The theory (and rational) behind Quantitative Easing explained

The primary channel through which LSAPs appear to work is the risk premium on the
asset being purchased. By purchasing a particular asset, the Federal Reserve reduces the amount
of the security that the private sector holds, displacing some investors and reducing the holdings
of others, while simultaneously increasing the amount of short-term, risk-free bank reserves held
by the private sector. In order for investors to be willing to make those adjustments, the
expected return on the purchased security has to fall. Put differently, the purchases bid up the
price of the asset and hence lower its yield. This pattern was described by Tobin (1958) and is
commonly known as the “portfolio balance” effect.
Note that the portfolio balance effect has nothing to do with the expected path of shortterm
interest rates. Longer-term yields can be parsed into two components: the average level of
short-term risk-free interest rates expected over the term to maturity of the asset and the risk
premium. The former represents the expected return that investors could earn by rolling over
short-term risk-free investments, and the latter is the expected additional return that investors
demand for holding the risk associated with the longer-term asset. In theory, the effects of the
LSAPs on longer-term interest rates could arise by influencing either of these two components.
However, the LSAPs have not been used as a signal that the future path of short-term risk-free
interest rates would remain low. In fact, at the same time that the Federal Reserve was
expanding its balance sheet through the LSAPs, it was going to great lengths to inform investors
that it would still be able to raise short-term interest rates at the appropriate time. Thus, any reduction in longer-term yields instead has likely come through a narrowing in risk premiums.
For Treasury securities, the most important component of the risk premium is referred to
as the “term premium,” and it reflects the reluctance of investors to bear the interest rate risk
associated with holding an asset that has a long duration. The term premium is the additional
return investors require, over and above the average of expected future short-term interest rates,
for accepting a fixed long-term yield. The LSAPs have removed a considerable amount of assets
with high duration from the markets. With less duration risk to hold in the aggregate, the market
should require a lower premium to hold that risk. This effect may arise because those investors
most willing to bear the risk are the ones left holding it. Or, even if investors do not differ
greatly in their attitudes toward duration risk, they may require lower compensation for holding
duration risk when they have smaller amounts of it in their portfolios.
In addition to the effect of removing duration and hence shrinking the term premium
across all asset classes, Federal Reserve purchases of agency debt and agency MBS might be
expected to have an additional effect on the yields on those assets through other elements of their
risk premiums. For example, these assets may be seen as having greater credit or liquidity risk
than Treasury securities. In addition, the purchases of MBS reduce the amount of prepayment
risk that investors have to hold in the aggregate. Prepayment risk on MBS causes the duration of
MBS to shrink when interest rates decline and rise when interest rates increase. These changes
in duration imply that MBS have negative convexity: compared to the price of a non-callable
bond with the same coupon and maturity, MBS prices rise less when rates fall and decline more when rates rise. Given this undesirable profile and the cost of hedging against it, investors
typically demand an extra return to bear the negative convexity risk, keeping MBS rates higher
than they would otherwise be. The LSAPs removed a considerable amount of assets with high
convexity risk, which would be expected to reduce MBS yields.
These portfolio balance effects should not only reduce longer-term yields on the assets
being purchased, but also spill over into the yields on other assets. With lower prospective
returns on agency debt, agency MBS, and Treasury securities, investors should bid up the prices
of other assets such as corporate bonds and equities. It is through the broad array of all asset
prices that the LSAPs would be expected to provide stimulus to economic activity. Many private
borrowers would find their longer-term borrowing costs lower than they would otherwise be, and
the value of long-term assets held by households and firms, and thus aggregate wealth, would be
higher.
The effects described so far would be caused by LSAP-induced changes in the stock of
assets that is held by the public. Moreover, to the extent that investors care about expected
future returns on their assets, today’s asset prices should reflect expectations about the future
stock of assets. Thus, a credible announcement that the Federal Reserve will purchase longerterm
assets at a future date should reduce longer-term interest rates immediately. Otherwise,
investors could make excess profits by buying the assets today to sell to the Federal Reserve in
the future.
There may also be effects on the prices of longer-term assets if the presence of the
Federal Reserve as a consistent and significant buyer in the market enhances market functioning
and liquidity. The LSAP programs began at a point of significant market strains, and the poor
liquidity of some assets weighed on their prices. By providing an ongoing source of demand for longer-term assets, the LSAPs may have allowed dealers and other investors to take larger
positions in these securities or to make markets in them more actively, knowing that they could
sell the assets if needed to the Federal Reserve. Such improved trading opportunities could
reduce the liquidity risk premiums embedded in asset prices, thereby lowering their yields.
This liquidity channel appears to have been important in the early stages of the LSAP
programs for certain types of assets. For example, the LSAP programs began at a point when the
spreads between yields on agency-related securities and yields on Treasury securities were well
above historical norms, even after adjusting for the convexity risk in MBS associated with the
high interest rate volatility at that time. These spreads in part reflected poor liquidity and
elevated liquidity risk premiums on these securities.9 The flow of Federal Reserve purchases
may have helped to restore liquidity in these markets and reduced the liquidity risk of holding
those securities, thereby narrowing the spreads of yields on agency debt and MBS to yields on
Treasury securities and reducing the cost of financing agency-related securities.
Another example is older Treasury securities, which had become unusually cheap relative
to more recently issued Treasury securities with comparable maturities. Such differences would
normally be arbitraged away, but investors and dealers were reluctant to buy the older securities
because their poor liquidity meant that they might be difficult to sell. However, once the Federal
Reserve began buying such bonds, investors and dealers became more willing to hold them, and
the yield spreads narrowed to normal levels.
Overall, LSAPs may affect market interest rates through a combination of portfolio balance and market functioning effects. Although the effects on market functioning were quite
important at the start of the LSAPs, the primary effects today are likely associated with the
portfolio balance effect, now that financial strains have receded. In such circumstances, the
winding down of LSAPs need not cause a meaningful rise in market interest rates as long as the
completion of purchases is announced well in advance. Indeed, the completion of the longerterm
Treasury purchases in late 2009 and the slowing of the agency debt and agency MBS
purchases in late 2009 and early 2010 do not appear to have had significant effects on interest
rates.

Gagnon, Joseph; Raskin, Matthew; Remache, Julie; Sack, Brian (2010) :
Large-scale asset purchases by the Federal Reserve: Did they work?, Staff Report, Federal
Reserve Bank of New York, No. 441