Federal Reserve announcements of future purchases of longer-term bonds may affect asset prices by changing market expectations of the future supply of targeted securities. Such announcements may also affect asset prices by signaling that the stance of conventional monetary policy is likely to remain loose for longer than previously anticipated. Research suggests that these signaling effects were a major contributor to the cumulative declines in Treasury security yields following the eight Fed announcements in 2008 and 2009 about its first round of large-scale asset purchases.Monetary policy ; Open market operations

Glenn Rudebusch

Michael Bauer

English

Research Papers in Economics

FRBSF ECONOMIC LETTER 
2011-36 November  21,  2011 
 
 
Signals from Unconventional Monetary Policy 
BY MICHAEL BAUER AND GLENN RUDEBUSCH 
  Federal Reserve announcements of future purchases of longer-term bonds may affect asset 
prices by changing market expectations of the future supply of targeted securities. Such 
announcements may also affect asset prices by signaling that the stance of conventional 
monetary policy is likely to remain loose for longer than previously anticipated. Research 
suggests that these signaling effects were a major contributor to the cumulative declines in 
Treasury security yields following the eight Fed announcements in 2008 and 2009 about its 
first round of large-scale asset purchases. 
 
After lowering short-term interest rates essentially to the zero lower bound, central banks in several 
countries have turned to unconventional measures to provide further monetary policy stimulus 
(Rudebusch 2009). In particular, the Federal Reserve has carried out large-scale asset purchases 
(LSAPs) of Treasury securities and other debt instruments in order to put further downward pressure on 
long-term interest rates, thereby stimulating consumer and business spending. Two rounds of LSAPs, 
dubbed QE1 and QE2 for quantitative easing, took place in 2009 and 2010, with purchases totaling $1.75 
trillion and $600 billion, respectively. On September 21, 2011, the Federal Open Market Committee 
announced a third round of LSAPs, which include purchases of an additional $400 billion in long-term 
Treasury securities financed by the sale of short-term debt. 
Recent research has analyzed the effects of the Fed’s first two LSAP programs on financial markets. 
Studies using a variety of methodologies generally agree that the Fed was successful in lowering long-
term interest rates (see surveys in Williams 2011 and Kozicki et al. 2011). For example, one influential 
study (Gagnon et al. 2011) estimated that QE1 announcements lowered the yield on the ten-year 
Treasury note about 0.50 to 1.0 percentage point. 
However, the exact mechanism by which LSAP announcements lowered long-term interest rates remains 
unclear. One possibility is that such announcements indicate greater Fed demand for specific securities, 
thereby driving up the prices of those securities. Another possibility is that LSAP announcements signal 
that the Fed will maintain an easier stance of conventional monetary policy in the future. In other words, 
the path of the Fed’s policy rate, the federal funds rate, will be lower than previously expected. This 
Economic Letter describes evidence on the relative importance of these two channels (for a more 
detailed explanation of this research, see Bauer and Rudebusch 2011). We find that the effectiveness of 
the Fed’s LSAPs reflected to a considerable extent signals about the likely future path of the short-term 
interest rate. 
 
    
FRBSF Economic Letter 2011-36    November 21, 2011 
 
2 
 
Portfolio balance and signaling 
Long-term interest rates can be separated into two components: expectations of average future short-
term interest rates; and a premium that investors require for bearing the risk of a long-term bond 
investment, known as a term premium. In conventional finance models, neither of these components is 
affected by changes in the supply of bonds. In such models, changes in supply don’t affect expectations of 
future monetary policy or the premium for interest rate risk. 
Researchers have departed from conventional asset price models in two ways to explain the effects of 
LSAPs. First, they have considered what would happen if markets for different fixed income securities 
were largely segmented and different bonds were not perfect substitutes for each other. In such a case, 
shifts in demand or supply for a specific security could directly affect the price of that security. This 
portfolio balance channel assumes that investors are heterogeneous, that is, that different investors 
prefer different kinds of assets. In other words, they have what has been called preferred habitats. As a 
result, the markets for these different kinds of assets are at least partly separated. Consequently, a 
decrease in the supply of long-term bonds available to private investors leads to a lower interest rate 
because of a decrease in the term premium, which in addition to compensation for risk also captures 
imbalances in supply and demand. 
Second, announcements of asset purchases may communicate more information than just the fact that 
the future supply of bonds will change. If that’s the case, then the announcements can affect the 
expectations of market participants regarding future policy rates. For example, the announcements may 
signal that the central bank has changed its views on economic conditions or that its policy reactions or 
objectives have changed. In such a signaling channel, LSAP announcements will affect the expectations 
component of long-term interest rates. In the case of the Fed’s LSAPs, market participants might have 
taken the announcements as signals that the Fed considered the economic situation worse than 
previously thought and that it would leave the policy rate near zero for longer than previously expected. 
Such a turn of events would decrease long-term interest rates by lowering average expectations of future 
short-term interest rates. 
To understand the observed effects of LSAPs on financial markets, policymakers and researchers need to 
evaluate the relative importance of these two channels. Only a few studies have looked at this question. 
Notably, Gagnon and co-authors (2011) are skeptical about signaling and conclude that the portfolio 
balance channel probably explains most of the effects. 
Here, we consider evidence based on responses in the interest rate futures market and movements in 
spreads between rates on different securities. We also use asset price models to separate changes in long-
term interest rates into expectations and term-premium components. We use an event study 
methodology that follows Gagnon et al. (2011), in which the effects of a policy action are estimated by the 
changes in asset prices or interest rates over a tight window of time around its announcement. As long as 
a policy announcement is unexpected and markets incorporate the new information quickly, this 
methodology accurately captures the announcement’s effects on financial markets. Most of the 
information about the QE1 asset purchases came from eight announcements: the initial announcement 
on November 25, 2008; Chairman Bernanke’s speech on December 1, 2009; and six subsequent FOMC 
announcements. The total financial market effects of QE1 are estimated by the cumulative daily changes 
around these eight announcements. 
    
FRBSF Economic Letter 2011-36    November 21, 2011 
 
3 
 
Changes in futures rates and spreads 
Information from money market futures can be used to estimate financial market expectations regarding 
monetary policy rates over short and medium horizons. By examining money market futures rates, one 
can construct a “futures-implied policy path.” Like any interest rate, futures rates contain an 
expectations component and a term premium component. Because the term premium is probably small 
for short maturities, changes in near-
term futures rates mostly reflect 
changes in expectations about 
monetary policy. Figure 1 shows how 
expectations about the path of policy 
changed on the day of the first LSAP 
announcement. The policy path shifted 
downward significantly at all horizons. 
Similarly, adding up the total response 
of futures rates following the eight QE1 
announcements, market participants 
appeared to have significantly lowered 
their expectations about the future 
path of the federal funds rate. 
It is also useful to compare interest 
rate movements of the Treasury 
securities targeted by the LSAPs to movements in rates of other debt securities with the same risk 
characteristics and maturities, such as overnight interest swap (OIS) rates. Assuming that the portfolio 
balance channel only affects risk premiums in targeted securities, movements in OIS rates will reflect 
LSAP signaling effects. By contrast, movements in the spreads between Treasury security yields and OIS 
rates will reflect portfolio balance effects (Joyce et al. 2011). It turns out that Treasury yields and OIS 
rates responded very similarly to LSAP announcements, which supports a signaling channel for LSAPs. 
However, a definitive assessment requires a model that can separate out the responses of the two 
components of Treasury yields. 
Changes in expectations and risk premiums 
To separate the expectations and term premium components of yields, researchers typically use what is 
called a dynamic term structure model. Gagnon et al. (2011) use the output of a model known as Kim-
Wright (see http://www.federalreserve.gov/econresdata/researchdata.htm) to estimate the relative 
importance of the signaling and portfolio balance channels. To ensure that the results from any single 
model are widely applicable, it is helpful to consider alternative model estimates. In Bauer and 
Rudebusch (2011), we estimate several different models. Here we present one set of estimates from our 
preferred model, known as the restricted risk prices model. 
Figure 2 shows the way our preferred model separates out the cumulative decline in five-year and ten-
year yields around the eight LSAP announcements, calculated as the sum of the eight daily changes. The 
total height of a bar corresponds to the cumulative change in yield as estimated by the model. These 
estimates differ from the actual yield changes because the model does not represent interest rates 
perfectly. The five-year yield cumulatively fell 0.97 percentage point and the ten-year yield 0.89 
percentage point. Estimates from our preferred model imply that changes in expectations contributed 
Figure 1 
Changes in futures-implied policy path 
 
0.0
0.5
1.0
1.5
2.0
0 3 6 9 1 21 51 82 12 42 73 03 33 6
Months forward
Percent
11/24/08
11/25/08   
FRBSF Economic Letter 2011-36    November 21, 2011 
 
4 
 
significantly to the decreases in yields. 
Notably, we find the decrease in 
expectations for the average future 
federal funds rate accounted for more 
than 50% of the decrease in the five-
year yield. Our estimates imply that 
changing expectations played a larger 
part than the Kim-Wright model 
suggests. 
Figure 3 shows how changing 
expectations about monetary policy 
affected forward interest rates. 
Forward rates are the rates that can be 
contracted today for an overnight loan 
to be made in the future. They 
therefore reflect expectations about the 
future value of the federal funds rate 
plus a term premium. The blue line 
shows the cumulative changes in 
model-generated forward rates 
following the eight LSAP 
announcements. The red line shows 
the cumulative change in the 
expectations component, that is, the 
response of the expected future path of 
monetary policy to the LSAP 
announcements. The graph shows that 
changes in expectations explained all 
of the changes in forward rates at very 
short horizons and a significant share 
of changes at longer horizons. Thus, 
the signaling effects were sizeable, with 
expectations of future policy rates at horizons of one to two years down by about 0.60 percentage point. 
These results include potentially large statistical uncertainty. To account for this uncertainty, we 
construct a range around our estimates. The dashed lines in Figure 3 represent 95% confidence intervals 
around the estimated changes in policy expectations, which represent the range that we are 95% 
confident contains the true changes. According to our model, the data are consistent with the view that 
changes in medium-term policy expectations account for around 50% of the cumulative yield response 
following LSAP announcements. 
Conclusion 
The Federal Reserve’s 2008 and 2009 LSAP announcements had significant and sizeable effects on 
interest rates, not only by directly changing the supply of Treasury securities, but also in all likelihood by 
affecting market expectations of future policy rates. In other words, the announcements affected rates 
through both a portfolio balance channel and a signaling channel. The relative contributions of the two 
Figure 2 
Decomposition of cumulative effect of QE1 on yields 
 
Figure 3 
Changes in forward rates and policy expectations 
 
-1.20
-1.00
-0.80
-0.60
-0.40
-0.20
0.00
Actual
change
Model
decomposition
Actual
change
Model
decomposition
expectations term premium
percentage 
points
5-year yield 10-year yield
Effects on yields due to changes in:
Actual Actual Model Model
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0 1 22 43 64 86 07 28 49 6 1 0 8 1 2 0
Months forward
percentage points
Forward rates
Expectations
95% confidence
95% confidence1 
     
FRBSF Economic Letter 2011-36    November 21, 2011 
 
 
Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of 
San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Sam Zuckerman and Anita 
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requests for reprint permission to Research.Library.sf@sf.frb.org. 
 
channels appear roughly equal in the United States. Notably this suggests that, even with the federal 
funds rate at the zero lower bound, forward guidance can be a useful tool in the conduct of monetary 
policy that can complement other unconventional monetary policy measures. 
Michael Bauer is an economist in the Economic Research Department of the Federal Reserve Bank of 
San Francisco. 
Glenn Rudebusch is executive vice president and director of research in the Economic Research 
Department of the Federal Reserve Bank of San Francisco. 
 
References 
Bauer, Michael, and Glenn Rudebusch. 2011. “The Signaling Channel for Federal Reserve Bond Purchases.” 
Federal Reserve Bank of San Francisco Working Paper 2011-21. 
http://www.frbsf.org/publications/economics/papers/2011/wp11-21bk.pdf 
Gagnon, Joseph, Matthew Raskin, Julia Remache, and Brian Sack. 2011. “The Financial Market Effects of the 
Federal Reserve’s Large-Scale Asset Purchases.” International Journal of Central Banking 7 (1, March), pp. 
3–43. http://www.ijcb.org/journal/ijcb11q1a1.htm 
Joyce, Michael, Ana Lasaosa, Ibrahim Stevens, and Matthew Tong. 2011. “The Financial Market Impact of 
Quantitative Easing in the United Kingdom.” International Journal of Central Banking 7(3, September), pp. 
113–161. http://www.ijcb.org/journal/ijcb11q3a5.htm 
Kozicki, Sharon, Eric Santor, and Lena Suchanek. 2011. “Unconventional Monetary Policy: The International 
Experience with Central Bank Asset Purchases.” Bank of Canada Review, Spring. 
http://www.bankofcanada.ca/wp-content/uploads/2011/05/kozicki.pdf 
Rudebusch, Glenn D. 2009. “The Fed’s Monetary Policy Response to the Current Crisis.” FRBSF Economic Letter 
2009-17 (May 22). http://www.frbsf.org/publications/economics/letter/2009/el2009-17.html 
Williams, John C. 2011. “Unconventional Monetary Policy: Lessons from the Past Three Years.” FRBSF Economic 
Letter 2011-31 (October 3). http://www.frbsf.org/publications/economics/letter/2011/el2011-31.html 
 
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The Signaling Channel for Federal Reserve Bond Purchases.” Federal Reserve Bank of San Francisco Working Paper 2011-21. http://www.frbsf.org/publications/economics/papers/2011/wp11-21bk.pdf

Signals from unconventional monetary policy

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Signals from unconventional monetary policy

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