This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics. Thornton spent over three decades at the St. Louis Fed as vice president and economic advisor.
The recent behavior of the 10-year Treasury rate and the Fed’s QE actions are further confirmation of the inability of QE to reduce long-term rates. After bottoming out at 0.52% on April 3, 2020, the 10-year Treasury increased to 1.64% as of March 12, 2021.
This occurred in spite of the fact that the Fed increased its purchases of long-term Treasuries by $1.7 trillion from the week ending April 2, 2020, to the week ending March 11, 2021. The 20-year Treasury rate increased even more (127 basis points).
The Bernanke Fed embarked on a large-scale-asset-purchase program, commonly referred to as QE in March 2009. The intent of the program was to increase spending by reducing long-term interest rates. This objective was motivated because of the widely acknowledged fact that short-term interest rates, which the Fed historically influenced, were relatively unimportant for spending decisions (e.g., Michael Woodford, pp. 307-308). Hence, in order to increase spending, aka aggregate demand, the Fed needed to reduce long-term interest rates.
This effort was undertaken in spite of the facts that a mountain of evidence shows that financial markets are very efficient and integrated internationally. These facts mean that the Fed would have to purchase an extraordinarily large amount of securities to have any significant effect on long-term rates.
Indeed, in an interview in 2014 (here), Bernanke quipped; “The problem with QE is it works in practice but it doesn’t work in theory.” But it only works in practice if one is willing to ignore the massive research that shows that, at best, QE had a small and temporary effect on long-term interest rates.
This is illustrated in the two figures below [these figures are taken from my 2009 Economic Synopses essay here]. Figure 1 shows the effect of the FOMC’s QE announcement on March 18, 2009, that the Fed would purchase a total of $1.75 trillion in long-term securities, on the Treasury yield curve. The figure shows the Treasury yield curve the day before the announcement and the day of the announcement. Treasury rates from about 12 months to 30 years declined dramatically on the announcement, suggesting that QE had more than a 50 basis point effect on longer-term Treasuries—the effect on other long-term rates was smaller. This is by far the single largest “announcement effect” of any of the QE announcements. The economic staff of the Board of Governors argued that all of the effect would occur on the announcement. If it didn’t, investors could make a capital gain by buying Treasuries now and selling them at a higher price when rates went down.
This large announcement effect translated into a marked decline in the term premium—the interest rate differential investor’s demand for holding long-term bonds. Long-term rates declined more than short-term rates. Bernanke e.g., here has argued that QE reduced long-term rates by reducing the term-premium. However, as I showed here, this is possible, if and only if, QE caused the most risk-averse investors to leave the security of the default-risk-free Treasury market, while the least risk-averse investors remained, which is improbable.
In any event, the effect on long-term rates was temporary. Figure 2 compares the yield curve the day before the announcement with the yield curve on April 19, 2009. This figure shows that the effect on longer-term yields was short lived. Treasury rates from 1-month to 3 years were slightly lower than the day before the announcement, but rates on Treasuries from 5 years to 30 years were either unchanged or slightly higher—the term premium increased!
In fact, longer-term Treasury rates continued to increase relative to short-term Treasuries. By the FOMC’s June 2009 meeting the 10-year Treasury rate was 120 basis points higher than it was on March 19.
This fact prompted Janet Yellen to say, “Initially I was an enthusiast for long-term Treasury purchases. I thought the purpose of it was not only to improve liquidity and market functioning, but also to influence yields to push them down…On theoretical grounds, I believe there’s a very strong case that they should have some effect, but it has been awfully hard to identify exactly what that effect is, and I think that we’re beginning to run into costs of pursuing that further.” During Yellen’s term as Fed chair, the Fed’s holdings of Treasuries and other long-term securities increased only slightly.
The Powell Fed significantly ramped up purchases of longer-term securities in response to the pandemic, most of the increase was in longer-term Treasuries.
In spite of this, the yield curve has steepened as shown in Figure 3, which shows the Treasury yield curve on April 3, 2020 and on March 12, 2021. Once again, short-term rates are somewhat lower and long-term rates are higher [you can get daily yield curves from the Treasury].
The Powell Fed’s motivation for QE is different. The April 29, 2020 FOMC statement read: “To support the flow of credit to households and businesses, the Federal Reserve will continue to purchase Treasury securities and agency residential and commercial mortgage-backed securities in the amounts needed to support smooth market functioning, thereby fostering effective transmission of monetary policy to broader financial conditions.”
The January 2021 statement was similar.
I have no idea what this means! I don’t understand how purchasing large amounts of long-term Treasuries and other securities will foster “effective transmission of monetary policy to broader financial conditions.” As far as I can see, the only thing that QE is doing, or has ever done, is to help the Treasury finance ever increasing deficit spending (see my previous essay here).
Federal debt held by the Federal Reserve as a percent of gross domestic product (GDP) increased from 12.1% in 2019Q4 to 23.0% in 2020Q3. Before Bernanke began QE, it was 3.4%. Foreign investors have also ramped up their purchases of Treasury securities since the start of the financial crisis in mid-2007. As of 2020Q3, the Fed and foreign investors hold 56% of the federal debt as a percent of GDP compared with 20% before the financial crisis.
On second thought, QE has done another thing. It has distorted financial markets across the term structure, but especially short-term interest rates, see My JMCB paper.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
