Conventional monetary policies, normally carried forward by central banks, mainly fixing short term interest rates, become ineffective when rates are close to zero and the economy can hardly be stimulated anymore, being stuck in a ‘liquidity trap’ (Krugman, 1998). Low rates should ease credit allocation through the banking system, making it cheaper, but in some circumstances the economy looks like a patient which is too ill to properly benefit from standard treatments.
Quantitative easing (QE), an unconventional monetary policy performed by central banks, modifies their balance sheet, with a short to long security swap. The balance sheet of any central bank is the fulcrum of its monetary policy, which QE reshapes with asset substitutions (i.e. selling short term bonds and buying riskier and longer termed assets) or balance sheet increases, so raising the monetary base.
The term structure of interest rates represents a key parameter of any monetary policy intervention; with QE, the term structure should flatten, due to the fact that the central bank swaps short with long termed bonds, and may also increase its risk profile, if low risk treasury bills are replaced by asset – backed securities.
QE increases inflation, but its impact on real (=deflated) rates is not so clear cut; long term real rates may incorporate lower risk premiums and so decrease.
If anybody has further explanations or tips, she or he is welcome!
I would say the evidence is fairly clear that QE in the US depressed real bond yields, We can observe these yields directly by the real interest rate on TIPS. I attach a chart of the 10-year TIP yield. The real yield is depressed through the various rounds of QE but surges when Bernanke starts the taper talk last May/June. So why the real yield? I would point out that the classic Fisher equation i = r + p where i is the nominal yield, r is the real yield and p is inflation has only two degrees of freedom. So which is the residual? It seems that Fed buying can indeed depress the nominal yield for a while (i is under Fed influence) but investors/speculators can make any bet on p in any nominal yield environment. If I think inflation is headed higher than embedded in breakevens, I buy the TIP and short the corresponding maturity nominal Treasury (which hedges any real interest rate risk--putting aside tax issues and some more subtle arguments about duration). It seems, therefore, that the inflation breakeven is market determined. Thus real rates are the residual.and QE as operated by the Fed depressed real yields.
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