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How Should We Measure Success?

In the nearly two and a half years since the onset of the financial crisis, the Fed has purchased over $2 trillion in long-term assets. Determining the effectiveness of such a policy is challenging for a number of reasons, including the lack of prior experience with this monetary policy tool. One approach is to examine changes in interest rates to assess how financial markets react to announcements related to and preceding policy decisions. A second approach is to look broadly at the overall effect that the purchases have had on macroeconomic conditions. This article uses both approaches to judge the effectiveness of the Federal Reserve's large-scale asset purchases.

A simple plot of the 10-year Treasury yield suggests that the Federal Reserve's asset purchases were effective in lowering bond yields. For example, yields declined sharply with the announcements of the first round of asset purchases in late 2008 and the most recent round in November 2010.

Figure 1. 10-Year Treasury Yields and the FOMC Policy

However, judging the effectiveness of asset purchases from broad movements in Treasury yields is complicated by several factors. First, compared to other financial assets such as mortgage-backed securities, Treasury bonds have a special function for investors as a highly liquid and safe investment. Times of stress in financial markets can induce what is known as a flight to safety, in which investors sell other assets and buy Treasuries. This rush to safe securities pushes the price of Treasuries up and yields down. For example, some portion of the fall in 10-year Treasury yields in late 2008 is almost certainly attributable to the rush to safe securities by foreign and domestic investors.

Because of this complexity in the Treasury market, other rates might provide a clearer picture about the effects of the purchases. The bulk of the first round of asset purchases was made in mortgage-backed securities, so the 30-year mortgage rate and the yield on a 30-year mortgage bond should reflect an impact if there was one, as might AAA-rated agency debt. Due to the general lack of liquidity in these securities during the financial crisis, their prices should have incorporated fewer market events. In the graphs for these rates, it is easier to see that the announcements on policy decisions and the announcements on policy direction seemed to help ease conditions. The interest rates associated with these securities all fell significantly on the initial announcement, and they also experienced smaller drops following later events.

To address these complications and carefully assess the effects of the Federal Reserve's asset purchases on bond yields, some researchers have used an approach known as an event study. This methodology involves assessing changes in bond yields over very short periods of time surrounding the announcements of asset purchases and controlling for other influences on bond yields.

In theory, because financial market participants are forward looking, markets should be able to immediately incorporate information into the prices of securities such as bonds. However, the immediate response to information requires that a market have high liquidity and trading volumes. Because of this condition, most studies of the effects of asset purchases have examined yields on Treasury securities rather than mortgage-backed securities or agency debt. Using this approach, several studies have all shown that the first round of security purchases by the Federal Reserve was successful in lowering bond yields (Gagnon et al. [2010], D'Amico and King [2010], and Hamilton and Wu [2010]).

So why do we care if the interest rates on Treasury bonds or mortgage-backed securities are lower? We care because reductions in these yields can help lower a broader array of interest rates. The effects of asset purchases on interest rates arise through what is known as the portfolio balance channel.

If this portfolio balance channel is truly functioning, a number of interest rates other than those on Treasury bonds and mortgage-backed securities should have declined with the Federal Reserve's asset purchases. In particular, interest rates on private credit instruments should have dropped, and the value of other asset prices should generally be higher. Both of these events have occurred.

Over time, these easier financial conditions should translate into stronger macroeconomic conditions and growth in economic output. Lower rates on long-term assets should encourage parts of the real economy to expand by making cars, equipment, houses, and other business and household investments more affordable.

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