New thinking on the transmission of QE to long-term yields

Jens Christensen and Signe Krogstrup introduce a third channel via which QE leads to lower interest rates.

Quantitative easing (QE) aims to reduce long-term interest rates, either broadly or in specific markets. Empirical evidence suggests that QE has indeed been effective. The preliminary experience with QE by the ECB’s QE lends further support. Yet, we still do not know exactly why QE programmes are effective at reducing long-term interest rates.

The literature has focused on two main channels of transmission. One is a signalling channel, which works through lowering market expectations about future policy rates (see, e.g., Bauer and Rudebusch 2011 and Christensen and Rudebusch 2012). Another is a supply-induced portfolio balance channel arising from reductions in the supply of the purchased asset available to market participants (see, e.g., Gagnon et al. 2011 and Krishnamurthy and Vissing-Jorgensen 2011).

In a recent paper, we argue that the expansion of central bank reserves that is a defining feature of QE programmes, is likely to also play an important role in the transmission (Christensen and Krogstrup 2015). The basic idea builds on Bernanke and Reinhart (2004) who suggest that an expansion of reserves could give rise to asset price changes through portfolio balance effects. Our contribution is to propose how this channel might work

  • Central to our argument is that central bank reserves can only be held by banks, and that this segmentation of the market for reserves matters for how central bank asset purchases affect private financial sector balance sheets, and hence, the financial market reaction.

There is a nice example where the authors show how QE works in this seting. Usually, we look at the transmission between central bank and banks. Then we draw balance sheets to understand the changes in balance sheets and expected changes in rates. The authors  introduce a non banking entities  in the cycle which help in figuring the reserve channel.

They use this in Swiss QE which was not attempted to lower int rates but target exchange rates. Still yields declined:

We provide supportive empirical evidence of the reserve-induced channel in Christensen and Krogstrup (2015) by analysing the large expansion of reserves undertaken by the Swiss National Bank in August 2011. These reserve expansions were unique and different from QE programmes implemented at other central banks, in that the Swiss National Bank only acquired short-term claims and left the available stock of long-term securities unchanged. By design, therefore, this programme cannot have had any supply-induced portfolio balance effects on long-term yields. We find that Swiss long-term government bond yields declined following the three key Swiss National Bank announcements, and show that these declines came predominantly from the reserve-induced portfolio balance channel.

Our research suggests that the strength of the reserve-induced channel depends on the specific market participants, their asset preferences and substitutability, and market structure in the economy in question. Such features have not yet been analysed in connection with assessments of the effectiveness of QE. If reserve-induced effects are material, the implication is that QE programmes can be implemented through purchases of assets other than long-term bonds and still reduce long-term yields

Hmm..

All highly technical stuff..

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