During the exit from Quantitative Easing (QE), when central bank balance sheets are reduced by letting assets mature as in the United States, the resulting reduction in the outstanding reserves could push up long-term interest rates.   That is one of the implications of new research on the way that QE affects bond yields.

While the impact of QE on long term government bond yields is well established, do we really understand how these policies work to lower yields and how QE should be managed to be most effective?  In research published in the January 2019 edition of The Economic Journal, Jens Christensen and Signe Krogstrup argue that a new mechanism, a reserve-induced portfolio balance channel, may explain how QE operates.

QE is conventionally thought to operate through one of two channels.  Either yields decline because our expectations on future monetary policy are altered by a ‘signaling effect’ where the purchases signal that the target rate will remain low for longer than it was previously thought.  Or the purchases lead to declines in yields by forcing investors to increase their demand for riskier assets – what is called the ‘supply-induced portfolio re-balance effect’.

The authors argue that there’s an alternative third channel at work which operates through the increase in central bank reserves on commercial banks’ balance sheets and is independent of the assets that central banks purchase.

The researchers explain that central bank reserves can only be held by banks and this segments the market.  This matters for how central bank asset purchases affect financial sector balance sheets and the reaction of the financial market.  Asset purchases enacted with nonbank entities, which cannot hold reserves and instead receive deposits with their correspondent banks, will lead to an expansion of commercial banks’ balance sheets and make them also adjust their portfolios.  The impact of this third channel is therefore a function of both the ratio of purchases from nonbanks and commercial banks’ desire to substitute away from reserves toward other assets.

To offer evidence of this new channel, the authors analyse the large expansion of reserves by the Swiss National Bank in August 2011.  This was unique and different from other QE programmes as they only acquired short-term claims and left the available stock of long-term securities unchanged.  This programme could not have any conventional supply-induced portfolio balance effects on long-term yields. Yet the Swiss long-term bond yields declined following the three key Swiss National Bank announcements on these reserve expansions.  The researchers demonstrate that the declines came predominantly from the reserve-induced portfolio balance channel.

What are the implications of this third channel?  The authors explain that:

  1. central banks that face obstacles in purchasing long-term bonds can implement QE programmes through the purchase of other assets and still reduce long-term yields.  
  2. the strength of the channel depends on the specific market participants, their asset preferences and substitutability along with the market structure in the economy, including bank regulations.
  3. during the exit from QE, when central bank balance sheets are reduced by letting assets mature as in the United States, the resulting reduction in the outstanding reserves could push up long-term interest rates.  This could be in the same way (but reversed) that they were negatively affected when the QE asset purchases were carried out. 

'Transmission of Quantitative Easing: The Role of Central Bank Reserves' by Jens H. E. Christensen and Signe Krogstrup is published in the January 2019 issue of The Economic Journal.

Jens Christensen

Research Advisor at Federal Reserve Bank of San Francisco

Signe Krogstrup

Advisor at International Monetary Fund