Quantitative easing lowered interest rates. Why isn’t quantitative tightening lifting them more?

The Federal Reserve bought trillions of dollars of bonds and other securities from 2008 to 2014 in what’s been dubbed “quantitative easing” (QE).  Economists from the Fed and elsewhere have estimated that the asset purchases lowered long-term interest rates by about 1.5 percentage points. But when the Fed began shrinking its portfolio in the summer of 2017 (called by some “quantitative tightening,” or QT), long-term interest rates didn’t move much in response initially, though they have risen some in recent months.

Why?

Ben Broadbent, deputy governor of the Bank of England, offered one answer at a recent Hutchins Center event, Unconventional Monetary Policy: How Well Did It Work?: Fed communication around QE was very different from communication around QT, and markets responded accordingly.

During the recession and recovery, the Fed used QE and its communication about the direction of short-term interest rates (known as “forward guidance”) for the same urgent goal: easing monetary policy and lowering long-term interest rates.

When the Fed began QT, it sent a different signal: it would make the balance sheet wind-down as quiet as possible and offset its tightening effects by slowing the pace of interest rate hikes. This forward guidance has dampened the effects of QT and helped keep long-term rates relatively low.

In short, says Broadbent:

• QE1: Balance sheet and future short rates were complements: easing on one front implied more on the other as well.
• QT: Balance sheet and future short rates are substitutes: tightening one implied less tightening of the other.

To illustrate just how different the market reactions to QE and QT were, Broadbent began with estimates of how much rates fell in response to QE1. He then asked what would have happened to long-term interest rates when the Fed announced in 2017 that it was beginning to shrink its portfolio if the market had been as sensitive to a shrinking portfolio as it was to the increases of QE1. His answer: 10-year Treasury yields would have risen by somewhere between 50 and 150 basis points following the Fed’s 2017 announcement. In reality, yields fell slightly over the course of 2017.

Find Broadbent’s full presentation here.

When QE launched in the fall of 2008, officials described the policy as one part of the Fed’s effort to ease financial conditions for an extended period of time. In this way, says Broadbent, explicit forward guidance and implicit signaling from QE pushed interest rates in the same direction. The Fed’s first statement after announcing QE1 described that “weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time,” and that the committee stood “ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.” Fed Chairman Ben Bernanke repeatedly described the asset purchases as an “addition” to easing monetary policy. Bond markets understood that more QE implied lower short-term rates for longer, amplifying the asset purchases’ effects on long-term rates.

Timeline of the Fed’s balance sheet

QE1

Nov. 2008 – Sept. 2009

The Fed purchased almost $2 trillion in mortgage-related assets and longer-term Treasury Securities under QE1.

QE2

Nov. 2010 – June 2011

In its second round of quantitative easing, the Fed purchased $600 billion in Treasury securities.

QE3

Sept. 2012 – Oct. 2014

The Fed purchased about $85 billion in mortgage-related assets and Treasury securities each month, eventually bringing the total size of the balance sheet to $4.5 trillion.

QE tapering

Oct. 2014 – Sept. 2017

The Fed stopped purchasing new assets, but kept the size of the balance sheet constant by replacing securities that matured.

QT

Oct. 2017 – today

The Fed has been gradually reducing the balance sheet by limiting how much it reinvests after assets mature.

But when it came time to reduce the portfolio, the Fed made clear that doing so didn’t mean policy would be tighter in the future. Officials continually reminded markets they would use short-term interest rates as their primary policy tool, and that the balance sheet would simply shrink “in the background.” After announcing plans to reduce the portfolio in early 2017, officials began adjusting their projections of future interest rates downwards. In a January 2017 speech, Chairwoman Janet Yellen remarked that shrinking the balance sheet “argues for a more gradual approach to raising short-term rates.” As a result, bond markets expected short-term rates to remain relatively low even while the balance sheet shrank.

Of course, a number of factors that were not relevant in 2017 could have amplified QE1’s effects on interest rates—including its novelty at the time, or that it provided liquidity to severely distressed securities markets. Understanding the role of Fed communication in QE, however, can help make sense of how it may have been effective, and at the same time, why its removal has been so uneventful.