Study On Quantitative Easing And Krishnamurthy Finance Essay - Free Essay Example

Quantitative easing, also known as large scale asset purchases (LSAP), is a specific monetary policy used by central banks to add to the supply of money by increasing reserves of the banking system. In certain economic situations, such as a low inflationary environment like the one we are experiencing today, targeting a low interest rate is not sufficient to maintain the level of money supply desired by the Federal Reserve, and so quantitative easing is employed. Through the quantitative easing process, the central bank purchases securities-most likely longer-dated Treasury Bonds and mortgage backed securities-in an effort to push longer-term interest rates lower and expand the money supply by making it cheaper for individuals to borrow and for businesses to raise capital. This works because the borrower receives about 93 percent more money than the bank holds in reserves (money creation). Krishnamurthy We build on the regression analysis from KVJ to estimate the effect of a purchase of long-term securities via the safety channel. We focus on the safety channel because it appears to be a dominant effect from the event studies. In KVJ, we mainly focus on the effect of changes in the total supply of Treasuries, irrespective of maturity, on bond yields. For evaluating QE, we are interested more in asking how a change in the supply of long-term Treasuries will affect yields. The larger effects obtained from the QE1 event study than the regression approach suggest that changes in Treasury supply have much larger impact on the safety premium in times of unusually high safety demand than they do in average times. Gagnon, et. al, (2010) report that in 10-year equivalents the Fed had purchased $169bn of Treasuries, $59bn of Agency debt, and $573bn of Agency MBS by Feb 1, 2010. The total purchase up to this date was $1.625tn and the anticipated total was $1.725tn. We scale up the n umbers up to Feb 1, 2010 by 1.725/1.625 to evaluate the effect of the total purchase. Important (Theoretical) Takeshi Kimura and David Small (2004) (Finance and Economics Discussion Series Divisions of Research Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. Quantitative easing was expected to have three effects on financial markets. First, it would lower longer-term interest rates because the Banks announcement that the new policy regime would be maintained until CPI inflation became zero or more would lower expected short-term rates. If this so-called commitment effect also contributed to diminishing uncertainty over future short-term interest rates, term premiums also would be reduced and hence longer term rates would be lowered further. 8 Such announcement effects would tend to be reinforced by the observed increase in current account balances. Second, the abundant provision of liquidity would make money market participants feel more secure about the ongoing availability of funds, thereby preserving financial market stability. Uncertainties about conditions in money markets might, at times, lead to elevated demands for liquidity, boosting the rates of illiquid assets relative to those of liquid assets. In such circumstances, the elevated levels of current account balances would reduce the probability of a liquidity shortage, and consequently would reduce liquidity premiums. Third, an open market operation by a central bank would change the relative supplies of assets held by the public and, thereby, may lead to changes in the relative prices of assets. This so-called portfolio-rebalancing effect has been described as follows: Suppose that a representative bank holds multiple assets and rebalances its portfolio so as to maximize its objective function under the constraint of containing overall risk amount below a certain limit. For example, if we assume that a utility function with given absolute risk aversion, the expected return and its variance from the portfolio become explanatory variables of utility. Risk constraint crucially depends on the capital position of the bank. Then, let us think of a case where, as a result of the outright purchase of long-term JGB by the BOJ, a portion of the long-term government holdings of the representative bank is converted to monetary base. The reduction on portfolio risk, that is, interest rate volatility risk of government bonds, generates room for new risk taking, and thus part of monetary base should be converted to some type of risk assets. At equilibrium, utility is kept constant by marginally increasing the amount of holding risk assets, and the marginal increa se in the expected profits offsets increased risk. In this rebalancing process, the risk premium of risk asset prices will be decreased. Although quantitative easing supported that improvement of Japans economy, the Banks drastic quantitative easing has not been quite strong enough by itself to boost the economy and prices, as stated by Governor Fukui (2003). In particular, it did not seem to have a strong beneficial effect on the corporate financing environment, such as on corporate bond rates. (See Figure 3 (panel 1).) The weakening role of banks as financial intermediaries made it especially important for easier monetary policy to benefit capital markets. However, the spread between interest rates on corporate bonds and risk-free government bonds declined only marginally after March 2001. And those firms that did feel the benefits of monetary easing were limited to those with high credit ratings. Credit spreads on low-grade corporate bonds rose after October 2001. The prices of other financial assets also did not seem to benefit from quantitative easing. Even after the introduction of quantitative easing, stoc k prices continued to decline until the summer 2003. (See Figure 3 (panel 2).) As for foreign exchange rates, the yen rate against the dollar depreciated rapidly from November 2001 until February 2002. (See Figure 3 (panel 3).) However, this depreciation seems to be attributable not only to monetary easing but also to a change in the economic outlook; while expectations for recovery of the US economy strengthened, uncertainty over prospects for Japans economy intensified, including financial system stability. Thereafter, on net, the yen appreciated. In the context of the Bank of Japans policy of quantitative easing, we have explicitly considered portfolio-rebalancing effects and how they may be affected by the attempts of portfolio holders to diversify business-cycle risk. In this framework, an outright purchase of long-term government bonds does not necessarily reduce the portfolio risk of financial institutions and other private-sector investors and thereby generate room for ne w risk taking as has been suggested. Indeed, the portfolio risk associated with the business cycle may have increased as the BOJs purchases of long-term government debt reduced the private-sectors holding of this asset whose returns are counter-cyclical, If we focus only on the portfolio-rebalancing effects, and neglect the other effects such as the BOJ using quantitative easing to demonstrate resolve to keep short-term rates low, the BOJs quantitative easing may have increased the demand for those JGB substitutes whose returns also are counter-cyclical. But these policy actions may have decreased the demand for assets whose returns are pro-cyclical and thus may have increased the risk premium for pro-cyclical assets. The following chart summarizes these estimation results. Doh (2010) See the paper conclusion Oda, N., and Ueda, K. (2007). The effects of the bank of Japans zero interest rate commitment and quantitative monetary easing on the yield curve: A macro-finance approach. The Japanese Economic Review. We have examined empirically the effects of the ZIRP and QMEP in Japan on mediumto long-term interest rates using a macro-finance model. We tentatively conclude that the BOJs monetary policy under the zero interest rate environment since 1999 has functioned mainly through the zero rate commitment, which has led to reduced medium- to long-term interest rates. More specifically, the commitment has been effective in lowering the expectations component of interest rates, especially with short- to medium-term maturities, while it has been less effective in lowering the risk premium component. In contrast, the portfolio rebalancing effect either by the BOJs supplying liquidity beyond the required level to keep the short-term policy rate at virtually zero (i.e. the expansion of the CAB at the BOJ) or by the BOJs purchases of JGBs on the risk premium component of the interest rates has not been found significant. There is some evidence that raising the target for the CABs has been percei ved by the market as a signal indicating the BOJs greater willingness to carry on RZIRP and has thus enhanced the effects of the zero rate commitment, although this interpretation is subject to further examination. Stroebel, J. C., and Taylor, J. B. (2009). Estimated impact of the feds mortgage-backed securities purchase program. National Bureau of Economic Research. We examine the quantitative impact of the Federal Reserves mortgage-backed securities (MBS) purchase program. We focus on how much of the recent decline in mortgage interest rate spreads can be attributed to these purchases. The question is more difficult than frequently perceived because of simultaneous changes in prepayment and default risks. When we control for these risks, we find evidence of statistically insignificant or small effects of the program. For specifications where the existence or announcement of the program appears to have lowered spreads, we find no separate effect of the size of the stock of MBS purchased by the Fed.