Economic growth and interest rates

There are two main channels through which quantitative easing affects interest rates and stimulates economic growth: signaling and portfolio rebalancing. 

The Federal Reserve sends a signal to markets about the future path of the federal funds rate through its forward guidance, clearly communicating its policy about what it will or will not do.

In addition, it shows credible commitment to keep interest rates low by purchasing a large quantity of assets. Investors know that if the Fed raises interest rates while holding these assets, it will lose money on them.

This sends a powerful signal, which lowers the yield on all bonds with effects depending on bond maturity. The impact will be larger on intermediate maturity bonds compared to long-term maturity bonds.

This is because the Fed’s commitment to keeping rates low will last only until the economy recovers, at which point it will sell the accumulated assets. (“Treasury market yields”).

Quantitative easing also impacts the economy and rates through a mechanism known as portfolio rebalancing. 

When the Fed purchases large-scale assets, it reduces the size of securities the private sector holds and increases the amount of short-term, risk-free bank reserves.

The Fed does this by bidding up the price of these assets, which lowers the expected return.

Treasury securities have a term premium. This premium is associated with holding assets with a long duration and the interest-rate risk that comes with it.

It represents an additional return investors want to have for accepting fixed long-term yields. 

And it must be above the average of expected future short-term interest rates.

The Fed’s purchase of a large quantity of these long-duration assets reduces the risk and should lower the premium to hold that risk.

This portfolio rebalancing not only reduces the yield on the long-term assets being purchased, it also spills over to yields of other assets.

Low prospective returns on Treasuries and agency MBS lead investors to shift some of their portfolio to other assets, such as corporate bonds and equities, bidding their prices up.

Individual borrowers will find interest rates on long-term loans such as mortgages lower than they would otherwise be. 

This explains why 30-year, fixed-rate mortgages were lower during the pandemic, resulting in refinance boom (“Average 30-year, fixed-rate mortgages”).

The value of assets held by households and firms will also be higher.

The Federal Reserve will end its quantitative easing program in March 2022. It is also expected that there will be three federal funds rate hikes this year.

As a result, the yield on long-term securities and borrowing costs for consumers will also start to increase.

DAWIT KEBEDE is senior economist for Credit Union National Association. Contact him at 608-231-5791 or at dkebede@cuna.coop.

This article appeared in the Spring 2022 issue of Credit Union Magazine. Subscribe here.