What exactly is quantitative easing? Part 3
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The Fed has all sorts of levers to influence short term rates, from the discount rate to the Fed Funds rate to open market operations. However, they have no control over long-term rates. Longer-term interest rates have historically been completely market-driven. The shape of the yield curve has provided important signals regarding the outlook for the U.S. economy. However, the Fed is now manipulating that too.
The Fed instituted quantitative easing in order to relieve pressure on the real estate market and consumers. It truly was an unorthodox move to try and stimulate the economy. Since mortgage rates are determined primarily by the long-term bond market (particularly the 10 year), the Fed had to intervene directly into these markets to influence rates.
To lower long-term rates which affect corporate borrowers, they have bought 10 year Treasuries directly in the market. Buying bonds lowers interest rates. The Fed was hoping that Corporate America would take advantage of these low rates and invest in additional capacity, which would hopefully employ more people. So far, we have very low capacity utilization rates, so there really isn’t much of an incentive to expand capacity. Companies have taken advantage of the low rates to issue long-term debt and buy back stock, which is not what the Fed was hoping would happen.
The main mission of quantitative easing however was to provide relief for homeowners by allowing them to refinance their mortgages at lower rates. This puts money directly into people’s pockets by reducing the monthly mortgage payment. The Fed has been buying TBA paper, which increases bond prices and reduces borrowing rates. Pretty much everyone who has an underwater house has taken advantage of these low rates.
The Fed periodically puts out a list of what it has purchased. So far, they have been concentrating on Fannie Mae TBAs, followed by Ginnie Mae TBAs. As a general rule, they purchase about $3 billion worth of mortgage backed securities a day. The Fed has committed to buy $85 billion worth of Treasuries and mortgage backed securities per month.
One final lever the Fed has used to influence long term rates was called Operation Twist. Operation Twist was used to increase the duration of the Fed’s balance sheet. They would sell short term Treasury notes (or simply let the mature) and then use the proceeds to buy the 10 year bond. While this isn’t exactly quantitative easing (because they are not net purchases), they did have the effect of lowering long-term interest rates.