Interest Rates Through the QE2 Episode

The Federal Reserve's second round of quantitative easing, which began in November and is commonly referred to as QE2, is slated to end this month. This chart via Bloomberg shows how it worked:

Bloomberg - The red dashed line represents total Fed holdings of Treasury notes and bills. You can see the sharp rise starting in November 2010. The Fed purchased $600 billion of long-term government bonds, giving banks $600 billion more reserves in return. (Bank reserves are accounts banks hold at the Fed.)

The vertical lines mark the two big Fed announcements. On Aug. 10, the central bank announced that it would reinvest maturing assets in Treasuries. On Nov. 3, it announced the actual QE2 program.

QE2 doesn't seem to have lowered any interest rates. Yes, five-year rates trended down between announcements, though no faster than before. The November QE2 announcement and subsequent purchases coincided with a sharp Treasury rate rise. The five-year yields where the Fed bought most heavily didn't decline relative to the other rates, as the Fed’s “segmented markets” theory predicts. The corporate and mortgage rates that matter for the rest of the economy rose throughout the episode.

Expected inflation could explain the sharp rise in long-term yields starting in November. But the rate for 10-year Treasury Inflation Protected Securities, or TIPS, rose in parallel, contradicting that interpretation. Simultaneously denying Bernanke, however, the five-year TIP rate didn't rise. An increase in that rate would have been a sign of a stronger economy in the next five years. The bond market is a tough critic.

You can read the rest of the article by John H Cochrane here at Bloomberg.com