DR.CHENJIAZI ZHONG

• FED TO KEEP POLICY STIMULATIVE FOR `CONSIDERABLE TIME’
• FED WILL ADD TO PURCHASES IF LABOR MARKET DOESN’T IMPROVE
• FED DOES NOT SAY WHEN MBS PURCHASE PROGRAM TO END
• FED TO BUY $40B MBS MONTHLY, CONTINUE `OPERATION TWIST’
• FED TO BUY MBS, EXTENDS ZERO-RATE POLICY INTO 2015

The mechanics and process of QE are: 1) the Fed purchases agency MBS through the TBA market via primary dealers; 2) the primary dealer sends the bond to the Fed that then credits the dealer’s Fed account; 3) agency mortgage pools are removed from the system; 4) additional “excess reserves” are pumped into the banking system.

Bernanke mentioned at his speech at Jackson Hole, “Federal Reserve purchases of MBS should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy.”

Broad fixed-income market are among the specific asset classes that have benefited from the Fed’s balance sheet expansion, although the differences are dramatic in the yield changes across different asset classes, as the duration risk channel has tow principal predictions:

1. QE decreases the yield on all long-term nominal assets, including Treasuries, Agency bonds, corporate bonds, and MBS.
2. The effects are larger for longer duration assets.

Treasury and Agency bonds are clearly safe in the sense of offering a sure nominal payment, however, Agency MBS has significant prepayment risk which means that it may not meet clientele safety demands, which predicts that:

QE involving Treasuries and Agencies lowers the yields on very safe assets such as Treasuries, Agencies, and possible high-grade corporate bonds, relative to less safe assets such as lower-grade corporate bonds or bonds with prepayment risk such as MBS.

The quantity of bank reserves is determined by the size of the Federal Reserve’s policy initiates but it does not reflect the initiatives’ effects on bank lending. A large increase in bank reserves need not be inflationary, because the payment of interest on reserves allows the Federal Reserve to adjust short-term interest rates independently of the level of reserves.

Paying interest on reserves allows central bank to maintain its influence over market interest rates independent of the quantity of reserves created by its liquidity facilities. Central bank can then let the size of the liquidity facilities be determined by conditions in the financial sector, while setting its target for the short-term interest rate based on macroeconomic conditions. If inflationary pressures begin to appear while the liquidity facilities are still in use, the central bank can use its interest-on-reserves policy to raise interest rates without removing the reserves created by these facilities.

The conflict is, holding excess reserves has an opportunity cost if higher risk-adjusted interest can be earned by putting the funds elsewhere, then why? The logic behind that banks hold excess reserves are: 1) the Federal Reserve’s new liquidity facilitates more smooth operation of payment; 2) while the lending decisions and other activities of banks may result in small changes in the level of required reserves, the vast majority of the newly-created reserves will end up being held as excess reserves.

The excess reserves themselves place an effective cap on the Fed Funds before the Fed begins to lose money on interest payment mismatches between its liabilities and assets, which could curtail the Fed’s ability to maintain inflation expectations “well-anchored,” citing a term used by Bernanke. Another side effect to note is, compared to traditional operating framework, now the link between the level of reserves and willingness of commercial banks to lend is broken.

References

1. Chairman Ben S. Bernanke at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming Aug 31, 2012
2. The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy — Arvind Krishnamurthy and Annette Vissing-Jorgensen (October 13, 2011)
3. Why Are Banks Holding So Many Excess Reserves? — Todd Keister and James McAndrews (July 2009)