How will the QE work through the economy?

How will the QE work through the economy?


While a new round of quantitative easing (QE II) by the Fed seems to be a foregone conclusion, the market remains skeptical about how effective it will be in spurring the economy. Before we can analyze its potential effectiveness, we need to address how the Large Scale Asset Purchase program (LSAP) works through the economy.

LSAP or quantitative easing is different from traditional monetary policy implementation in that quantitative easing has not been used as a signal of the future path of short-term risk-free interest rates. We can see that dating back to the time of the QE I, the Fed informed markets about the chance of raising short-term rates at the appropriate time while expanding its balance sheet. In contrast, the LSAP is being conducted for the purpose of narrowing risk premiums, which will in turn pull down longer-term yields. As the QE is perceived as a government life support that will help ease systemic risks, it will not only reduce the yields on assets being purchased, but also spill over into the yields on other assets.

Now we can look at how the QE I worked to reduce risk premiums. The risk premium is the additional return that investors require when holding risky assets. In our study, we use the difference in 30-year government bond yields and 30-year fixed mortgage rates to represent risk premiums. The risk premiums ran at 124 bps on average during the end of the 2001 recession and the onset of the latest recession (December 2007). The premiums soared 82 bps from 172 bps at the onset of the recession to peak at 253 bps, triggering the first QE in late November 2008. Subsequently, the premiums dropped markedly to uncharted territory at 28 bps in March 2010 when the Fed’s MBS purchase program ended. The premiums have since gradually risen by 36 bps to 64 bps as of September. At the current levels, the risk premiums are still well below the average of the past five recessions (200 bps). This implies that even though the new QE may not do much to further reduce risk premiums and long-term yields, it could at least help keep a lid on them. By putting a ceiling on risk premiums, the Fed is at the same time putting a floor under economic growth. Figure 1 shows a negative relationship between risk premiums and the ISM manufacturing index, with a correlation of 0.5. The graph also suggests that risk premiums higher than 150 bps can lead the ISM index lower into contraction territory.