13. How Islam Created The Modern World / Graham Mark. : Amana Publications, 2006. 205p. 297.09 GRA (80913) 14. Islamic Banking and Finance What Is and What It Could Be / El-Diwany Tarek.
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The Effects of Quantitative Easing on Interest Rates Channels and Implications for Policy. Arvind Krishnamurthy and Annette Vissing Jorgensen. NBER Working Paper No 17555,October 2011,JEL No E4 E5 G01 G14 G18. ABSTRACT, We evaluate the effect of the Federal Reserve s purchase of long term Treasuries and other long term. bonds QE1 in 2008 2009 and QE2 in 2010 2011 on interest rates Using an event study methodology. we reach two main conclusions First it is inappropriate to focus only on Treasury rates as a policy. target because QE works through several channels that affect particular assets differently We find. evidence for a signaling channel a unique demand for long term safe assets and an inflation channel. for both QE1 and QE2 and an MBS pre payment channel and a corporate bond default risk channel. for QE1 Second effects on particular assets depend critically on which assets are purchased The. event study suggests that a mortgage backed securities purchases in QE1 were crucial for lowering. mortgage backed security yields as well as corporate credit risk and thus corporate yields for QE1 . and b Treasuries only purchases in QE2 had a disproportionate effect on Treasuries and Agencies. relative to mortgage backed securities and corporates with yields on the latter falling primarily through. the market s anticipation of lower future federal funds rates . Arvind Krishnamurthy,Kellogg School of Management,Northwestern University. 2001 Sheridan Road,Evanston IL 60208,and NBER,a krishnamurthy northwestern edu. Annette Vissing Jorgensen,Finance Department,Kellogg School of Management. Northwestern University,2001 Sheridan Road,Evanston IL 60208 2001. and NBER,a vissing northwestern edu, 1 Introduction. The Federal Reserve has recently pursued the unconventional policy of purchasing large. quantities of long term securities including Treasuries Agency bonds and Agency Mortgage. Backed Securities quantitative easing or QE The stated objective of quantitative easing is to. reduce long term interest rates in order to spur economic activity 3 There is significant evidence. that QE policies can alter long term interest rates For example Gagnon Raskin Remache and. Sack 2010 present an event study of QE1 that documents large reductions in interest rates on. dates associated with positive QE announcements Swanson 2011 presents confirming event . study evidence from the 1961 Operation Twist where the Fed Treasury purchased a substantial. quantity of long term Treasuries Apart from the event study evidence there are papers that look. at lower frequency variation in the supply of long term Treasuries and documents causal effects. from supply to interest rates see for example Krishnamurthy and Vissing Jorgensen 2010 4. While it is clear from this body of work that QE lowers medium and long term interest. rates the channels through which this reduction occurs are less clear The main objective of this. paper is to evaluate these channels and their implications for policy We review the principal. theoretical channels through which QE may operate We then examine the event study evidence. with an eye towards distinguishing among these channels studying a range of interest rates and. drawing in additional facts from various derivatives prices to help separate the channels We. furthermore supplement previous work by adding evidence from QE2 and evidence based on. intra day data Studying intra day data allows us to document price reactions and trading volume. in the minutes after the main announcements thus increasing confidence that any effects. documented in daily data are causal , It is necessary to understand the channels of operation in order to evaluate whether a. given QE policy was successful Here is an illustration of this point Using annual data back to. 1919 Krishnamurthy and Vissing Jorgensen 2010 present evidence for a channel whereby. changes in long term Treasury supply drives the safety premia on near zero default risk long . term assets Their findings suggest that QE policy that purchases very safe assets such as. Treasuries or Agency bonds should work particularly to lower the yields of bonds which are. 3, http www newyorkfed org newsevents speeches 2010 dud101001 html. 4, Other papers in the literature that have examined Treasury supply and bond yields include Bernanke Reinhart and. Sack 2004 Greenwood and Vayanos 2010 D Amico and King 2010 Hamilton and Wu 2010 and Wright. 2011 , 2, extremely safe such as Treasuries Agency bonds and high grade corporate bonds But even if. a policy affects Treasury interest rates such rates may not be the most policy relevant ones A. lot of economic activity is funded by debt that is not as free of credit risk as Treasuries or Aaas . For example about 40 percent of corporate bonds are rated Baa or lower for which our earlier. work suggests that the demand for assets with near zero default risk does not apply Similarly . mortgage backed securities issued to fund household mortgages are less safe than Treasuries due. to the substantial pre payment risk involved in such securities Whether yields on these less safe. assets fall as much as those on very safe assets depends on whether QE succeeds in lowering. default risk default risk premia for corporate bonds and pre payment risk premia for. mortgage backed securities , One of the principal findings of this paper is that the large reductions in mortgage rates. due to QE1 appear to be driven partly by the fact that QE1 involved large purchases of agency. MBS thus reducing the price of mortgage specific risk In contrast for QE2 which involved. only Treasury purchases we find a substantial impact on Treasury and Agency bond rates but. smaller effects on MBS rates and corporate rates Furthermore we find a substantial reduction in. the default risk default risk premium for corporate bonds only for QE1 suggesting that the QE1. MBS purchases may also have helped drive down corporate credit risk and thus corporate yields. possibly via the resulting mortgage refinancing boom and its impact on the housing market and. consumer spending The main effect on corporate bonds and MBS in QE2 appears to be through. a signaling channel whereby financial markets interpreted QE as signaling lower federal funds. rates going forward This finding for QE2 raises the question of whether the main impact of a. Treasuries only QE may have been achievable with a Fed statement committing to lower federal. funds rates i e without the Fed putting its balance sheet at risk in order to signal lower future. rates , The next section of the paper lays out the channels through which QE may be expected to. operate We then present event studies of QE1 and QE2 in Section 3 and 4 to evaluate the. channels We document that QE worked through several channels First a signaling channel. reflecting the market inferring information from QE announcement about future Federal funds. rates significantly lowered yields on all bonds with effects depending on bond maturity . Second the impact of quantitative easing on mortgage based security MBS rates was large. when QE involves MBS purchases but not when it involves only Treasury purchases indicating. 3, that another main channel for QE1 was to affect the equilibrium price of mortgage specific risk . Third default risk default risk premia for corporate bonds fell for QE1 but not QE2 contributing. to lower corporate rates Fourth yields on medium and long maturity safe bonds fell because of a. unique clientele for safe nominal assets and Fed purchases reduce the supply of such assets and. hence increase the equilibrium safety premium Fifth evidence from inflation swap rates and. TIPS show that expected inflation increased due to both QE1 and QE2 implying larger. reductions in real than nominal rates Section 5 presents regression analysis building on our. previous work in Krishnamurthy and Vissing Jorgensen 2010 to provide estimates of the. expected effects of QE on interest rates via the safety channel Section 6 concludes . 2 Channels,a Signaling Channel, Eggertson and Woodford 2003 argue that non traditional monetary policy can have a beneficial. effect in lowering long term bond yields only if such policy serves as a credible commitment by. the central bank to keep interest rates low even after the economy recovers i e lower than what. a Taylor rule may call for Clouse et al 2000 argue that such a commitment can be achieved. when the central bank purchases a large quantity of long duration assets in QE If the central. bank raises rates it takes a loss on these assets To the extent that the central bank weighs such. losses in its objective function purchasing long term assets in QE serves as a credible. commitment to keep interest rates low Furthermore some of the Federal Reserve. announcements regarding QE explicitly contain discussion of the Federal Reserve s policy on. future federal funds rates Markets may also infer that the Fed s willingness to undertake an. unconventional policy like QE indicates that it will be willing to hold its policy rate low for an. extended period , The signaling channel affects all bond market interest rates with effects depending on. bond maturity since lower future federal funds rates via the expectations hypothesis can be. expected to affect all interest rates We examine this channel by measuring changes in the prices. of the federal funds futures contract as a guide to market expectations of future federal funds. rates 5 The signaling channel should have a larger impact in lowering intermediate maturity rates. 5, Piazzesi and Swanson 2008 show that these futures prices reflect a risk premium in addition to such. expectations The risk premium is smaller the lower short rates are and the stronger employment growth is To the. 4, rather than long maturity rates since the commitment to keep rates low only lasts until the. economy recovers and the Fed can sell the accumulated assets . b Duration Risk Channel, Vayanos and Vila 2009 offer a theoretical model for a duration risk channel Their one factor. model produces a risk premium on a bond of maturity t that is approximately the product of the. duration of a maturity t bond and the price of duration risk which in turn is a function of the. amount of duration risk borne by the marginal bond market investor and this investor s risk. aversion By purchasing long term Treasuries Agency debt or Agency MBS policy can reduce. the duration risk in the hands of investors and thereby alter the yield curve particularly reducing. long maturity bond yields relative to short maturity yields To deliver these results the model. departs from a frictionless asset pricing model The principal departures that generate the. duration risk premium result are the assumptions that there is a subset of investors who have. preferences for bonds of specific maturities preferred habitat demand and another subset of. investors who are arbitrageurs and who become the marginal investors for pricing duration risk . An important but subtle issue in using the model to think about QE is to ask whether the. preferred habitat demand applies narrowly to a particular asset class e g only the Treasury. market or whether it applies broadly to all fixed income instruments For example if some. investors had a special demand for 10 year Treasuries but not 10 year corporate bonds or. mortgages or bank loans then the Fed s purchase of 10 year Treasuries can be expected to. affect Treasury yields more than corporate bond yields Vayanos and Vila 2009 do not take a. stand on this issue Greenwood and Vayanos 2010 offer evidence for how a change in the. relative supply of long term versus short term Treasuries affects the spread between long term. and short term Treasury bonds This evidence also does not settle the issue because it only. focuses on Treasury data , Recent studies on QE have interpreted the model as being about the broad fixed income. market see Gagnon Raskin Remache and Sack 2010 and that is how we proceed Under this. interpretation the duration risk channel has two principal predictions . extent that this risk premium is reduced by QE our estimates of the signaling effect are too large It is difficult to. assess whether changes in short rates or employment growth due to QE have the same effect as non policy related. change in these variables so we do not attempt to quantify any such bias . 5, i QE decreases the yield on all long term nominal assets including Treasuries Agency. bonds corporate bonds and MBS , ii The effects are larger effects for longer duration assets . c Liquidity Channel, The QE strategy involves purchasing long term securities and paying by increasing reserve. balances Reserve balances are a more liquid asset than long term securities Thus QE. increases the liquidity in the hands of investors and thereby decreases the liquidity premium on. the most liquid bonds, It is important to emphasize that this channel implies an increase in Treasury yields . That is it is commonly thought that Treasury bonds carry a liquidity price premium and that this. premium has been high during particularly severe periods of the crisis An expansion in liquidity. can be expected to reduce such a liquidity premium and increase yields This channel thus. predicts that , i QE raises yields on the most liquid asset such as Treasuries relative to other less. liquid assets ,d Safety Premium Channel, Krishnamurthy and Vissing Jorgensen 2010 offer evidence that there are significant clienteles. for long term safe i e near zero default risk assets that lower the yields on such assets The. evidence comes from relating the spread between Baa bonds and Aaa bonds or Agency bonds . to variation in the supply of long term Treasuries over a period from 1925 to 2008 They report. that when there are less long term Treasuries so that there are less long term safe assets to meet. clientele demands the spread between Baa and Aaa bonds rises The safety channel can be. thought of as describing a preferred habitat of investors but only applying to the space of safe. assets , The safety channel is not the same as the risk premium of a standard asset pricing model . it reflects a deviation due to clientele demand A simply way to think about investor willingness. to pay extra for assets with very low default risk is to plot an asset s price against its expected. default rate Krishnamurthy and Vissing Jorgensen 2010 argue that this curve is very steep for. low default rates with a slope that flattens as the supply of Treasuries increases Figure 1. 6, illustrates the distinction The bottom line is the C CAPM value of a risky bond As default risk. rises the price of the bond falls The distance from this line up to the middle solid line. illustrates the safety premium for bonds that have very low default the bond price rises as a. function of the safety of the bond The figure also illustrates the dependence of the safety. premium on the supply of long term Treasuries The distance from the bottom line to the top. line is the safety premium for a smaller supply of safe assets The clientele demand shifts the. premium up due to a higher marginal willingness to pay for safety when supply is lower This. dependence on the premium on the supply of long term Treasuries is how Krishnamurthy and. Vissing Jorgensen 2010 distinguish a standard risk premium explanation of defaultable bond. pricing with the clientele driven safety demand , This same effect may be expected to play out in QE However there is a subtle issue in. thinking about different asset classes in QE Treasury and Agency bonds are clearly safe in the. sense of offering an almost sure nominal payment note that the government takeover of. Fannie Mae and Fredidie Mac was announced on 9 7 2008 prior to QE1 and QE2 making. agency bonds particularly safe during the period of QE1 and QE2 however Agency MBS has. significant prepayment risk which means that it may not meet clientele safety demands The. safety channel thus predicts that , i 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 , We expect Baa bonds to be the relevant cutoff for these safety effects First such bonds. are the boundary between investment grade and non investment grade securities so that if driven. by safety clientele demands the Baa bond forms a natural threshold More rigorously . Longstaff Mithal and Neis 2006 use credit default swap data from December 2000 to October. 2001 to show that the component of yields that is hard to explain by purely default risk. information is about 50 bps for Aaa and Aa rated bonds and about 70 bps for lower rated bonds . suggesting that the cutoff for bonds whose yields are not affected by safety premia is somewhere. around the A Baa rating , 7, e Prepayment Risk Premium Channel. QE1 involved the purchase of 1 25tn of Agency MBS Gabaix Krishnamurthy and Vigneron. 2007 present theory and evidence that mortgage prepayment risk carries a positive risk. premium and that this premium depends on the quantity of prepayment risk borne by mortgage. investors The theory requires that the MBS market is segmented and that a class of arbitrageurs. who operate predominantly in the MBS market are the relevant investors in determining the. pricing of prepayment risk This theory is similar to the Vayanos and Vila 2009 explanation of. the duration risk premium and more broadly fits into theories of intermediary asset pricing see. He and Krishnamurthy 2010 , This channel is particularly about QE1 and its effects on MBS yields which reflect a. prepayment risk premium , i MBS purchases in QE1 lowers MBS yields relative to other bond market yields . ii No such effect should be present in QE2 ,f Default Risk Channel. Lower grade bonds such as Baa bonds carry higher default risk than Treasury bonds QE may. affect the quantity of such default risk as well as the price i e risk premium of the default risk . If QE succeeds in stimulating the economy we can expect that the default risk of corporations. will fall and hence Baa rates will fall Moreover standard asset pricing models predict that. investor risk aversion will fall as the economy recovers implying a lower default risk premium . Finally extensions of the intermediary pricing arguments we have offered above for pricing. prepayment risk can imply that increasing health capital in the intermediary sector can further. lower the risk premium on default risk , We use credit default swap CDS rates to evaluate the importance of a default risk. channel A credit default swap is a financial derivative used to hedge against default by a firm . The credit default swap rate measures the percentage of face value that must be paid as an. annual insurance premium to insure against default on the bonds of a given firm The 5 year. CDS refers to an insurance contract that expires in 5 years while the 10 year CDS refers to the. same expiring in 10 years We use these CDS to infer default risk at different maturities . 8, g Inflation Channel, To the extent that QE is expansionary it increases inflation expectations and this can be expected. to have an effect on interest rates In addition some commentators have argued that QE may. increase tail risks surrounding inflation 6 That is in an environment where investors are unsure. about the effects of policy on inflation policy actions may lead to greater uncertainty over. inflation outcomes Others have argued that aggressive policy decreases uncertainty in the sense. that it effectively combats the possibility of a deflationary spiral Ultimately this is an issue that. can only be sorted out by data We propose looking at the implied volatility on interest rate. options since a rise in inflation uncertainty will plausibly also lead to a rise in interest rate. uncertainty and implied volatility The inflation channel thus predicts . i QE increases the rate on inflation swaps as well inflation expectations as measured by. the difference between nominal bond yields and TIPS . ii QE may increase or decrease interest rate uncertainty as measured by the implied. volatility on swaptions , Two explanations are in order on the measurements in i and ii First a zero coupon . inflation swap is a financial instrument used to hedge against a rise in inflation The swap is a. contract between a fixed rate payor and a floating rate payor that specifies a one time. exchange of cash at the maturity of the contract The floating rate payor pays the realized. cumulative inflation over the life of the swap as measured using the CPI index The fixed rate. payor makes a fixed payment contracted at the initation of the swap agreement In an efficient. market the fixed rate payment thus measures the expected inflation rate over the life of the swap . Second a swaption is a financial derivative on interest rates The buyer of a call. swaption earns a profit when the interest rate rises relative to the strike on the swaption As with. any option following on the Black Scholes model the expected volatility of interest rates enters. as an important input for pricing the swaption The implied volatility is the expected volatility of. interest rates as implied from current market prices of swaptions . h Summary,6, See Calomiris and Tallman 2010 op ed In Monetary Targeting Two Tails are Better than One . 9, The channels we have discussed and our empirical approach can be summarized with a few. equations Suppose that we are interested in the real yield on a T year long term risky and. illiquid asset such as a corporate bond or a mortgage backed security Denote this yield by. Also denote the expected average interest rate over the next T years on. short term safe and liquid nominal bonds as and the expected inflation. rate over the same period as Then we can decompose the long term rate as . Eq 1 , , Each line in this equation reflects a channel we have discussed The first line is the expectations. hypothesis terms The long term rate reflects the expected average future real interest rate The. signaling channel for QE may affect through the first line Expected. inflation can also be expected to affect long term real rates The second term reflects a duration. risk premium that is a function of duration and the price of duration risk as explained above . This decomposition is analogous to the textbook treatment of the CAPM where the return on a. given asset is decomposed as the asset s multiplied by the market risk premium The third. term is the illiquidity premium we have discussed which is likewise related to an asset s. liquidity multiplied by the market price of liquidity The next terms reflect the safety premium. the extra yield on the non safe bond because it doesn t have the extreme safety of a Treasury. bond a premium on default risk and for the case of MBS a premium on prepayment risk . The equation makes clear that a given interest rate can be affected by QE through a. variety of channels It is not possible to examine the change in say the Treasury rate to conclude. how much QE affects interest rates more broadly because different interest rates are affected by. QE in different ways , 10, Our main empirical methodology to examining the various channels can be thought of as. difference in difference approach supplemented with information from derivatives For. example in asking whether there is a liquidity channel that may affect interest rates we consider. the yield spread between a long term Agency bond and a long term Treasury bond and measure. how this yield spread changes over the relevant QE event The yield decomposition from Eq 1. for each of these bonds is identical except for the term involving liquidity That is these bonds. have the same duration safety default risk etc but the Treasury bond is more liquid than the. Agency bond Thus the difference in yield changes between these bonds isolates a liquidity. channel We examine how this yield spread changes over the QE event dates We take this. difference in difference approach in evaluating the liquidity safety duration risk premium and. prepayment risk channels In addition to the difference in difference approach in some cases we. use derivatives prices which are affected by only a single channel to separate out the effect of a. particular channel This is how we use the federal funds futures contracts the CDS swap rates . the inflation swap rates and the implied volatility on interest rate options . 3 Evidence from QE1,a Event Study, Gagnon et al 2010 provide an event study of QE1 based on the announcements of long term. asset purchases by the Federal Reserve in the late 2008 to 2009 period QE1 QE1 included. purchase of mortgage backed securities Treasury securities and Agency securities Gagnon et . al 2010 identify eight event dates beginning with the 11 25 08 announcement of the Fed s. intent to purchase 500bn of Agency MBS and 100bn of Agency debt and running into the. summer of 2009 We focus on the first five of these event dates 11 25 2008 12 1 2008 . 12 16 2008 1 28 2009 and 3 18 2009 leaving out three later event dates on which only small. yield changes occurred , There was considerable turmoil in financial markets in the period from the fall of 2008 to. the spring of 2009 which makes inference from an event study somewhat tricky Some of the. assets we consider such as corporate bonds and CDS are less liquid than Treasuries During a. period of low liquidity the prices of such assets may react slowly in response to an. announcement We deal with this issue by presenting two day changes for all assets from the. day prior to the day after the announcement In the data for high liquidity assets like Treasuries . 11, two day changes are almost the same as one day changes For low liquidity assets the two day. changes are almost always higher than one day changes . The second issue that arises is that we cannot be sure that the identified events are in fact. important events or the dominant events for the identified event day That is other significant. economic news arrives through this period and potentially creates measurement error problems. for the event study To increase our confidence that QE1 announcements were the dominant. news on the five event dates we study Figure 2 presents graphs of intraday movements in. Treasury yields and trading volume for each of the QE1 event dates The figure is based on data. from BG Cantor and the data graphed is for the on the run 10 year Treasury bond at each date . Yields graphed are averages by the minute and trading volume graphed is total volume by. minute The vertical lines indicate the minute of the announcement defined as the minute of the. first article covering the announcement in Factiva These graphs show that the events identify. significant movements in Treasury yields and Treasury trading volume and that the. announcements do appear to be the main piece of news coming out on the event days especially. on 12 1 2008 12 16 2008 and 3 18 2009 For 11 25 2008 and 1 28 2009 the trading volume. graphs also suggest that the announcements are the main events with more mixed evidence from. the yield graphs for those days , While it is likely that these five dates are most relevant event dates it is possible that. there are other true event dates that we have omitted How does focusing on too limited a set. of event dates affect inference For the objective of analyzing through which channels QE. operates omitting true event dates reduces the power of our tests by increasing the noise in the. sample but does not lead to any biases 7 For estimating the overall effect of QE omitting. potentially relevant dates could lead to an upward or downward bias depending on how the. omitted dates affected the market s perception of the probability or magnitude of QE . Table 1 presents data on two day changes in Treasury non callable Agency and. Agency MBS yields around the main event study dates spanning a period from 11 25 08 the. two day change from 11 24 08 to 11 26 08 to 3 18 09 the two day change from 3 17 09 to. 3 19 09 Over this period it became evident from Fed announcements that the government. intended to purchase a large quantity of long term securities Across the five event dates interest. 7, We thank Gabriel Chodorow Reich for clarifying this point . 12, rates fell across the board on long term bonds consistent with a contraction of supply effect . Now consider the channels through which the supply effect may have worked . In all tables we provide tests of the statistical significance of the rate changes or changes. in derivatives documented focusing on the total change shown in the last row of each table for. QE1 and QE2 separately Specifically we test whether changes on QE announcement days. differ from changes on other days To do this we regress the daily changes for the variable in. focus on 6 dummies A dummy for whether there was a QE1 announcement on this day a. dummy for whether there was a QE1 announcement on the previous day a dummy for whether. there was a QE2 announcement on this day a dummy for whether there was a QE2. announcement on the previous day a dummy for whether there was a QE3 announcement on this. day a dummy for whether there was a QE3 announcement on the previous day By QE3 we. refer to the Fed announcement in its FOMC statement on 9 21 2011 this event happened after. the Brookings panel took place but we analyze it briefly below This regression is estimated on. daily data from the start of 2008 to the end of the third quarter of 2011 using OLS but with. robust standard errors to account for heteroscedasticity F tests for the QE dummy coefficients. being zero are then used to assess statistical significance When testing for statistical significance. of 2 day changes the F test is a test of whether the sum of the coefficient on the QE dummy. QE1 or QE2 and the coefficient on the dummy for a QE announcement QE1 or QE2 on the. previous day is equal to zero When testing statistical significance of two day changes in CDS. rates we follow a slightly different approach described below due to the way our CDS rates. changes are constructed ,b Signaling Channel, Figure 3 graphs the yields on the monthly federal funds futures contract for contract maturities. from March 2009 to October 2010 The pre announcement average yield curves are computed. on the day before each of the five QE1 events and then averaged across these dates The post . announcement average yield curve is computed likewise based on the five days after the QE1. event dates Dividing the downward shift from the initial to the post announcement average. yield curve by the slope of the initial average yield curve and multiplying by the number of. event dates tells us how much the policy shifted the rate cycle forward in time The graph shows. that on average each QE announcement shifts an anticipated rate hike cycle by the Fed later. 13, by a little over one month Evaluating the forward shift at the point and slope of the March 2010. contract the total effect of the five QE announcements is to shift anticipated rate increases later. by 6 3 months This effect is consistent with the signaling channel whereby the Fed s portfolio. purchases as well as direct indications of the stance of policy in the relevant Fed. announcements signals a commitment to keep the federal funds rate low . Table 4 reports the one and two day change in the yields of the 3rd month 6th month 12th. month and 24th month futures contracts across the five event dates We aggregate by for. example the 3rd month rather than a given contract month e g March because it is more. natural to think of the information in each QE announcement as concerning how long from today. rates will be held low on the other hand for plotting a yield curve it is more natural to hold the. contract month fixed as we did above in Figure 3 For two of the four Fed funds futures. contracts two day changes for QE1 announcement dates are significantly more negative than on. other days The two day decrease in the 24th month contract is 40 basis points . How much effect can the signaling channel have on longer term rates The difficulty in. assessing the effects on longer rates is that we cannot precisely measure changes in the expected. future federal funds rates for horizons over 2 years due to the lack of federal funds futures. contracts An upper bound on the signaling effect can be found by extrapolating the 40 bps fall. in the 24th month contract to all horizons This is an upper bound because it is clear that at. longer horizons market expectations should reflect a normalization of the accommodative. current Fed policy so that signaling should not have any effect on rates at that horizon . Nevertheless with the 40bp number equation 1 predicts that rates at all horizons fall by 40bps . A second approach to estimating the signaling effect is to build on the observation that. QE shifted the path of anticipated rate hikes by about 6 months Signaling affects long term rates. by changing the expectations term in equation 1 Consider the. expectations term for a T year bond , , where is the expected federal funds rate t years from today Let us use to denote the. path described by the federal funds rate as expected by the market prior to QE announcements . Suppose that QE policy signals that the rate is going to be held at for the next X months .
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