Large-Scale Asset Purchases by the Federal Reserve: Did They Work?

FRBNY Economic Policy Review / May 2011 41

Large-Scale Asset

Purchases by the Federal

Reserve: Did They Work?

1. Introduction

n December 2008, the Federal Open Market Committee

(FOMC) lowered the target for the federal funds rate to

a range of 0 to 25 basis points. With its traditional policy

instrument set as low as possible, the Federal Reserve faced the

challenge of how to further ease the stance of monetary policy

as the economic outlook deteriorated. The Federal Reserve

responded in part by purchasing substantial quantities of assets

with medium and long maturities in an effort to drive down

private borrowing rates, particularly at longer maturities.

These large-scale asset purchases (LSAPs) have greatly

increased the size of the Federal Reserve’s balance sheet, and

the additional assets may remain in place for years to come.

To be sure, the Federal Reserve undertook other important

initiatives to combat the financial crisis. It launched a number

of facilities to relieve financial strains at specific types of

institutions and in specific markets. In addition, in an attempt

to provide even more stimulus, it used public communications

about its policy intentions to lower market expectations of the

federal funds rate in the future. All of these strategies were

designed to ease financial conditions and to support a

sustained economic recovery. Over time, though, the credit

extended by the liquidity facilities has declined, and the

dominant component of the Federal Reserve’s balance sheet

has become the assets accumulated through the LSAP

programs.

The decision to purchase large volumes of assets through

March 2010 came in two steps. In November 2008, the Federal

Reserve announced purchases of housing agency debt and

agency mortgage-backed securities (MBS) of up to $600 bil-

lion. In March 2009, the FOMC decided to substantially

expand its purchases of agency-related securities and to

purchase longer term Treasury securities as well, with total

asset purchases of up to $1.75 trillion, an amount twice the

magnitude of total Federal Reserve assets prior to 2008.

The

FOMC stated that the increased purchases of agency-related

securities should “provide greater support to mortgage lending

and housing markets” and that purchases of longer term

Treasury securities should “help improve conditions in private

credit markets.”

In this paper, we review the Federal Reserve’s experience

with implementing the LSAPs through March 2010 and

describe some of the challenges raised by such large purchases

in a relatively short time. In addition, we discuss the economic

The Treasury Department also established a program to purchase agency

MBS beginning in September 2008. By the program’s termination at year-end

2009, it had purchased $220 billion of such securities. This program was much

smaller than the Federal Reserve’s LSAPs and no specific purchase amount

targets were announced, so it is not included in our analysis.

Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack

Joseph Gagnon is a senior fellow at the Peterson Institute for International

Economics; Matthew Raskin is an economic analyst and Julie Remache an

assistant vice president in the Markets Group of the Federal Reserve Bank

of New York; Brian Sack is executive vice president and head of the Markets

Group as well as manager of the System Open Market Account for the

Federal Open Market Committee.

Correspondence: [email protected]

The authors thank Seamus Brown, Mark Cabana, Michelle Ezer, Michael

Fleming, Jeremy Forster, Joshua Frost, Allen Harvey, Spence Hilton,

Warren Hrung, Frank Keane, Karin Kimbrough, David Lucca, Brian Madigan,

Patricia Mosser, Asani Sarkar, Lisa Stowe, Richard Wagreich, Carl Walsh, and

Jonathan Wright for helpful comments; Clara Sheets for valuable research

assistance; and Carol Bertaut for guidance on the foreign official holdings

data. A variation of this paper, “The Financial-Market Effects of the Federal

Reserve’s Large-Scale Asset Purchases,” is appearing in a special issue of the

International Journal of Central Banking. The views expressed are those of the

authors and do not necessarily reflect the position of the Peterson Institute,

the Federal Reserve Bank of New York, or the Federal Reserve System.

42 Large-Scale Asset Purchases by the Federal Reserve

mechanisms through which LSAPs may be expected to

stimulate the economy and present some empirical evidence

on those effects. In particular, LSAPs reduce the supply to the

private sector of assets with long duration (and, in the case of

mortgage securities, highly negative convexity) and increase

the supply of assets (bank reserves) with zero duration and

convexity.

To the extent that private investors do not view

these assets as perfect substitutes, the reduction in supply of the

riskier longer term assets reduces the risk premiums required

to hold them and thus reduces their yields. We assess the extent

to which LSAPs had the desired effects on market interest rates

using two different approaches and find that the purchases

resulted in economically meaningful and long-lasting

reductions in longer term interest rates on a range of securities,

including securities that were not included in the purchase

programs. We show that these reductions in interest rates

primarily reflect lower risk premiums rather than lower

expectations of future short-term interest rates.

We conclude

with a discussion of issues raised by these policies and potential

lessons for implementing monetary policy at the zero bound in

the future.

2. How LSAPs Affect the Economy

The primary channel through which LSAPs appear to work is

by affecting the risk premium on the asset being purchased. By

purchasing a particular asset, a central bank reduces the

amount of the security that the private sector holds, displacing

some investors and reducing the holdings of others, while

simultaneously increasing the amount of short-term, risk-free

bank reserves held by the private sector. In order for investors

to be willing to make those adjustments, the expected return on

the purchased security has to fall. Put differently, the purchases

bid up the price of the asset and hence lower its yield. This

pattern was described by Tobin (1958, 1969) and is commonly

known as the “portfolio-balance” effect.

Note that the portfolio-balance effect has nothing to do with

the expected path of short-term interest rates. Longer term

yields can be parsed into two components: the average level of

short-term risk-free interest rates expected over the term to

maturity of the asset and the risk premium. The former

Negative convexity arises from the ability of mortgage borrowers to prepay

their loans. As interest rates fall, the incentive to prepay increases, generally

resulting in an increase in prepayments to MBS holders. This effect causes the

duration of MBS to fall as interest rates decline and vice versa. Convexity is

explained in more detail in the next section.

As we discuss below, these risk premiums, or excess expected returns, arise

due to interest rate, credit, or liquidity risk, or other characteristics that make

the assets’ returns uncertain.

represents the expected return that investors could earn by

rolling over short-term risk-free investments, and the latter is

the expected additional return that investors demand for

holding the risk associated with the longer term asset. In

theory, the effects of the LSAPs on longer term interest rates

could arise by influencing either of these two components.

However, the Federal Reserve did not use LSAPs as an explicit

signal that the future path of short-term risk-free interest rates

would remain low.

In fact, at the same time that the Federal

Reserve was expanding its balance sheet through the LSAPs, it

was going to great lengths to inform investors that it would still

be able to raise short-term interest rates at the appropriate

time. Thus, any reduction in longer term yields instead has

likely come through a narrowing in risk premiums.

For Treasury securities, the most important component of

the risk premium is referred to as the “term premium,” and it

reflects the reluctance of investors to bear the interest rate risk

associated with holding an asset that has a long duration. The

term premium is the additional return investors require, over

and above the average of expected future short-term interest

rates, for accepting a fixed, long-term yield. The LSAPs have

removed a considerable amount of assets with high duration

from the markets. With less duration risk to hold in the

aggregate, the market should require a lower premium to hold

that risk. This effect may arise because those investors most

willing to bear the risk are the ones left holding it.

Or, even

if investors do not differ greatly in their attitudes toward

duration risk, they may require lower compensation for

holding duration risk when they have smaller amounts of it

in their portfolios.

In addition to the effect of removing duration and hence

shrinking the term premium across all asset classes, Federal

Reserve purchases of agency debt and agency MBS might be

expected to have an effect on the yields on those assets through

other elements of their risk premiums. For example, these

There is a large body of literature on consumer-optimizing models of

portfolio selection, which are variants of the portfolio-balance model that

impose restrictions arising from the assumed (risk-averse) utility functions of

investors. See Markowitz (1952), Sharpe (1964), and Campbell and Viceira

(2001, 2005). More recently, Vayanos and Vila (2009) have developed a

theoretical model of the term structure based on preferred habitats of investors,

which also relies on risk aversion. Andres, Lopez-Salido, and Nelson (2004)

provide an example of a dynamic stochastic general equilibrium model with

imperfect asset substitutability based on frictions in financial markets.

Indeed, the FOMC instead directly used language in its statements to signal

that it anticipates that short-term interest rates will remain exceptionally low

for an extended period. However, as discussed below, neither the language

about future policy rates in the FOMC statements nor the LSAP announce-

ments appear to have had a substantial effect on the expected future federal

funds rate.

Indeed, in the preferred-habitat model of Modigliani and Sutch (1966),

it is possible that some agents seek to hold long-duration assets, such as for

retirement, so that the term premium can, in principle, be negative.

FRBNY Economic Policy Review / May 2011 43

assets may be seen as having greater credit or liquidity risk

than Treasury securities.

In addition, the purchases of MBS

reduce the amount of prepayment risk that investors have to

hold in the aggregate. Prepayment risk on MBS causes the

duration of the securities to shrink when interest rates decline

and rise when interest rates increase. These changes in duration

imply that MBS have negative convexity: compared with the

price of a noncallable bond with the same coupon and

maturity, MBS prices rise less when rates fall and decline more

when rates rise. Given this undesirable profile and the cost of

hedging against it, investors typically demand an extra return

to bear the negative convexity risk, keeping MBS rates higher

than they would otherwise be. The LSAPs removed a

considerable amount of assets with high convexity risk, which

would be expected to reduce MBS yields.

These portfolio-balance effects should not only reduce

longer term yields on the assets being purchased, but also spill

over into the yields on other assets. The reason is that investors

view different assets as substitutes and, in response to changes

in the relative rates of return, will attempt to buy more of

the assets with higher relative returns. In this case, lower

prospective returns on agency debt, agency MBS, and Treasury

securities should cause investors to seek to shift some of their

portfolios into other assets, such as corporate bonds and

equities, and thus should bid up their prices. It is through the

broad array of all asset prices that the LSAPs would be expected

to provide stimulus to economic activity. Many private

borrowers would find their longer term borrowing costs lower

than they would otherwise be, and the value of long-term assets

held by households and firms—and thus aggregate wealth—

would be higher.

The effects described so far would be caused by LSAP-

induced changes in the stock of assets held by the public.

Moreover, to the extent that investors care about expected

future returns on their assets, today’s asset prices should reflect

expectations about the future stock of assets. Thus, a credible

announcement that the Federal Reserve will purchase longer

term assets at a future date should reduce longer term interest

rates immediately. Otherwise, investors could make excess

profits by buying the assets today to sell to the Federal Reserve

in the future.

There may also be effects on the prices of longer term assets

if the presence of the Federal Reserve as a consistent and

significant buyer in the market enhances market functioning

Prior to December 2009, the Treasury had committed to sizable but limited

capital injections in the housing agencies, and thus had not issued a blanket

guarantee of agency obligations. On December 24, 2009, the Treasury removed

the limit on capital injections over the next three years, stating that it wished to

“leave no uncertainty about the Treasury’s commitment to support these

firms.” Agency debt and agency MBS are not as liquid as Treasury securities.

The direct effect of LSAPs on liquidity of these securities is considered in more

detail below.

and liquidity. The LSAP programs began at a point of

significant market strains, and the poor liquidity of some assets

weighed on their prices. By providing an ongoing source of

demand for longer term assets, the LSAPs may have allowed

dealers and other investors to take larger positions in these

securities or to make markets in them more actively, knowing

that they could sell the assets, if needed, to the Federal Reserve.

Such improved trading opportunities could reduce the

liquidity risk premiums embedded in asset prices, thereby

lowering their yields.

This liquidity (or market-functioning) channel, which is

distinct from the portfolio-balance channel, appears to have

been important in the early stages of the LSAP programs for

certain types of assets. For example, the LSAP programs began

at a point when the spreads between yields on agency-related

securities and yields on Treasury securities were well above

historical norms, even after adjusting for the convexity risk

in MBS associated with the high interest rate volatility at that

time.

These spreads in part reflected poor liquidity and

elevated liquidity risk premiums on these securities.

The flow

of Federal Reserve purchases may have helped to restore

liquidity in these markets and reduced the liquidity risk of

holding those securities, thereby narrowing the spreads of

yields on agency debt and MBS to yields on Treasury securities

and reducing the cost of financing agency-related securities.

Another asset for which the market-functioning channel

was important in the early stages of the LSAP programs is

older Treasury securities, which had become unusually cheap

relative to more recently issued Treasury securities with

comparable maturities.

Such differences would normally

be arbitraged away, but investors and dealers were reluctant

to buy the older securities because their poor liquidity meant

that they might be difficult to sell. However, after the Federal

Reserve began buying such bonds, the yield spreads narrowed

to normal levels.

Overall, LSAPs may affect market interest rates through

a combination of portfolio-balance and market-functioning

effects. Although the effects on market functioning appear to

It is possible that the flow of purchases may affect longer term interest rates

for reasons other than the effects on market functioning and liquidity, if the

market faces other frictions.

According to Bloomberg L.P., the option-adjusted spread between the

current-coupon Fannie Mae thirty-year MBS and Treasuries averaged

146 basis points in the four weeks ending November 21, 2008. Over the

period 1996 to 2007, this spread averaged 89 basis points and exceeded

146 basis points on less than 4 percent of days.

Another contributing factor to the high yield spreads is that many financial

firms at that time faced constraints on their balance sheets, given the large

capital losses on other assets and limited access to new funds. Capital

constraints put agency-related debt at a disadvantage relative to Treasury

securities, as agency-related holdings have a 20 percent risk weighting

compared with 0 percent for Treasury securities.

See Gürkaynak and Wright (2010, p. 56).

44 Large-Scale Asset Purchases by the Federal Reserve

have been important at the start of the LSAPs when financial

markets were unusually strained, the primary long-run effects

are likely associated with the portfolio-balance effect. The lack

of significant movements in interest rates around the time that

each component of the LSAP programs was wound down

suggests that market functioning was no longer impaired and

that the Federal Reserve presence in the market had little

additional effect beyond that through its portfolio holdings.

3. Implementation of LSAPs

The Federal Reserve holds assets that it has purchased in the

open market in its System Open Market Account (SOMA).

Historically, SOMA holdings have been nearly all Treasury

securities, although small amounts of agency debt were held

at times.

Purchases and sales of SOMA assets are called

outright open market operations (OMOs). Outright OMOs,

in conjunction with repurchase agreements and reverse

repurchase agreements, traditionally were used to alter the

supply of bank reserves in order to influence conditions in

the federal funds market.

Most of the higher frequency

adjustments to reserve supply were accomplished through

repurchase and reverse repurchase agreements, with outright

OMOs conducted periodically to accommodate trend growth

in currency demand.

OMOs generally were designed to have a minimal effect on

the prices of the securities included in the operations. To that

end, they tended to be small in relation to the markets for

Treasury bills and Treasury coupon securities. LSAPs, however,

aimed to have a noticeable impact on the interest rates of the

assets being purchased as well as on other assets with similar

characteristics. In order to achieve this goal, the Federal

Reserve designed LSAPs to be large relative to the markets for

these assets. Between December 2008 and March 2010, the

Federal Reserve purchased more than $1.7 trillion in assets.

This represents 22 percent of the $7.7 trillion stock of longer

term agency debt, fixed-rate agency MBS, and Treasury

securities outstanding at the beginning of the LSAPs.

Another

Agency purchases were introduced in 1971 in order to “widen the base for

System open market operations and to add breadth to the market for agency

securities.” New purchases were stopped in 1981, although some maturing

funds from agency holdings were reinvested in newly issued agency securities.

Beginning in 1997, all holdings of agency securities were allowed to mature

without replacement. The last agency holding acquired under these programs

matured in December 2003.

A repurchase agreement is similar to a collateralized loan. The borrower sells

a security to the lender and simultaneously promises to buy back the security

at a fixed price. The Federal Reserve lends funds to the market through

repurchase agreements in order to increase reserves. To withdraw funds, the

Federal Reserve engages in repurchase agreements in the opposite direction,

also known as “reverse repurchase agreements.”

way to scale the purchases is to measure the amount of

duration they removed from the market using the concept of

“ten-year equivalents,” or the amount of ten-year-par Treasury

securities that would have the same duration as the portfolio of

assets purchased. Between December 2008 and March 2010,

the Federal Reserve purchased about $850 billion in ten-year

equivalents. That represents more than 20 percent of the

$3.7 trillion outstanding stock of ten-year equivalents across

these three asset classes at the beginning of the programs.

15, 16

We believe that no investor—public or private—has ever

accumulated such a large amount of securities in such a short

period of time.

As with all OMOs, the implementation of LSAP programs

was carried out by the Federal Reserve Bank of New York under

delegated authority from the FOMC to the SOMA manager at

the New York Fed. Under this authority, the SOMA manager is

responsible for the design and execution of OMOs to achieve

the policy mandate set forth by the FOMC. Among the

challenges in implementing OMOs for the LSAP programs was

the need to communicate clearly to market participants the

Federal Reserve’s goals and strategy for LSAPs and to execute

such large purchases while maintaining healthy market

functioning.

Purchases of MBS posed the greatest operational challenge,

owing to the more complex nature and heterogeneity of these

securities and to the size of the MBS purchase program.

Although the New York Fed had routinely accepted agency

MBS as collateral in repurchase agreement transactions, these

securities previously had not been purchased on an outright

basis. In order to quickly and efficiently implement the MBS

purchases and to mitigate financial and operational risk, the

New York Fed hired external investment managers to execute

these purchases.

Working closely with staff at the New York

Fed on a day-to-day basis, the investment managers executed a

certain quantity of purchases on behalf of the Federal Reserve

The outstanding stock is computed from Barclay’s Capital Indices, based

on data for November 24, 2008 (the day before the initial announcement of

LSAPs). The amount includes only fixed-rate issues with at least one year to

final maturity, and at least $250 million par amount outstanding. The measure

of agency debt outstanding includes debt issued by U.S. government agencies,

quasi-federal corporations, and corporate or foreign debt guaranteed by the

U.S. government (such as USAID securities), but the largest issues are from

Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System.

The outstanding stock of ten-year equivalents is also computed from Barclay’s

Capital Indices, based on data for November 24, 2008. Note that this measure

of duration is affected by changes in the shape of the Treasury yield curve, and

by the level of interest rates through their effect on prepayment of MBS.

Note that in these calculations, we combine the purchases of all three asset

types, as they all remove duration from the market and hence should affect risk

premiums on all assets with duration exposure. In the regression analysis in

section 4, we focus on the net public sector supply of long-term assets held

because this measure plausibly may be assumed to be exogenous with respect

to risk premiums. We thus ignore privately issued long-term assets that are

held by private investors.

FRBNY Economic Policy Review / May 2011 45

across a range of actively traded securities in the market each

day. Those transactions were carried out with the Federal

Reserve’s primary dealers as the counterparties.

Purchases of agency debt and Treasury securities posed less

of a challenge, as these securities were already handled by the

New York Fed in traditional OMOs. Unlike MBS purchases,

the agency and Treasury purchases were arranged as multi-

price reverse auctions conducted over the Federal Reserve’s

proprietary trading system, FedTrade.

The auctions provided

a mechanism through which primary dealer counterparties

could indicate the prices and quantities that they were willing

to sell, facilitating competition between auction participants

and enabling a market-based determination of purchases.

Overall, the New York Fed conducted sixty operations for

purchasing Treasury securities, or an average of nearly two per

week over the course of the program; for agency securities, the

number of operations through January 2010 totaled sixty-two,

or about one per week.

Each operation focused on a

particular maturity segment of securities and, to the extent

possible, was scheduled to avoid conflicting with other

operations or market events, such as Treasury debt auctions,

agency offerings, and significant planned economic news

releases. A summary of purchases was published on the New

York Fed’s website following each operation.

For each of the three types of assets included in the LSAPs,

the SOMA manager, in consultation with the FOMC, designed

a strategy for the pace and composition of purchases. The

approach for each program was similar, but not identical, as

due consideration needed to be given to the unique features of

each asset class. In general, the composition of purchases was

tilted toward longer maturity or longer duration securities in

Four investment firms were hired to provide trading and advisory services at

the start of the program: BlackRock, Goldman Sachs Asset Management,

PIMCO, and Wellington Management Company. On August 17, 2009, the

New York Fed announced that Wellington Management Company would

become the sole investment manager and that BlackRock would be retained for

analytical support services. JPMorgan was hired as the program administrative

agent and custodian.

Weekly summaries of MBS purchases can be found at http://www.newyorkfed

.org/markets/mbs/.

In these multi-price reverse auctions, participants enter prices at which they

are willing to sell selected amounts of specific securities to the New York Fed.

The offers are ranked according to their attractiveness and accepted until the

desired purchase amount is reached, much like in the case of a single-price

auction. However, in the case of these multi-price auctions, sellers whose offers

are accepted receive the price they submitted, whereas in a single-price auction

all successful offers would receive the clearing price for that security.

A tentative two-week schedule of Treasury operations was announced on

a biweekly basis, while agency operations were announced one day ahead.

Providing advance notice of auctions helped to boost participation by allowing

dealers time to assess and adjust their inventories.

Summaries of Treasury purchases are available at http://www.newyorkfed.org/

markets/pomo/display/index.cfm. Summaries of agency purchases are

available at http://www.newyorkfed.org/markets/pomo/display/

index.cfm?opertype=agny.

order to enhance the portfolio-balance effect and reduce longer

term interest rates. But purchases included a range of

maturities in order to minimize any distortions in the yield

curves for these assets. Within each sector, the New York Fed

focused purchases on assets that appeared to be underpriced

relative to other assets within that sector, in some cases

reflecting reduced market liquidity, as discussed above. These

assessments were made using modeled yield curves and fair

market values for securities to be purchased.

The overall pace

of purchases had to be high enough to achieve the FOMC’s

targets within the stated time frame, but allow for some

variation from day to day based on market liquidity conditions.

Recall that purchases of agency debt and MBS began at a

time when liquidity in these markets was poor and spreads to

Treasury yields were unusually wide. In these circumstances,

LSAPs helped to improve market liquidity by providing a large

buyer for these securities on a consistent basis. Spreads of MBS

and agency yields narrowed relative to Treasury yields and

spreads between on-the-run and off-the-run Treasury

securities narrowed. Trading flows increased and market

participants reported narrower bid-ask spreads in these

markets, reflecting improved liquidity. However, as financial

conditions improved over the course of the programs, the

LSAPs became more of an impediment to market liquidity by

removing such a large amount of the available supply. Some

market analysts argued that the relatively rich pricing of agency

debt and MBS was also having a negative impact on market

liquidity because it was driving some major investors out of

these markets. However, displacing agency debt and MBS

investors to a significant extent was an unavoidable element

of the programs that was necessary for achieving their goals.

Despite periodic strains, these markets generally continued to

function with adequate liquidity, in that investors could trade

relatively large amounts of securities with little effect on

market prices.

Because the MBS purchases were arranged with primary

dealer counterparties directly, there was no auction mechanism

to provide a measure of market supply. Instead, the New York

Fed aimed to adjust the pace of purchases of each class of

MBS in response to measures of whether that class appeared

relatively cheap or expensive, driven in part by changes in

liquidity. To avoid buying at excessively high prices and to

support market functioning, the New York Fed increased

purchases when market liquidity appeared to be good and

reduced them when liquidity appeared to be poor. Different

measures of liquidity were used to make these adjustments,

For Treasury and agency debt purchases, underlying discount curves were

estimated from prices of a current cross-section of comparable securities from

the same issuer to generate a fair valuation for securities being purchased. In

the case of MBS, valuations between different securities were compared with

historical norms.

46 Large-Scale Asset Purchases by the Federal Reserve

Chart 1

Distribution of Agency Debt Purchases by Maturity

Source: Federal Reserve Bank of New York.

Billions of dollars

100

More than

ten years

More than

five years,

to ten years

More than

two years,

to five years

More than

three months,

to two years

Zero to three

months

Maturity bucket

Chart 2

Distribution of Mortgage-Backed Securities

Purchases by Coupon

Source: Federal Reserve Bank of New York.

Billions of dollars

100

200

300

400

500

600

6.56.05.55.04.54.03.5

Coupon rate (percent)

including measures of trading volumes, relative price

valuations, bid-ask spreads, and indications of supply

imbalances. Throughout the program, the pace of daily

purchases ranged from $2 billion to $9 billion.

In terms of

composition, the Federal Reserve purchased MBS in all coupon

classes, but purchases were concentrated in the “production,”

or newly issued, thirty-year securities, which were in abundant

supply in the first few months of the program and generally had

lower coupons than existing MBS because of the prevailing low

interest rates.

It was felt that concentrating purchases on

production MBS would help to reinforce the decline in primary

mortgage rates by providing mortgage originators with a deep

and ready market for new loans.

In the case of agency debt, the New York Fed adjusted the

amount of securities purchased in each operation in response

to the total amount of propositions submitted, provided that

these propositions were at competitive prices. This strategy was

used in order to target different segments of the maturity

spectrum optimally from the perspective of market functioning

and liquidity. The program initially focused on off-the-run

securities; but as liquidity improved and yield spreads for these

securities narrowed, the New York Fed added on-the-run

securities to the eligible set of securities in September 2009

in order to mitigate market dislocations that had developed

during the program.

The program also made purchases and sales in the MBS dollar roll market to

help support financing of dealer MBS portfolios and to smooth out temporary

fluctuations in the supply of particular coupon categories of MBS. In a dollar

roll transaction, the buyer purchases MBS for the current delivery month and

simultaneously sells substantially similar MBS for a future delivery month.

MBS with low coupons have a longer duration than high-coupon securities,

in part because they tend to have a lower prepayment rate.

Concerns about market functioning and liquidity were

generally lower in the Treasury LSAP program, as that program

was much smaller in relation to the size of the market and to

the level of typical trading flows. As such, neither the pace

nor the composition of purchases was adjusted significantly

throughout the program. The amount of propositions in each

operation routinely exceeded the targeted quantity by three

times or more.

Purchases of agency debt were concentrated in medium-

term securities because of the small outstanding supply at

longer maturities (Chart 1). Purchases of agency MBS were

concentrated in newly issued, low-coupon, thirty-year

securities of Fannie Mae and Freddie Mac (Chart 2), which

were relatively more liquid and had longer durations than

other MBS. Purchases of Treasury securities were concentrated

in the two- to ten-year maturity sectors (Chart 3). Never-

theless, there were significant amounts purchased outside of

these targeted sectors, including a range of maturities of

Treasury debt and higher coupon, seasoned agency MBS, in

order to avoid substantial distortions in the yield curves and

spreads on these assets. In these circumstances, LSAPs

appeared to improve market liquidity. Spreads of agency debt

and MBS yields narrowed relative to Treasury yields, and

spreads between on-the-run and off-the-run Treasury

securities also narrowed.

The pace of purchases evolved fairly smoothly over the

course of the program. Total purchases ranged between

$50 billion and $200 billion on a monthly basis (Chart 4).

Purchases were somewhat heavier from March 2009 through

June 2009, reflecting the expansion of the LSAP programs at

that time and the large amount of MBS purchases made to

FRBNY Economic Policy Review / May 2011 47

Chart 3

Distribution of Treasury Purchases by Maturity

Source: Federal Reserve Bank of New York.

Billions of dollars

100

Treasury Inflation-

Protected Securities

(TIPS)

Seventeen to

thirty years

Ten to

seventeen years

Seven to ten years

Four-and-a-half

to seven years

Three to four-

and-a-half years

Two to

three years

One to

two years

Maturity bucket

Chart 4

Pace of Purchases by Asset Class

Source: Federal Reserve Bank of New York.

Billions of dollars

100

150

200

201020092008

Agency mortgage-

backed securities

Agency debt

Treasury

Total

offset significant origination activity. The decision to taper

purchases led to a slowing pace after mid-2009.

The Federal Reserve issued a press release shortly after the

initial announcement of each program providing further

details on the timing and overall structure of the programs.

Documents providing answers to frequently asked questions

were released at the start of each program. These documents

provided details as to the types of securities eligible for

purchase and the investment strategy that would be employed,

The decision to gradually slow the pace of Treasury purchases was

announced in the August 2009 FOMC statement. The decision to gradually

slow the pace of agency purchases was announced in the September 2009

FOMC statement.

and they were updated to reflect changes in the programs, such

as the increase in the targeted size of the agency debt and MBS

programs or the inclusion of on-the-run securities for purchase

in the agency debt program. The timely release of information

was provided in order to reduce uncertainty and speculation

about operational details. This information may also have

helped to prevent erratic trading based on differential access

to information or on rumors and misconceptions.

4. Estimates of LSAP Effects

4.1 Other Studies

According to the expectations theory of the term structure,

altering the maturity of the net supply of assets from the

government to private investors should have only minimal

effects on the term structure of interest rates. This view was

supported by the literature studying Operation Twist in the

early 1960s, which did not find robustly significant effects of a

swap between short-term and long-term Treasury securities in

the SOMA portfolio.

However, as noted by Solow and Tobin

(1987), Federal Reserve purchases during Operation Twist

were small and were soon more than offset by increased

Treasury issuance of long-term debt. Overall, there was little

movement in the average maturity of Treasury debt held by the

public and thus little hope of estimating a statistically

significant and robust effect.

Subsequent time-series studies, using longer spans of data,

generally have found a noticeable effect on the term structure

of shifts in the maturity structure of Treasury debt.

The

estimated size of this effect depends on the degree of theoretical

restrictions imposed on the estimating equation. Tighter

restrictions implied by simple models of household behavior

generally lead to smaller estimates, but these restrictions

typically are rejected statistically in favor of less restrictive

specifications. Other time-series studies, while not focusing on

the maturity structure of public debt, have found that increases

in the total supply of public debt tend to raise longer term

See, for example, Modigliani and Sutch (1967). The current program differs

from Operation Twist in that the reduction in long-term bonds is financed by

reserve creation rather than sales of short-term Treasury bills. However, with

interest rates on bank reserves and short-term bills roughly equal in the current

environment, the two assets should be viewed as close substitutes, and thus the

effect on the term spread should be similar.

All of the studies focused on the United States. See Friedman (1981), Frankel

(1985), Agell and Persson (1992), Kuttner (2006), and Greenwood and

Vayanos (2010). Since the original draft of this paper was written, Hamilton

and Wu (2010) have estimated the model of Vayanos and Vila (2009) and

obtained results broadly similar to ours.

48 Large-Scale Asset Purchases by the Federal Reserve

interest rates.

Kozicki, Santor, and Suchanek (2010) analyze

time-series data on the size of central bank balance sheets and

find that increases in the balance sheets are associated with

declines in long-term forward interest rates. Stroebel and

Taylor (2009) find little effect of daily Federal Reserve

purchases on the spread between MBS yields and swap yields

and a moderate effect on the spread between MBS yields and

Treasury yields.

Bernanke, Reinhart, and Sack (2004) adopt an alternative

approach to time-series analysis. They examine specific news

events concerning future Treasury issuance or purchases of

longer term securities and find that longer term yields dropped

significantly on days when the market learned of future

declines in the net supply of longer term Treasury securities.

Since the original draft of this paper was written, several

studies have examined the issue of whether LSAPs can affect

longer term interest rates. D’Amico and King (2010),

Hamilton and Wu (2010), Krishnamurthy and Vissing-

Jorgensen (forthcoming), Neely (2010), and Swanson (2011)

all find evidence that LSAPs do indeed reduce longer term

interest rates.

In this paper, we employ both time-series and event-study

methodologies to gauge the overall effects of the LSAP programs.

4.2 An Event Study of Recent LSAP

Communications

In this section, we use an event-study analysis of Federal

Reserve communications to derive estimates of the effects of

LSAPs implemented between December 2008 and March 2010.

In particular, we examine changes in interest rates around

official communications regarding asset purchases, taking the

cumulative changes as a measure of the overall effects. In doing

so, we implicitly assume that: 1) our event set includes all

announcements that have affected expectations about the total

future volume of LSAPs, 2) LSAP expectations have not been

affected by anything other than these announcements, 3) we

can measure responses in windows wide enough to capture

long-run effects but not so wide that information affecting

yields through other channels is likely to have arrived, and

4) markets are efficient in the sense that all the effects on yields

occur when market participants update their expectations

and not when actual purchases take place.

The financial variables we examine are the two-year and

ten-year Treasury yields, the ten-year agency debt yield, the

current-coupon thirty-year agency MBS yield, the ten-year

Treasury term premium (based on Kim and Wright [2005]),

See Engen and Hubbard (2005), Gale and Orszag (2004), and Laubach

(2009). Warnock and Warnock (2009) also find that purchases of U.S. debt

by foreign governments tend to lower U.S. long-term interest rates.

the ten-year swap rate, and the Baa corporate bond index

yield.

Swap rates and corporate bond yields help us gauge

the extent to which news about LSAPs affected yields on assets

that were not purchased by the Federal Reserve.

We focus on a narrow set of official communications, each

of which contained new information concerning the potential

or actual expansion of the size, composition, and/or timing of

LSAPs. The eight announcements included in this “baseline”

event set are:

• the initial LSAP announcement on November 25, 2008,

in which the Federal Reserve announced it would

purchase up to $100 billion in agency debt, and up to

$500 billion in agency MBS;

• Chairman Bernanke’s December 1, 2008, speech, in

which he stated that in order to influence financial

conditions, the Fed “could purchase longer term

Treasury securities...insubstantial quantities”;

• the December 2008 and January 2009 FOMC

statements, which indicated that the FOMC was

considering expanding purchases of agency securities

and initiating purchases of longer term Treasury

securities;

• the March 2009 FOMC statement, in which the FOMC

announced the decision to purchase “up to” $300 billion

of longer term Treasury securities and to increase the

size of agency debt and agency MBS purchases to “up to”

$200 billion and $1.25 trillion, respectively;

• the August 2009 FOMC statement, which dropped the

“up to” language qualifying the maximum amount of

Treasury purchases and announced a gradual slowing in

the pace of these purchases;

These are strong assumptions. The need for them arises in part because we

do not have a direct measure of expectations about the size of future LSAPs.

With such a measure, we could use announcements to identify exogenous

shocks to LSAP expectations. The corresponding yield responses could then be

used to derive statistical estimates of the effects of changes in expectations and,

from these, the total effects of LSAPs could be extrapolated. Such an approach

is typical of studies of the effects of surprise changes to the target federal funds

rate, using interest rate futures contracts to measure market expectations. A

particular challenge in isolating the effects of LSAPs is that the announcements

we identify are likely to have contained non-LSAP information relevant to

yields, including policy measures and updates to the FOMC’s economic

outlook. As a result, it is impossible to draw a response window narrow enough

to include only the effects of LSAPs.

We measure agency debt yields using Freddie Mac’s on-the-run fixed-rate

senior benchmark noncallable note; as of February 1, 2010, Fannie Mae had

not issued a ten-year note since 2007. On-the-run agency debt was not

included in LSAPs until September 2009, but the cumulative changes in the

first off-the-run yield are almost identical to the changes in the on-the-run

yield. The MBS yield is the average of the Freddie Mac and Fannie Mae current-

coupon thirty-year agency MBS yields. The interest rates are from Bloomberg

L.P., except for the Baa yield, which is from Barclay’s Capital. The Kim-Wright

term premium data are made available by the Federal Reserve Board at http://

www.federalreserve.gov/econresdata/researchdata.htm. The Kim-Wright term

premium is based on implied zero-coupon yields on off-the-run securities,

whereas the Treasury yield series are for on-the-run coupon securities.

FRBNY Economic Policy Review / May 2011 49

• the September 2009 FOMC statement, which dropped

the “up to” language qualifying the maximum amount

of agency MBS purchases and announced a gradual

slowing in the pace of agency debt and MBS purchases;

and

• the November 2009 FOMC statement, which stated that

the FOMC would purchase “around $175 billion of

agency debt.”

Table 1

Interest Rate Changes around Baseline and Extended Event Set Announcements

Basis points

Date Event

Two-Year

U.S. Treasury

Ten-Year

U.S. Treasury

Ten-Year

Agency

Mortgage-

Backed

Securities

Ten-Year

Term

Premium

Ten-Year

Swap Baa Index

11/25/2008

Initial large-scale-asset-

purchase announcement -2 -22 -58 -44 -17 -29 -18

12/1/2008

Chairman speech -8 -19 -39 -15 -17 -17 -12

12/16/2008

Federal Open Market

Committee (FOMC)

Statement -9 -26 -29 -37 -12 -32 -11

1/28/2009

FOMC statement 10 14 14 11 9 14 2

3/18/2009

FOMC statement -22 -47 -52 -31 -40 -39 -29

4/29/2009 FOMC statement 1 10 -1 6 6 8 -3

6/24/2009 FOMC statement 10 632445

8/12/2009

FOMC statement -2 542312

9/23/2009

FOMC statement 1 -3 -3 -1 -1 -5 -4

11/4/2009

FOMC statement -2 681553

12/16/2009 FOMC statement -2 1 0 -1 1 1 -1

1/27/2010 FOMC statement 11 344131

3/16/2010 FOMC statement -3 -5 -4 -4 -4 -4 -5

1/6/2009 Minutes release 0 -4 3 -17 -1 -9 -14

2/18/2009 Minutes release 9 11468916

4/8/2009 Minutes release 2 -4 -7 -9 -4 -6 -6

5/20/2009 Minutes release -5 -5 -5 -7 -4 -4 -10

7/15/2009 Minutes release 7 13 16 16 10 16 7

9/2/2009 Minutes release -1 -6 -6 -4 -7 -8 -5

10/14/2009 Minutes release 1 7 10 3 7 7 8

11/24/2009 Minutes release 0 -5 -5 -9 -5 -6 -3

1/6/2010 Minutes release -2 65467-1

2/17/2010 Minutes release 4 778685

Baseline event set -34 -91 -156 -113 -71 -101 -67

Baseline set + all FOMC -1 -55 -134 -114 -47 -75 -72

Cumulative change: 11/24/08 to 3/31/2010 -19 50 -75 -95 30 28 -489

Standard deviation of daily changes:

11/24/08 to 3/31/10 5 8 9 10 6 9 7

Sources: Bloomberg L.P.; Barclay’s Capital; Board of Governors of the Federal Reserve System.

Included in the baseline event set.

Two-day change for agency mortgage-backed securities on March 18, 2009, because of a Bloomberg L.P. data error.

50 Large-Scale Asset Purchases by the Federal Reserve

Chart 5

Cumulative Interest Changes on Baseline

Event Set Days

Sources: Bloomberg L.P.; Barclay’s Capital; Board of Governors of

the Federal Reserve System.

Basis points

-200

-150

-100

-50

Baa index

Ten-year swap

Ten-year

term premium

Agency

mortgage-backed

securities

Ten-year

agency

Ten-year

U.S. Treasury

Two-year

U.S. Treasury

-34

-91

-156

-113

-71

-101

-67

We consider the response of interest rates using one-day

windows around the announcements, measured from the

closing level the day prior to the announcement to the closing

level the day of the announcement.

Selecting the window

length involves a trade-off between allowing sufficient time for

revised expectations to become fully incorporated in asset

prices and keeping the window narrow enough to make it

unlikely to contain the release of other important information.

Although event studies often examine intraday price changes in

order to avoid the pollution of measured responses by

extraneous information, we believe a wider window is suitable

in this context. Specifically, given the novelty of the LSAPs and

the diversity of beliefs about the mechanisms by which they

operate, changes may have been absorbed more slowly than for

typical monetary policy shocks (such as those to the federal

funds target rate).

Table 1 displays the changes in interest rates on each day in

the baseline event set described above as well as on days in

which the FOMC issued communications concerning the

LSAPs that provided little new information. With one minor

exception, interest rates moved in the expected direction on

each of the baseline event days. On November 25, December 1,

December 16, and March 18, FOMC communications pointed

to greater-than-expected LSAP purchases, and long-term rates

fell. On January 28, August 12, and November 4, FOMC

communications pointed to lower-than-expected LSAP

purchases, and long-term rates rose. The magnitude of the

surprise was likely rather low on these last two dates, which is

consistent with the relatively small movements in long-term

interest rates. On September 23, long-term rates fell despite

FOMC language that might have reduced expected future

LSAPs, but the decline was very small (only 1 basis point for the

term premium).

Chart 5 displays the cumulative changes in interest rates

across the eight announcements in the baseline event set. All

interest rates declined notably, with the ten-year Treasury

yield, ten-year agency debt yield, and current-coupon agency

MBS yield declining 91, 156, and 113 basis points, respectively.

The large change in the ten-year Treasury yield relative to the

two-year Treasury yield suggests that the announcements

reduced longer term rates principally by reducing the term

premium, as opposed to signaling a commitment to keep

policy rates low for an extended period of time. This inference

is confirmed by the large cumulative drop in the Kim-Wright

ten-year term premium measure. The relatively large changes

in agency debt and agency MBS yields demonstrate that the

LSAPs also helped to lower spreads of the yields on these assets

relative to those on Treasury securities. The substantial declines

We use the two-day change for the MBS yield around the March 2009 FOMC

meeting because of an error in the Bloomberg MBS yield series on March 18.

As discussed below, we also tried using two-day windows for all event days and

interest rates.

in the swap rate and the Baa corporate bond yield show that

LSAPs had widespread effects, beyond those on the securities

targeted for purchase.

Some observers, noting that the ten-year Treasury yield did

not decline on net over the course of the LSAP programs, have

argued that the LSAPs did not have a lasting effect. Chart 6

compares the net changes in interest rates on the baseline event

days with the net changes on all other days from November 24,

2008, through March 31, 2010. The ten-year Treasury yield and

swap rate increased more than 100 basis points on nonevent

days, and hence were up moderately over the entire period.

However, there were many factors at play that would have been

expected to lift Treasury yields over that period, including

a very large increase in the expected future fiscal deficit, a

significant rebound in the economic outlook, and a sharp

reversal of the flight-to-quality flows that had occurred in the

fall of 2008.

It is likely those factors, and not a reversal of the

effects of the LSAP announcements, that drove Treasury

yields higher on other days. Supporting that view, other

interest rates showed very different patterns than that of the

ten-year Treasury yield on nonevent days. The agency debt

yield rose less than the Treasury yield, the MBS yield was little

changed, and the Baa corporate bond yield dropped about

400 basis points. This combination of a rising Treasury yield

and a falling corporate bond yield is consistent with the

relaxation of the extreme financial strains and flight-to-quality

On December 10, 2008, the Blue Chip Economic Indicators survey’s average

projection of the fiscal year 2009 federal deficit was $672 billion. In January

2010, the Congressional Budget Office estimated the 2009 deficit at $1,587

billion and projected the 2010 deficit at $1,381 billion. The Conference Board’s

Index of Leading Economic Indicators rose from 99.2 in November 2008 to

109.4 in March 2010.

FRBNY Economic Policy Review / May 2011 51

Chart 6

Cumulative Changes since November 2008,

Event versus Nonevent Days

Sources: Bloomberg L.P.; Barclay’s Capital; Board of Governors of

the Federal Reserve System.

Basis points

-600

-500

-400

-300

-200

-100

100

200

Baa index

Ten-year swap

Ten-year

term premium

Agency

mortgage-backed

securities

Ten-year

agency

Ten-year

U.S. Treasury

Two-year

U.S. Treasury

All days:

November 24, 2008,

to March 31, 2010

Event days

Nonevent days

Chart 7

Cumulative Interest Rate Changes around

Announcement Events, Alternative Event

Study Parameters

Sources: Bloomberg L.P.; Barclay’s Capital; Board of Governors of

the Federal Reserve System.

Basis points

-200

-150

-100

-50

Baa index

Ten-year swap

Ten-year

term premium

Agency

mortgage-backed

securities

Ten-year

agency

Ten-year

U.S. Treasury

Two-year

U.S. Treasury

Two-day response

Baseline + all FOMC

Baseline

that characterized the early part of 2009, and it highlights the

importance of focusing on event days to measure the effects

of LSAPs separately from the effects of other developments.

Finally, Chart 7 plots cumulative interest rate changes using

two modifications to our event study. In the first, we continue

to use one-day response windows, but expand the event set to

include all FOMC statements and minutes between November

2008 and January 2010 to allow for the possibility that markets

gleaned information about the future of LSAPs from these

communications. In the second, we use the same baseline event

set as above, but extend the response window to two days to

allow for lagged reactions to the news by some market

participants. Most of the measured effects of the LSAPs change

only modestly using these alternative parameterizations of the

event study. Using the expanded event set, we show that the

cumulative declines are between 10 basis points larger and

30 basis points smaller than when we use the baseline set. The

smaller declines may reflect that markets had attributed some

probability to further increases in the LSAPs and that these

expectations were adjusted downward when the FOMC did

not move in that direction on the nonbaseline event days.

However, using two-day response windows, we see that the

cumulative declines are 0 to 40 basis points larger than they are

when the one-day windows are used, suggesting that it may

have taken more than one day for the market to fully adjust

to these communications.

MBS yields in particular may have taken longer to respond fully to these

communications. Adding a third day to the windows increases the cumulative

decline of MBS yields by more than 30 basis points, whereas it has little effect

on the cumulative declines in the other yields.

To more carefully evaluate whether the effects found above

arose through the term premium, as would be expected from

the theoretical discussion in section 2, we focus on yield

movements around the two FOMC announcements that also

contained new language on the prospects for future short-term

interest rates. In particular, on December 16, 2008, the FOMC

stated its view that the federal funds rate was likely to remain at

“exceptionally low levels for some time.” On March 18, 2009,

the FOMC modified this language to “exceptionally low levels

for an extended period.” We want to make sure that the yield

movements around those dates do not reflect a decline in

expected future short-term interest rates associated with

those statements.

One way to approach this issue is to rely on the Kim-Wright

(2005) estimated term premium used above to examine the

market interest rates with maturities that are most likely to be

affected by the FOMC statements concerning the future federal

funds rate. Any movement in the expected federal funds rate at

these horizons is likely to be much greater than the average

movement in the expected federal funds rate over the next ten

years. We focus on the movement in the estimated one-year-

ahead instantaneous interest rate around the release of the

FOMC statements.

According to the Kim-Wright estimates,

the one-year-ahead expected instantaneous interest rate

dropped only 4 basis points on December 16, 2008, and rose

16 basis points the following day.

An alternative gauge of

The instantaneous interest rate is a construct of the Kim-Wright model that

is essentially equivalent to the federal funds rate.

The two-year-ahead expected instantaneous interest rate dropped 6 basis

points on December 16 and rose 4 basis points on December 17.

52 Large-Scale Asset Purchases by the Federal Reserve

market expectations is the one-year-ahead forward

instantaneous interest rate, as the term premium would

presumably be limited in size at this horizon.

This rate

dropped 11 basis points on December 16, but rose 17 basis

points the following day.

On March 18, 2009, the Kim-Wright one-year-ahead

expected instantaneous interest rate dropped 4 basis points and

rose by the same amount on the following day.

The one-year-

ahead forward instantaneous rate dropped 28 basis points on

March 18, but about half of this decline was unwound over the

next few days. Overall, these observations on expected future

and forward interest rates suggest that the December 2008 and

March 2009 FOMC statements did not have large effects on

market expectations of the future path of the federal funds

rate—certainly not enough to explain the substantial decline

in longer term interest rates on those days.

In principle, the LSAP programs could have raised the

expected future path of the federal funds rate by accelerating

the expected pace of economic recovery. In this case, the LSAP

effect on the term premium would be greater than the effect on

the long-term Treasury yield. According to Table 1, however,

the LSAP effects on the ten-year Treasury yield are slightly

larger than those on the ten-year term premium, suggesting

that LSAPs did not raise the expected future federal funds rate.

Altogether then, we find that longer term interest rates

declined by up to 150 basis points around key LSAP

announcements. Moreover, the majority of the decline in the

ten-year Treasury yield around these announcements can be

attributed to declines in the term premium. Chart 7 shows that,

depending on the event set and response window used, LSAP

announcements reduced the ten-year term premium by

between 50 and 100 basis points. Little of the observed declines

in longer term yields appears to reflect declining expectations

of future short-term interest rates associated with FOMC

communications about the likely future path of the federal

funds rate.

The forward rate is the sum of the expected future instantaneous rate and the

forward term premium. It can be derived directly from the yield curve without

requiring any modeling of, or assumptions about, its components beyond

those required to fit a yield curve to observed bond yields.

The two-year-ahead expected instantaneous interest rate dropped

14 basis points on March 18 and rose 3 basis points on March 19.

It is possible that these FOMC statements affected the term premium directly

by reducing uncertainty about the path of future interest rates. Estimating this

effect is beyond the scope of this paper, but we believe such effects are likely to

have been small.

4.3 Time-Series Analysis of Longer Term

Treasury Supply

In this section, we use a different method and different data to

measure the impact of asset purchases (or sales) on the ten-year

term premium.

Specifically, we estimate statistical models

that explain the historical variation (prior to the announce-

ment of the LSAP programs) in the term premium using

factors related to: 1) the business cycle, 2) uncertainty about

economic fundamentals, and 3) the net public sector supply of

longer term dollar-denominated debt securities. Using a

variety of model specifications, we estimate the effects on the

term premium of changes in the stock of longer term debt held

by private investors. We then use these results to estimate

the (out-of-sample) impact of the Federal Reserve’s asset

purchases through March 2010, which represent a reduction in

the supply of longer term debt securities to private investors.

Following Backus and Wright (2007), we explain historical

time-variation in the term premium using an ordinary-least-

squares regression model of the form:

where is the nominal ten-year yield term premium, and

is a set of observable factors.

However, we expand on the set

of explanatory variables used by Backus and Wright, focusing

on the three types of variables noted above.

In particular, the following variables are included to capture

term premium variation related to the business cycle and

fundamental uncertainty:

• Unemployment gap: measured as the difference between

the unemployment rate and the Congressional Budget

Office’s estimate of the natural rate of unemployment.

• Core CPI inflation: a second measure of the macro-

economic state, the twelve-month change in core CPI,

may also proxy for inflation uncertainty.

The term premium likely captures the largest component of the LSAPs’

effects on private borrowing rates. However, as we highlighted in section 2,

LSAPs also affected other components of risk premiums. The statistical models

here do not attempt to estimate these other effects or the effects on term

premiums at different horizons.

Whereas Backus and Wright modeled the instantaneous forward term

premium ten years ahead, we focus on the ten-year yield term premium because

of our interest in the purchases’ effects on longer term interest rates.

In early analysis, we also included a measure of the on-the-run Treasury

liquidity premium as a proxy for the flight-to-quality demand for Treasuries.

However, the coefficient on this term was never significant, and excluding it

did not affect the magnitude or significance of the other coefficients. For ease

of exposition, we omit it here.

Mankiw, Reis, and Wolfers (2004) show that inflation disagreement, the

level of inflation, the absolute value of the change in inflation, and relative price

variability positively covary.

βε

FRBNY Economic Policy Review / May 2011 53

• Long-run inflation disagreement: measured as the

interquartile range of five- to ten-year-ahead inflation

expectations, as reported by the Michigan Survey of

Consumers.

• Six-month realized daily volatility of the on-the-run ten-

year Treasury yield: a proxy for interest rate uncertainty.

We use this instead of option-implied volatility because

it is available over a longer period.

To capture the effects of changes in the net public sector supply

of longer term debt securities, we use the following time series,

each of which is expressed as a percentage of nominal GDP:

• publicly held Treasury securities with at least one year to

maturity, including securities held by private investors as

well as those held by the Federal Reserve and by foreign

official institutions;

• Treasury securities held in the Federal Reserve’s SOMA

portfolio with at least one year to maturity;

• U.S. debt securities held by foreign official agencies, with

at least one year to maturity; this measure includes

Treasury securities, agency-related securities, and

corporate bonds, and is interpolated from annual stock

surveys, using monthly Treasury International Capital

(TIC) flows, by the Board of Governors of the Federal

Reserve System.

An important assumption of our statistical analysis is that

these longer term debt stock variables are exogenous with

respect to the term premium. For example, this assumption

implies that the Treasury does not issue more long-term debt

when the term premium declines. To the extent that these

public sector agencies do respond to term premiums in a

manner similar to private investors, that is, by buying more

long-term debt (or selling less long-term debt) when the term

premium is high, our estimates of the effect of public sector

longer term debt supply on the term premium will be biased

downward. Overall, we believe it is reasonable to assume that

these public agencies respond very little to term premiums.

We use the Michigan survey because of its long history and relatively high

frequency (monthly), but our results are not significantly affected if we use

long-run inflation disagreement taken from the Blue Chip Economic Indicators

survey instead. The Michigan survey did not include the long-run inflation

question during some months in the 1980s. We linearly interpolate the series

when data are missing.

Realized and implied volatility are highly correlated at the monthly

frequency, and our modeling choice does not appear to substantively alter

the results.

As noted above, the SOMA held agency securities between 1971 and 2003.

However, these were a very small portion of total SOMA holdings (less than

5 percent), and information on the maturity and duration of these holdings

is not available.

See Bertaut and Tryon (2007). The data are available at http://www

.federalreserve.gov/pubs/ifdp/2007/910/default.htm.

However, our estimates may be viewed as somewhat

conservative owing to this potential downward bias.

The response of private investors to the net public sector

supply of assets should not be affected by the specific public

sector agency doing the purchases or sales. Thus, when the

Treasury buys back a longer term security, it should have the

same effect on longer term yields as when the Federal Reserve

buys that security or when a foreign official agency buys that

security (assuming that each is expected to hold the security on

a persistent basis and controlling for any policy signals the

purchases convey). Moreover, the term premium should be

roughly equally affected by public sector purchases of either

Treasury securities or agency-related securities with similar

durations. Accordingly, the appropriate measure of the net

supply of longer term debt securities by the public sector would

include longer term Treasury securities less the total amount of

longer term debt held by the SOMA and by foreign official

institutions.

We estimate models with this measure of the net

supply of longer term debt expressed in both unadjusted terms

and as ten-year Treasury equivalents.

The duration

adjustment captures relevant variation in the composition

of the outstanding stock of debt securities.

We estimate the model on monthly data over the period

January 1985 to June 2008. This period was selected because

it is the full sample over which data on each of the variables

are available, and because it ends shortly before the initial

announcement of asset purchases in the fall of 2008. The first

two columns of Table 2 present results from a regression of the

ten-year term premium on the explanatory variables, using the

unadjusted net debt stock measure. The third and fourth

columns present results using the duration-adjusted net debt

stock. For comparison, in this and subsequent tables we

include estimates from the model without any debt supply

variable in the final columns.

We do not include privately issued debt securities held by private investors

because these securities have a net zero supply from the point of view of the

private sector, and because demand and supply for them are likely not

exogenous with respect to the term premium.

The unadjusted stock of Treasury securities with remaining maturity greater

than one year is obtained from Table FD-5 of the Treasury Bulletin. This table

excludes SOMA holdings but includes foreign official holdings, which we

subtracted using the TIC data described above. The duration-adjusted stock

of non-SOMA Treasuries comes from Barclay’s Capital and, unlike the

unadjusted measure, excludes Treasury Inflation-Protected Securities (TIPS).

In the duration-adjusted regressions, we use foreign holdings of long-term

Treasury securities only (that is, we do not use agency-related securities or

corporate bonds) and assume that these have the same duration as non-SOMA

Treasuries held by the public. Because we cannot isolate foreign holdings of

TIPS, the adjusted stock variable may understate holdings (by subtracting TIPS

holdings from a total stock measure that already excludes it). The effect should

be minor.

As described in section 2, the adjustment converts the amount, S, into an

amount of ten-year Treasury securities with the same portfolio duration:

ten-year equivalents = S*duration(S)/duration(10y).

54 Large-Scale Asset Purchases by the Federal Reserve

The results are similar with either measure of the debt stock.

The explanatory variables are almost all significant at the

1 percent level and always have the expected sign. Specifically,

one percentage point increases in the unemployment gap, core

CPI inflation, inflation disagreement, and realized volatility

increase the term premium about 20, 30, 40, and 100 basis

points, respectively. As for the supply variables, a 1-percent-of-

GDP increase in longer term debt supply increases the ten-year

term premium by 4.4 basis points on an unadjusted basis and

by 6.4 basis points when expressed in terms of ten-year

Treasury equivalents.

Both coefficients are statistically

significant at the 1 percent level.

The $1.725 trillion in purchases by the Federal Reserve

between December 2008 and March 2010 is roughly 12 percent

of 2009 nominal GDP, which, according to the estimates in the

first column of Table 2, implies that total Federal Reserve asset

purchases reduced the term premium by 52 basis points. In

terms of ten-year equivalents, the Federal Reserve purchased a

We cannot reject the possibility that the debt stock coefficients are constant

between the first and second halves of the sample.

If the debt stock components—Treasury, SOMA, and TIC—are entered

separately into the regression, the coefficients on SOMA and TIC are a bit

larger and the coefficient on Treasury is considerably smaller than the

coefficient on the combined variable. We suspect that the smaller separate

Treasury estimate arises because shifts in the supply of long-term Treasury

securities are anticipated far in advance. In the regressions reported here, we

nevertheless impose the assumption that the effects are the same.

total of approximately $850 billion—roughly 6 percent of 2009

nominal GDP—which, according to estimates in the third

column, would imply that asset purchases reduced the term

premium by 38 basis points.

None of the variables included in the model can grow or

decline without bound, and thus there is a strong presumption

that they are stationary. However, some of them may have a

sufficiently large autocorrelation to appear nonstationary

within our twenty-three-year estimation sample. Thus, we also

use dynamic ordinary least squares (DOLS) based on Stock and

Watson (1993) to estimate the long-run relationship (also

known as the cointegrating vector) between the term premium

and the explanatory variables. In addition to the levels of our

explanatory variables, the contemporaneous, lead, and lagged

first differences of each are included as regressors.

The level

coefficients from the DOLS regression estimate the long-run

relationship between the variables, and the deviation of the

The following procedure was used to select the leads and lags included within

the DOLS regression. We started with a single lead and lag of the first difference

of each explanatory variable. If the lead or lag for a variable was statistically

significant at the 5 percent level (using Newey-West standard errors with

twelve lags), we added one more and removed all leads and lags that were not

significant. If the added lead or lag was still significant, we added four more.

For each specification, this was enough to make the leads and lags of the longest

length statistically insignificant. For robustness, we also estimated the model

using six leads and lags of the first differences. The coefficient estimates on

supply in the cointegrating vectors were virtually unchanged from those

derived according to the selection procedure just described.

Table 2

Ordinary-Least-Squares Regression of Ten-Year Term Premium, January 1985 to June 2008

Coefficient Standard Error Coefficient Standard Error Coefficient Standard Error

Constant -2.182*** 0.348 -2.324*** 0.349 -1.852*** 0.334

Cyclical factors

Unemployment gap 0.180** 0.064 0.185** 0.063 0.252*** 0.070

Core CPI 0.307*** 0.056 0.298*** 0.057 0.480*** 0.062

Uncertainty

Inflation disagreement 0.377** 0.131 0.394** 0.133 0.286* 0.123

Realized volatility 0.943*** 0.207 0.994*** 0.206 0.944*** 0.271

Supply

Unadjusted 0.044*** 0.009 ————

Duration-adjusted — — 0.064*** 0.014 — —

Adjusted R

0.84 0.84 0.78

Standard error of regression 0.36 0.37 0.43

Number of observations 282 282 282

Source: Authors’ calculations.

Note: Newey-West standard errors with twelve lags.

***Statistically significant at the 1 percent level.

**Statistically significant at the 5 percent level.

***Statistically significant at the 10 percent level.

FRBNY Economic Policy Review / May 2011 55

term premium from this long-run relationship is referred to as

the cointegration error. Regressing the change in the term

premium on the contemporaneous change in the explanatory

variables and on the lagged level of the cointegration error

allows us to estimate the long-run adjustment speed of the

cointegrating relationship and to test the significance of the

cointegrating relationship.

The first two columns of Table 3 present results from the

DOLS model, again estimated over the period January 1985

to June 2008. The long-run effects of changes in the longer

term debt stock are almost identical to those obtained in

Table 2. Specifically, an increase in longer term debt equal

to 1 percent of GDP increases the term premium by slightly

more than 4 basis points in the unadjusted specification and

by slightly more than 6 basis points in the duration-adjusted

specification. The adjustment speed parameters of -0.15

imply that deviations in the term premium from long-run

equilibrium have a half-life of roughly five months. The

t-statistics on the adjustment speeds are -5.7 and -6.3, which

are sufficiently large to reject the hypothesis that these

variables do not have a stable long-run relationship (that is,

they are not cointegrated) at the 1 percent significance level.

Note that the adjustment speed drops substantially when

the debt stock variables are excluded (the final columns),

suggesting that the longer term debt stock is an important

part of the long-run relationship.

The preceding regressions are based on the Kim-Wright

model of the ten-year term premium, which was estimated

over a sample that does not include a major financial crisis or

monetary policy constrained by the zero bound on nominal

interest rates. As a robustness check, we also estimate a

specification that uses the ten-year Treasury yield as the

dependent variable and that includes the target federal funds

rate and the slope of the near-term Eurodollar futures curve

to proxy for the expected path of policy rates.

If we assume

that the two additional variables adequately control for

expected future policy interest rates, the estimated

coefficients on the other variables should continue to reveal

their impact on the ten-year term premium. Note that

another reason for focusing directly on the behavior of the

Specifically, we use the difference between the implied rates on Eurodollar

futures contracts settling approximately two years and one year ahead.

Table 3

Dynamic Ordinary-Least-Squares Regression of Ten-Year Term Premium, January 1985 to June 2008

Coefficient Standard Error Coefficient Standard Error Coefficient Standard Error

Constant -2.288*** 0.388 -2.351*** 0.425 -1.879*** 0.355

Cyclical factors

Unemployment gap 0.222*** 0.062 0.219*** 0.063 0.283*** 0.071

Core CPI 0.302*** 0.065 0.281*** 0.063 0.502*** 0.067

Uncertainty

Inflation disagreement 0.458** 0.173 0.454* 0.180 0.292 0.152

Realized volatility 0.822*** 0.221 0.901*** 0.229 0.867** 0.296

Supply

Unadjusted 0.042*** 0.008 ————

Duration-adjusted — — 0.062*** 0.014 — —

Long-run properties

Adjustment parameter

-0.154*** 0.03 -0.151*** 0.024 -0.116*** 0.021

ADF test on cointegration error

-6.051*** -5.957*** -3.441**

Number of observations 282 280 282

Source: Authors’ calculations.

Note: Newey-West standard errors with twelve lags.

Estimated by regressing the change in the term premium on the contemporaneous change in each explanatory variable and on the lagged level

of the cointegration error.

Null hypothesis: no cointegrating relationship. Critical values are from Ericsson and MacKinnon (1999).

***Statistically significant at the 1 percent level.

**Statistically significant at the 5 percent level.

*Statistically significant at the 10 percent level.

56 Large-Scale Asset Purchases by the Federal Reserve

ten-year yield is that the ultimate goal of LSAPs is to lower

longer term private borrowing rates, many of which are

highly correlated with ten-year Treasury yields. As the first

and third columns of Table 4 show, the estimated longer term

debt supply effects are somewhat higher in this specification

than in the term premium regressions. The estimated

coefficients of 0.07 and 0.10 on the unadjusted and duration-

adjusted debt stocks imply that LSAPs have reduced the

ten-year term premium by 82 basis points (unadjusted

model) or 58 basis points (duration-adjusted model).

Table 4

Ordinary-Least-Squares Regression of Ten-Year Treasury Yield, December 1986 to June 2008

Coefficient Standard Error Coefficient Standard Error Coefficient Standard Error

Constant 0.297 0.432 0.103 0.443 -0.013 0.513

Rate expectations

Target fed funds 0.403*** 0.114 0.424*** 0.118 0.742*** 0.114

Eurodollar slope 0.477* 0.214 0.478* 0.225 0.602* 0.273

Cyclical factors

Unemployment gap 0.127 0.208 0.172 0.210 0.784*** 0.198

Core CPI 0.378** 0.125 0.342** 0.131 0.163 0.157

Uncertainty

Inflation disagreement 0.210 0.165 0.215 0.170 0.111 0.187

Realized volatility 1.057*** 0.25 1.145*** 0.27 1.340*** 0.31

Supply

Unadjusted 0.069*** 0.014 ————

Duration-adjusted — — 0.098*** 0.023 — —

Adjusted R

0.92 0.91 0.88

Standard error of regression 0.45 0.46 0.53

Number of observations 259 259 259

Source: Authors’ calculations.

Note: Newey-West standard errors with twelve lags.

***Statistically significant at the 1 percent level.

**Statistically significant at the 5 percent level.

*Statistically significant at the 10 percent level.

Table 5

Effect of 1-Percent-of-GDP Increase in Long-Term

Debt on Ten-Year Term Premium

Basis points

Ordinary-Least-

Squares Term

Premium Model

Dynamic

Ordinary-Least-

Squares Term

Premium Model

Yield-Level

Model

Unadjusted 4.4 4.2 6.9

Duration-

adjusted

6.4 6.2 9.8

Source: Authors’ calculations.

Long-run effect.

Table 6

Total Effect of Large-Scale Asset Purchases (LSAPs)

on Ten-Year Term Premium

Basis points

Ordinary-Least-

Squares Term

Premium Model

Dynamic

Ordinary-Least-

Squares Term

Premium Model

Yield-Level

Model

Unadjusted 52 50 82

95 percent CI 31-74 31-69 50-115

Duration-adjusted 38 36 58

95 percent CI 22-54 20-53 31-84

Source: Authors’ calculations.

Note: For LSAPs implemented through March 2010. Based on asset

durations as of March 2010 and the advance estimate of fourth-quarter

2009 nominal GDP.

Long-run effect.

FRBNY Economic Policy Review / May 2011 57

Table 5 summarizes the estimated coefficients on longer

term debt stock across our specifications while Table 6 lists

the implied effects of the Federal Reserve’s asset purchases

on the ten-year term premium. Our results suggest that the

$1.725 trillion in announced purchases reduced the ten-year

term premium by between 38 and 82 basis points. This range

of point forecasts overlaps considerably with that obtained in

our event study, which is impressive given that entirely separate

data and methodologies were used to obtain the results.

5. Conclusion

With policy interest rates in many countries constrained by the

zero bound, and with short-term interest rates in Japan having

been near zero for more than a decade, expansion of the

monetary policy toolkit is an important objective. In this paper,

we examine lessons from the experience of the Federal Reserve

since late 2008 with one of the key policy tools available at the

zero bound—large-scale purchases of longer term assets.

By reducing the net supply of assets with long duration, the

Federal Reserve’s LSAP programs appear to have succeeded in

reducing the term premium. The overall size of the reduction

in the ten-year term premium associated with LSAPs through

March 2010 appears to be somewhere between 30 and 100 basis

points, with most estimates in the lower and middle thirds of

this range. In addition to reducing the term premium, the

LSAP programs had an even more powerful effect on longer

term interest rates on agency debt and agency MBS by

improving market liquidity and removing assets with high

prepayment risk from private portfolios.

Based on this evidence, we conclude that the Federal

Reserve’s LSAP programs did lower longer term private

borrowing rates, which should stimulate economic activity.

While the effects are especially noticeable in the mortgage

market, they appear to be widespread, extending, for example,

to the markets for Treasury securities, corporate bonds, and

Using a longer sample and somewhat different specification, Greenwood and

Vayanos (2010) also find a statistically significant effect of bond supply on the

bond yields. They regress the spread of the five-year Treasury yield to the one-

year Treasury yield and the spread of the twenty-year yield to the one-year yield

on the ratio of Treasury securities with maturities greater than ten years to total

Treasury securities. They do not subtract SOMA or TIC holdings. Over the

period 1952-2005, they find that a one percentage point increase in the share of

Treasury securities with maturities above ten years increases the five-year yield

spread 4 basis points and the twenty-year yield spread 8 basis points.

The event-study range is somewhat higher than the time-series range. This

difference may reflect the possibility that LSAP effects are larger when financial

conditions are strained. Alternatively, it is possible that the effect of maturity

supply on bond yields is nonlinear, so that large reductions in net supply have

a proportionally larger (or smaller) effect on yields. The LSAP programs

constituted a large shift in maturity supply by historical standards.

interest rate swaps. That conclusion is promising, as it means

that monetary policy remains potent even after the zero bound

is reached. To be sure, achieving this further stimulus was not

without its challenges, as it required a sizable expansion of the

Federal Reserve’s balance sheet, and the purchase of such a

large volume of securities in a relatively short time frame

required the surmounting of operational hurdles. However, by

restoring functioning to the mortgage market and lowering the

term premium, the programs provided considerable benefits.

Even though the LSAPs appear to have been successful, it is

worth reflecting on their structure and considering whether the

approach taken was optimal. The LSAPs, as implemented, were

discrete in nature, in that the broad characteristics of the

programs were set in two decisions upfront (in November 2008

and March 2009). The remainder of the programs involved

carrying out those decisions, with little responsiveness to

changes in the economic or financial outlook.

By stating a specific amount and a timetable for LSAPs

upfront, the FOMC appeared to commit itself to a future

course of action. This commitment was softened somewhat by

the use of the phrase “up to” before the specified purchase

amounts. However, market participants generally indicated

that they expected the full amounts to be purchased, and in the

later stages of the programs the FOMC made it clear that close

to the full amounts would be purchased. Policymakers often

prefer not to make strong commitments on future policies

because there is always a chance that future economic

conditions will call for a different policy stance than expected.

Policymakers may want to assess the benefits of this element of

commitment relative to an approach that instead allows greater

responsiveness to economic and financial conditions. Bullard

(2009) lays out the theoretical case for a policy rule for LSAPs

analogous to conventional policy rules for interest rates, but he

shows that the practical issues in designing such a rule are

substantial, particularly in light of the limited historical

experience of economies operating near the zero bound on

nominal interest rates.

Indeed, further study of both the

theoretical and empirical issues raised by LSAPs would be

helpful in order to assess whether they can be employed even

more effectively in the future.

An alternative strategy, proposed by Bernanke (2002), is to use unlimited

purchases to target near-zero yields on Treasury securities with successively

longer maturities, starting with one-year securities. This strategy entails a

completely elastic response of LSAPs to interest rates on the targeted securities,

but leaves open the question of how to relate the choice of targeted maturities

to economic conditions.

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