuals from (1) and represen he esimaed error correcion erm, ie deviaions of acual yields from heir esimaed implied equilibrium level. We use informaion crieria o selec he opimal lag srucure, which ypically includes one or wo lags for each variable. We focus our discussion based on esimaes from he equilibrium co-inegraing relaionships. One concern is ha he model esimaes may no be sable over ime. We esimae he model wih daa from January 199 o June 27, before he large jump in he average mauriy of ed Treasury holdings. There is evidence ha changes in he mauriy srucure of ed holdings and 26 BIS Quarerly Review, March 212

5 Treasury deb ousanding acually had more of an effec in his earlier period when ed mauriy exension or asse purchases were no used as policy ools (Table 1). We inerpre he coefficien on as represening he quaniy effec on yields of he proporional reducion in Treasury deb supply resuling from ed ourigh asse purchases. Wheher his correcly measures he impac of he LSAP is debaable, as he raio depends on boh ed and Treasury acions. Bu he ed purchases ake Treasury acions as given, and he size of inervenion relaive o oal supply is a key deerminan for yields. We conduc a number of robusness checks. irs, we run regressions wih he ed holdings and Treasury deb ousanding, in logarihms, as wo separae variables. The coefficien esimaes on he wo variables are significan and have he righ signs, and hose on he mauriy variables are in line wih he presened resuls. Second, we normalise he average mauriy of ed holdings by he ed s marke share, and he new variables are again significan wih he righ sign. More deails are provided in Meaning and Zhu (212). as do changes in he size of ed Treasury holdings mauriy under he MEP could reduce he 1-year bond yield by 85 basis poins, assuming ha he sock and mauriy of he ousanding Treasury deb remain unchanged. 3 This cavea is imporan because our esimaes, second, show ha changes in he size of he ed Treasury holdings relaive o oal Treasury deb ousanding can have a significan effec on yields. An increase of 1% in he raio of ed holdings o Treasuries ousanding reduces yields by 2 basis poins for bonds of 1-year residual mauriy. This effec was significanly smaller in he pre-crisis period, probably because bond purchases were no considered a policy ool a ha ime. 4 Indeed, as shown in Meaning and Zhu (211), mere announcemens of ed asse purchases following he global crisis had sizeable effecs on yields, on op of he impac of acual purchases. Admiedly, he esimaed model is quie simple, and may fail o conrol for oher drivers of yields. Tha said, he resuls sugges ha ed asse purchase programmes have been effecive. We esimae ha in he absence of any ed purchases, he 1-year Treasury yield would have been 18 basis poins higher by mid-211 (Graph 2). During LSAP1 and LSAP2, he proporion of ousanding Treasury deb held by he ederal Reserve increased by 3. and 7.7 percenage poins (Graph 1), respecively, implying reducions of 6 and 156 basis poins in he 1-yield Treasury yield (Graph 2). On he oher hand, ed ourigh asse purchases had lile effec on he mauriy srucure of ed Treasury holdings. The average mauriy of hese holdings increased by only wo monhs during LSAP1 and acually declined by over six monhs during LSAP2 (Graph 3), so he yield effecs of mauriy ransformaion were small. Taking accoun of he sizes of ourigh asse purchases during LSAP1 and LSAP2, and he planned size of he MEP asse rade o suppor he mauriy ransformaion of ed Treasury holdings, he programmes effecs on he 1- year Treasury yield are of similar magniude. 3 See Meaning and Zhu (212) for more deails. Applying he same model o differen mauriies, hey find ha he MEP could have a significan impac on he enire Treasury yield curve. 4 Ineres rae policy appears o have been slighly more effecive before he crisis. We esimae ha lowering he federal funds rae by 1 basis poins leads o a 22 basis poin reducion in he 1-year bond yield. This compares o he pre-crisis sample esimae of 26 basis poins. BIS Quarerly Review, March

6 The impac of ederal Reserve asse purchase programmes Ten-year Treasury bond yield Mauriy ransformaion and quaniy effecs 1 ed asse purchases and Treasury deb managemen AM 1 2 AMT Acual QE Wihou ed QE R Wihou Treasury deb managemen 3 Toal 2 LSAP1 LSAP2 MEP The shaded areas represen LSAP1: March 29 November 29; and LSAP2: November 21 June AM is he impac of changes in he average mauriy of he ederal Reserve s Treasury securiies porfolio; AMT is he impac of changes in he average mauriy of Treasury deb ousanding; QE is he impac of changes in he size of he ederal Reserve s Treasuries porfolio relaive o oal Treasury deb ousanding; R measures he impac of changes in he federal funds rae. The projeced impac of he MEP is based on he ederal Reserve decision o exend he average mauriy of is Treasury deb porfolio by 25 monhs assuming he Treasury does no change he size and mauriy profile of he deb ousanding. 2 Counerfacual 1-year Treasury bond yield keeping he average mauriy of ed holdings of Treasuries and he size of he ed bond holdings relaive o oal Treasury deb ousanding consan a he ebruary 29 levels. 3 Counerfacual 1-year Treasury bond yields keeping he average mauriy of Treasury deb ousanding consan a he ebruary 29 level. Source: Auhors' calculaions. Graph 2 Asse purchases and Treasury deb managemen policy Our esimaes sugges ha he effeciveness of he ederal Reserve s asse purchase programmes is consrained by he Treasury s deb managemen policy. A one-monh mauriy exension of Treasury deb ousanding raises he 1-year bond yield by 7 basis poins, wice he yield reducion effec of a onemonh mauriy lenghening of he ed holdings. This is unsurprising as he ed porfolio makes up beween 7 and 18% of he overall Treasuries marke over our sample period. 5 The impac of bond purchases on he 1-year bond yield would have been greaer had he Treasury no expanded he supply of Treasuries especially he longer-erm securiies hereby increasing he mauriy of Treasury deb ousanding during LSAP1 and LSAP2 (Graph 2). The ne effecs on 1-year bond yields of 43 basis poins during LSAP1 and 121 basis poins during LSAP2 are consisen wih he esimaes of D Amico and King (21) and Meaning and Zhu (211, 212). Sovereign deb managers and moneary policymakers do no share he same goals. 6 Seeking o minimise borrowing coss and maximise reurns, Treasury deb managers could be emped o ake advanage of he lower long 5 Tha said, mauriy ransformaion of ed Treasury holdings via bond purchases seems o have a greaer impac on yields per dollar spen han ha of Treasury deb ousanding. 6 isher (22) argues ha he Treasury s deb managemen serves a single, overriding objecive, which is o mee he financing needs of he federal governmen a he lowes cos over ime. 28 BIS Quarerly Review, March 212

7 Treasury deb managemen limis he impac of ed asse purchases raes afforded by ed bond purchase programmes by issuing more longer-erm deb. 7 As a maer of fac, he Treasury increased he average mauriy of ousanding deb during LSAP1 and LSAP2 from 47 monhs in March 29 o almos 59 monhs in June 211 (Graph 3). We esimae ha, all oher hings being equal, his would have pushed he 1-year bond yield up by 27 basis poins during LSAP1 and 14 basis poins during LSAP2 (Graph 2, lef-hand panel). Were i no for he Treasury s deb mauriy exension, he 1-year yield would have been 8 basis poins lower by mid-211 (Graph 2, righ-hand panel). The same lesson can be learned from he implemenaion of he original Operaion Twis: is apparen lack of success can be parly aribued o he Treasury raising he average mauriy of markeable deb from 41 monhs in 196 o 55 monhs in The average mauriy of Treasury deb ousanding remains well below he average level over he wo decades preceding he crisis (Graph 3). Looking ahead, he Treasury may coninue o favour issuance of longer-daed deb, and he average mauriy of Treasury deb ousanding may rise furher. The Treasury issued $31 billion in ne markeable deb in he fourh quarer of 211. I expecs o issue an addiional $444 billion in deb in he firs quarer of 212 and $2 billion in he second quarer, wih plans for sales of more longer-erm noes and bonds. The planned issuance of $644 billion in new deb in he firs half of 212 is larger han he $4 billion MEP. Expanding he size of Treasury deb ousanding would reduce he raio of ed Treasury holdings relaive o deb ousanding, furher diluing he simulaive effecs of ed asse purchases. Mauriy disribuion of US Treasury deb securiies 1 Held by he ederal Reserve Treasury securiies ousanding 3 1 year 1 5 years 5 1 years 1 years Average mauriy Breakdown of securiies held ourigh refers o remaining mauriy as a percenage of oal; verical lines mark he firs days of he LSAP and MEP programmes: March 29, November 21 and Sepember In monhs. 3 Excluding inragovernmenal holdings. Sources: ederal Reserve Board; US Deparmen of he Treasury; Daasream. Graph 3 7 See Borio and Disyaa (21), Chadha (211), McCauley and Ueda (29), Meaning and Zhu (212) and Turner and Mohany (211). 8 See Unied Saes Deparmen of he Treasury (1968). BIS Quarerly Review, March

8 Conclusion The ederal Reserve s new Operaion Twis, he MEP, may have a significan impac on he 1-year Treasury bond yield, comparable o ha of ourigh asse purchases under he LSAP programme. The MEP does no involve any size changes in he ed balance shee, bu i is limied by he exising amoun of shor-mauriy asses in he ed asse porfolio. Tha said, he effeciveness of he ederal Reserve asse purchase programmes depends on Treasury deb managemen policy. When he ederal Reserve acs o lower yields for longerdaed bonds and he Treasury has large longer-erm borrowing needs, a conflic of ineress may emerge. 3 BIS Quarerly Review, March 212