In particular, by purchasing longer-term securities, the Federal Reserve removes duration risk from the market, which should help to reduce the term premium that investors demand for holding longer-term securities. That effect should in turn boost other asset prices, as those investors displaced by the Fed’s purchases would likely seek to hold alternative types of securities. Some research studies have estimated that the effects of the earlier expansion of our securities holdings by just over $ trillion lowered longer-term Treasury yields by about 50 basis points through this portfolio balance channel. 3 These effects on Treasury yields appear to have been transmitted into lower rates on private credit instruments and higher asset prices more broadly. 1  Reflecting the long-standing practice of the Desk, principal payments on our holdings of Treasury securities were already being fully reinvested at Treasury auctions. 2  The Fed’s asset purchases initially had an additional and important effect on mortgage rates by improving the functioning of the MBS market. As I have noted in earlier speeches, the use of the central bank’s balance sheet can be particularly effective when focused on markets in which liquidity and market functioning have become impaired. The focus here is whether, in addition to those effects, the size and composition of the Fed’s balance sheet have a lasting impact on financial conditions in well-functioning and relatively liquid markets.
The market response to the reinvestment decision at the August FOMC meeting seemed largely in line with the estimated effects from the earlier round of asset purchases, once we account for the size of the surprise and the anticipatory pricing that occurred ahead of its announcement. And the increased expectations for balance sheet expansion in response to the September FOMC statement also generated a sizable market response. To be sure, I think it is fair to say that this is an imperfect policy tool. Even under the estimates noted earlier, the Federal Reserve had to increase its securities holdings considerably to induce the estimated 50 basis point response of longer-term rates. In addition, there is a large degree of uncertainty surrounding the estimates of these effects, given our limited experience with this instrument. Lastly, it is reasonable to assume that the effects of balance sheet expansion would diminish at some point, especially if yields were to  6  The duration of our Treasury purchases are modestly higher than the duration of the MBS that are being produced in the market. 7  See “The Outlook, Policy Choices and Our Mandate,” October 1, 2010. 4  BIS Review 128/2010  move to extremely low levels. Nevertheless, the tool appears to be working, and it is not clear that we have yet reached a point of diminishing effects. Some observers have argued that balance sheet changes, even if they influence longer-term interest rates, will not affect the economy because the transmission mechanism is broken.