The Signaling Channel for Federal Reserve Bond Purchases

Abstract

Previous research has emphasized the portfolio balance effects of Federal Reserve bond purchases, in which a reduced bond supply lowers term premia. In contrast, we find that such purchases have important signaling effects that lower expected future short-term interest rates. Our evidence comes from a model-free analysis and from dynamic term structure models that decompose declines in yields following Fed announcements into changes in risk premia and expected short rates. To overcome problems in measuring term premia, we consider bias-corrected model estimation and restricted risk price estimation. In comparison with other studies, our estimates of signaling effects are larger in magnitude and statistical significance. Federal Reserve Bank of San Francisco or in the Federal Reserve System. † Federal Reserve Bank of San Francisco, michael.bauer@sf.frb.org ‡ Federal Reserve Bank of San Francisco, glenn.rudebusch@sf.frb.org analysis substantially extends their analysis and provides formal statistical evidence for the importance of the signaling channel. Finally, again subsequent to our initial work, Christensen and Rudebusch (2012) also provide a model-based event study using a different set of DTSM specifications that contrasts the effects of the Fed's and the Bank of England's asset purchase programs. Interestingly, their results suggest that the relative contribution of the portfolio balance and signaling channels seems to depend on the forward guidance communication strategy pursued by the central bank and the institutional depth of financial markets.suggest that the contribution of expectations to daily changes in long-term interest rates is still understated by the resulting estimates.

Evaluating the impact of unconventional monetary policy measures: Empirical evidence from the ECB׳s Securities Markets Programme

“…This signaling, however, is different from the "signaling channel" in Christensen and Rudebusch (2012) and Bauer and Rudebusch (2014), where purchases signal future low short-term interest rates. Such signaling of future low monetary policy rates was neither intended by the SMP, nor did it result from it, as the monetary policy stance remained unaffected and the impact on central bank liquidity in circulation was sterilized.…”

“…Above we mentioned four channels through which the ECB's SMP could in principle have affected bond yields: (i) the 'classical' signaling channel, which signals future low monetary policy rates (Christensen and Rudebusch, 2012;Bauer and Rudebusch, 2014), (ii) signaling that affects a country's default risk premium (Hoerova, Monnet, and Temzelidesc, 2012;Corsetti and Dedola, 2013), (iii) reducing required liquidity risk premia (Duffie, Garleanu, and Pedersen, 2007;De Pooter, Martin, and Prui 2013), and (iv) local supply effects in weakly segmented markets (Vayanos and Vila, 2009;Duffie, Garleanu, and Peder 2007). We examine the different channels by studying the impact of bond purchases on other markets, such as that for overnight index swap (OIS) contracts and credit default swaps (CDS), as well as on bond market bid-ask spreads and the CDS-bond basis.…”

“…The 'signaling channel' of Christensen and Rudebusch (2012) and Bauer and Rudebusch (2014), according to which purchases affect medium-and long-term rates by signaling low future monetary policy rates, is not important in the case of SMP purchases. The ECB emphasized throughout that the monetary policy stance would remain unaffected.…”

Fiscal and Monetary Policies after the Crises

“…See, for instance, the widely-cited study by Gagnon et al (2011) for the US, and Joyce et al (2011) for the UK case. Bauer and Rudebusch (2014) argue that these studies rely on a decomposition of the yield curve that is biased in favour of finding too high a portfolio rebalancing effect. 32.…”

“…This is the so-called 'signalling channel', by which large-scale asset purchases are found to reduce expected future short-term interest rates. Work by Krishnamurthy and Vissing-Jorgensen (2011), Christensen and Rudebusch (2012), Bauer and Rudebusch (2014) and Lloyd (2015) all find significant evidence of these expectational changes, with Lloyd (2015) attributing 70 per cent of the fluctuations in yield on announcement days to signalling.…”