FINE 442 - Quantitative Easing (9)

What is Quantitative Easing (QE)?

A non-standard monetary policy where the central bank buys large amounts of long-term securities (e.g. Treasury bonds, mortgage bonds) to stimulate the economy when usual rate cuts no longer work.

How does QE differ from standard open-market operations?

Standard OMOs mainly buy/sell short-term government bills to move the short-term policy rate, while QE focuses on buying long-term assets in large size to affect long-term rates and risk premia.

What did QE look like in the US (example QE2)?

The Fed announced in Nov 2010 it would purchase about $600 billion of long-term Treasuries at roughly $75 billion per month.

Which assets did the Fed buy under QE programs?

Long-term Treasury bonds and mortgage-backed securities (MBS), rather than only short-term T-bills.

What is the "zero lower bound" problem?

After the crisis the short-term interest rate was already at (about) 0%, so the central bank could not cut it further to offset the negative demand shock.

Why did the zero lower bound motivate QE?

Because with the policy rate stuck at 0%, the central bank needed another tool to provide additional stimulus—hence large-scale purchases of long-term assets.

What does it mean that "the link across interest rates is broken"?

Short-term rates were at 0%, but long-term rates stayed relatively high, partly because risk premia increased, so moving short-term rates no longer reliably moved long-term borrowing costs.

Why does a broken link across rates justify QE?

Because QE targets long-term rates directly by buying long-term bonds, instead of relying on the usual transmission from short- to long-term rates.

What were the main objectives of QE after 2008?

Offset the negative demand shock by lowering long-term rates, reducing firms' borrowing costs, making new and refinanced mortgages cheaper, improving banks' balance sheets, and providing more liquidity to support lending.

How can QE improve banks' financial health?

By raising the prices of assets they hold (e.g. mortgage-backed securities) and injecting reserves, which strengthens their capital and liquidity positions.

What is an event-study in the context of QE?

A method that looks at how asset prices react around unanticipated policy announcements, assuming markets are semi-strong-form efficient and the consequences of the event are understood.

Why is the event-study approach useful for measuring QE's effects?

Because if a QE announcement is a surprise, immediate changes in bond yields, CDS spreads, or inflation expectations can be attributed to that announcement.

Through which channels can QE affect short-term rates?

By signalling that the Fed will keep policy rates low for longer (raising rates would create losses on its bond holdings) and by signalling a dovish stance on inflation.

Through which channels can QE affect long-term rates?

Mechanical link from expected future short-term rates plus a term premium, and a liquidity/portfolio-balance effect where large-scale purchases push up bond prices and lower yields along a downward-sloping demand curve.

What effects of QE are typically studied in data?

Moves in long-term government yields, corporate bond yields and credit default swaps, and changes in inflation expectations derived from TIPS vs plain Treasuries.

How did QE tend to affect corporate bond markets?

It lowered corporate bond yields and CDS spreads, easing credit conditions for firms.

What are some broader questions about QE's effectiveness?

Whether there are diminishing returns across successive rounds (QE1, QE2, QE3) and how QE affected banks' capital, the housing market, and corporate financing.

What was one major concern expressed about QE and inflation?

Some commentators argued that the huge increase in the monetary base would inevitably cause high inflation, though realized inflation remained relatively contained.

Name two other examples of QE outside the 2008 US crisis.

Japan's QE starting in 2001 and the large-scale bond-buying programs during the COVID-19 pandemic.

How has the Fed's balance sheet evolved since the mid-2000s?

It jumped sharply after 2008 with QE, rose again during COVID-19, and more recently has been shrinking as the Fed lets assets roll off (quantitative tightening, QT).