The Effect of the Fed's Large-scale Asset Purchases on Inflation Expectations

Author Name Willem THORBECKE (Senior Fellow, RIETI)
Research Project East Asian Production Networks, Trade, Exchange Rates, and Global Imbalances
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This Non Technical Summary does not constitute part of the above-captioned Discussion Paper but has been prepared for the purpose of providing a bold outline of the paper, based on findings from the analysis for the paper and focusing primarily on their implications for policy. For details of the analysis, read the captioned Discussion Paper. Views expressed in this Non Technical Summary are solely those of the individual author(s), and do not necessarily represent the views of the Research Institute of Economy, Trade and Industry (RIETI).

Macroeconomy and Low Birthrate/Aging Population (FY2016-FY2019)
East Asian Production Networks, Trade, Exchange Rates, and Global Imbalances

In 2008, aggregate demand in the United States collapsed and triggered deflation. The U.S. Federal Reserve Board (Fed), unable to lower short-term interest rates, turned to large-scale asset purchases (LSAP) to stimulate the economy. It purchased housing agency debt, mortgage-backed securities, and longer-term Treasury bonds. How did these actions affect financial markets and deflationary expectations?

LSAP news could raise expected inflation if investors expect it to stimulate the economy. LSAP news could also lower expected inflation if investors learn from it that the Fed is forecasting greater deflation (see Romer and Romer, 2001).

I investigated how LSAP news affects inflationary expectations. If investors believe that LSAP would raise inflation, they would respond to news of LSAP by selling assets exposed to inflation and purchasing assets that hedge against inflation. This would lower the prices of assets that are harmed by inflation and raise the prices of assets that benefit from inflation, generating a positive relationship between assets' sensitivities to inflation (their inflation betas) and asset returns. If investors instead interpret LSAP news to imply lower inflation, they would react in the opposite way and produce a negative relationship between inflation betas and asset returns.

To obtain inflation betas, I regress returns on 60 assets on the left-hand side on inflation and other macroeconomic variables on the right-hand side. For LSAP announcement dates, I used what Roache and Rousset (2013) call the standard event dates for the first round of asset purchases (QE1), the second round (QE2), and the third round (QE3). I then regress returns on the 60 assets over the 24 hours bracketing LSAP events on the assets' inflation betas.

Table 1 reports the results. Positive values indicate that investors expect more inflation, and negative values imply the opposite. For the first seven events, the coefficients in Table 1 are always negative, indicating that LSAP news cause investors to expect less inflation. Examining the first five events, Wright (2011) found that events 1, 2, 3, and 5 were episodes when policy was more expansionary than investors expected. The surprise expansionary components were especially strong for events 3 and 5. Swanson (2017) reported that the fifth event corresponded to a surprise 5.6 standard deviation expansionary shock.

These events influenced financial markets both by causing them to expect expansionary policies that might raise output and inflation and by indicating that the Fed was expecting lower inflation. The negative coefficients imply that markets did not expect LSAP to raise inflation. In the months when events 1, 2, 3, and 5 occurred, the consumer price index was experiencing deflation. The deflation rate when events 1 and 2 were announced was easily the highest the U.S. economy had witnessed over the last 60 years, and was almost six standard deviations away from zero. The combination of deflation and untried policy tools left investors unconvinced that the Fed could raise inflation.

For the fourth event, the coefficient in Table 1 equals -0.0078 and is significant at the 1% level. This coefficient implies that the assets with the largest inflation betas in the sample fell by 2.8% on average, and the assets the most negative inflation betas rose by 2.8% on average. According to Wright's calculation, the fourth event was a contractionary surprise to markets. So this event both underwhelmed investors in terms of what the Fed was doing to fight deflation and conveyed news of low inflation through the inflation revelation channel.

The last event of QE1 occurred on 4 November 2009. The coefficient is positive and significant at the 1% level. The U.S. economy was recovering at this time and exiting from deflation, and the announcement caused investors to expect more inflation.

For QE2, the last two events in October and November 2010 caused returns on assets that hedge against inflation to fall. Both of these announcements were classified by Wright (2011) as events when monetary policy was more contractionary than expected. This contractionary policy news, combined with forecasts of lower inflation through the inflation revelation channel, caused market participants to revise their perceptions of inflation downwards.

QE3 began two years later, in August and September of 2012. The seasonally adjusted annual change in the price index for personal consumption expenditures excluding food and energy for the previous two quarters equaled 2.1% and 1.9%, close to the Fed's target of 2% for this variable. Both of the QE3 announcements in the third quarter of 2012 caused investors to expect higher inflation.

These results indicate that, as actual inflation approached its target, the Fed was better able to influence inflationary expectations in the desired direction. The ability to affect expected inflation is important for monetary policy. At the zero lower bound, increases in expected inflation cause one-for-one decreases in the real interest rate. This provides needed stimulus when the economy faces deflationary risks. At higher interest rates, the ability to keep inflationary expectations anchored reduces the extra return that bondholders require to compensate for the risk of inflation. This keeps long-term interest rates from rising too high and choking economic activity. To influence inflation expectations, central bankers should remember the time-honored lesson that inflationary credibility increases as inflationary outcomes improve.

Table 1. Relationship between Assets' Returns and their Inflation Betas on Days of Large-scale Asset Purchase Announcements
Event Number Date Phase Coefficient on Inflation Beta Standard Error
1 11/25/2008 QE1 -0.0032 0.0021
2 12/1/2008 QE1 -0.0039 0.0037
3 12/16/2008 QE1 -0.0033 0.0023
4 1/28/2009 QE1 -0.0078*** 0.0023
5 3/18/2009 QE1 -0.0006 0.0049
6 8/12/2009 QE1 -0.0011 0.0008
7 9/23/2009 QE1 -0.0008 0.0011
8 11/4/2009 QE1 0.0044*** 0.0012
9 8/10/2010 QE2 0.0005 0.0007
10 8/27/2010 QE2 -0.0016 0.0010
11 10/15/2010 QE2 -0.0022*** 0.0006
12 11/3/2010 QE2 -0.0025*** 0.0008
13 8/31/2012 QE3 0.0032*** 0.0010
14 9/13/2012 QE3 0.0034** 0.0014
Note: The table presents coefficients from a cross-sectional regression of returns on 60 assets on the days of announcements of large-scale asset purchases on inflation betas for the 60 assets.
Inflation betas are obtained from iterated nonlinear seemingly unrelated regression estimation of a multi-factor model including returns on the 60 assets on the left-hand side and the Treasury bond/Treasury bill spread, the corporate bond/Treasury bond spread, the monthly growth rate in industrial production, the change in expected inflation, and unexpected inflation on the right-hand side.
Unexpected inflation comes from the residuals of a regression of inflation on lagged inflation and current and lagged Treasury bill returns. QE1 refers to the first round of asset purchases, QE2 to the second round, and QE3 to the third round.
*** (**) denotes significance at the 1% (5%) level.
  • Roache, S. and M. Rousset. (2013). "Unconventional Monetary Policy and Asset Price Risk," IMF Working Paper WP/13/190.
  • Romer, C. and D. Romer. (2001). "Federal Reserve Information and the Behavior of Interest Rates," American Economic Review 90 (3), pp. 429-457.
  • Swanson, E. (2017). "Measuring the Effects of Federal Reserve Forward Guidance and Asset Purchases on Financial Markets," NBER Working Paper No. 23311.
  • Thorbecke, W. (2017), "The Effect of the Fed’s Large-Scale Asset Purchases on Inflation Expectations," RIETI Discussion Paper No. 17-E-097.
  • Wright, J. H. (2011). "What Does Monetary Policy Do to Long-term Interest Rates at the Zero Lower Bound?" NBER Working Paper No. 17154.