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10 Technical Appendix: Construction of the Real-Time LSAP Measures
The LSAP measures are constructed by incorporating official FOMC policy announcements and real-time market information from various sources, in particular the Survey of Primary Dealers compiled by the Federal Reserve Bank of New York. The survey contains valuable information about market expectations of future monetary policy, for instance, on how soon the FOMC may “taper” the QE III purchases, when the first federal funds rate “lift-off” is expected to occur, and the likely size of the SOMA balance in the following five years, etc.
The first step in constructing the LSAP measures is to impute the market participants’ projections of future excess SOMA balance at each point of time since November 2008. Therefore, in addition to the explicit LSAP announcements by the FOMC as listed in Table A1, I also need to trace how the market’s expectations of the future LSAP program evolve over time, for instance, on the monthly pace of the asset purchases that have already been announced, or when and how soon the purchased LSAP assets will be sold off, and when the size of the Fed’s balance sheet is expected to return to normal, which are closely related to the Fed’s “forward guidance” policy. The Survey of Primary Dealers contains key information based on which the market projections of future SOMA balance paths can be imputed, with a minimal number of assumptions to be made.
In particular, in constructing the real-time LSAP measures, the following observations and assumptions are utilized:
1) Market participants anticipate that the FOMC will implement the announced asset purchases in a steady pace within the announced time frame. For instance, when the FOMC announced on November 3, 2010 that it “intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011,” I assume that the market expects a purchasing pace of about $75 billion each month from November 2010 to June 2011.
2) I assume that the market participants anticipate a steady pace for the FOMC to sell off the LSAP assets during the “exit.” Moreover, the projected SOMA balance paths are imputed based on the following observations and assumptions:
i. Throughout the QE I period (November 2008 to March 2010), market participants had generally anticipated that the purchased assets would be sold off and the Fed’s balance sheet would return to normal by the first quarter of 2016;
ii. During the second half of 2010 and the first half of 2011, market participants had expected that the passive runoff of LSAP assets (i.e., the FOMC stops re-investing the principal payments from matured LSAP securities) would occur at “some point in 2012,” and the sell-off would begin in early 2013 and would take five years to finish, as reflected in the Survey of Primary Dealers during this period;
iii. Since the FOMC explicitly announced its “exit principle” in June 2011 and the sequencing of federal funds rate “lift-off” and the LSAP unwinding steps, I assume that the market participants have expected that the passive runoff of LSAP assets would begin six months prior to the “lift-off” and the active sell-off would begin nine months after the “lift-off,” and the sell-off would take five years to finish.
3) Unless the FOMC explicitly announces a new purchasing plan, I assume that the market participants do not expect any new purchases beyond the ones that have already been announced. Of course, prior to any FOMC announcement, it is possible that market participants might have already anticipated some changes to the existing plan. However, market information regarding such views is sparse and very unreliable. Therefore, a conservative approach seems more appropriate here and I assume that market participants do not anticipate any new purchases until the FOMC makes the announcement.
4) Survey results on the future path of the SOMA balance size come with a range, and the median responses of the surveyed projections are used in constructing the LSAP measures.
Once the market projections of future SOMA balance paths are obtained, the next step is to calculate the LSAP measure, defined as the present discounted value of the excess-SOMA-balance-to-potential-GDP ratio at each point of time t, excluding the holdings of Treasury bills
where SOMAt is the SOMA balance excluding holdings of Treasury bills,
The LSAPN measure is constructed in a similar fashion, except that at each point of time, I assume that market participants do not update the expected length of the holding period of the LSAP assets that have already been purchased. For instance, after the completion of QE I purchases in March 2010, even if market participants have gradually updated their expectations of the unloading schedule of all LSAP assets, I assume that the market participants will only update their expectations of the length of the holding period for assets to be purchased going forward, but not the QE I assets, i.e., the “forward guidance” after March 2010 does not affect market projections of the unloading schedule of QE I assets. Therefore, the LSAPN measure only captures the effects of asset purchases per se, but is not affected by the Fed’s “forward guidance” over time, and the difference between LSAP and LSAPN captures the influences of “forward guidance” in extending the holding period of purchased LSAP assets.
I thank Roberto Cardarelli, Andy Levin, Rebecca McCaughrin, and Gian Maria Milesi-Ferretti for helpful comments.
For instance, in his congressional testimony on July 17, 2013, the Federal Reserve Chairman Ben Bernanke made the following remarks on the QE III purchases “…asset purchases depend on economic and financial developments, they are by no means on a preset course.”
The Federal Reserve’s primary dealers consist of large commercial banks and securities brokers and dealers who serve as trading counterparties of the Federal Reserve Bank of New York in its implementation of monetary policy on behalf of the Federal Reserve. The current complete list of primary dealers can be found at http://www.newyorkfed.org/markets/pridealers_current.html.
Here I assume that the LSAP purchases affect bond yields and term premiums primarily through stock effects, i.e., “persistent changes in prices that result from movements along Treasury demand curves,” rather than flow effects (“response of prices to the ongoing purchase operations” due to “sluggish price discovery” (D’Amico and King, forthcoming). As these two authors find out, the majority of bond yield responses to the $300 billion Treasury purchases during QE I in 2009 were due to stock effects (50 basis points) rather than flow effects (3 to 4 basis points).
Of course, “forward guidance” and the LSAP program are so intimately related to each other that there is not an approach to clearly separate their effects. For instance, one may also argue that, in deciding the magnitude of QE II purchases, the FOMC might have already taken into account the “forward guidance” and changes in market expectations of the length of holding period of QE I assets after the completion of QE I purchases, and thus the LSAPN measure of QE II only captures part of the stimulus that the FOMC intended to provide through LSAP by then, so that the estimated effect is a lower bound of the LSAP effect in QE II.
Even opinions among the FOMC members seem to be divided. For instance, according to published minutes of the March 20, 2013 FOMC meeting, some FOMC members “expressed the view that these effects had likely been stronger during the Federal Reserve’s initial large-scale asset purchases … Other participants, however, saw little evidence that the efficacy of asset purchases had declined over time, and a couple of these suggested that the effectiveness of purchases might even have increased more recently.”
For instance, the FOMC statement on September 13, 2012 indicates that the committee “currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.” However, the simultaneously published “FOMC Participants’ Assessments of Appropriate Monetary Policy” reveals that at least 6 of the 19 FOMC participants would like to raise the federal funds rate by the end of 2014. Undoubtedly, this has generated uncertainties regarding the future path of short-term interest rates and more generally, the Fed’s exit strategy.
One may argue that when the short-term interest rate becomes bounded by zero, the short rate process, if previously dictated by a simple Taylor rule, becomes non-linear, and the projection of future short rates may not be linear any more. However, even after the short rate hits the zero bound, the average of expected future short rate (e.g., over the next ten years) remains well above zero (Figure 3), and as long as a central bank aims at lowering the projected future short rate path, equation (5) should still be a valid specification.
The estimates presented here are very close to those obtained in other studies. For instance, the implied “signaling” effect of QE I purchases on the average expected future short rates over the next ten years is 27 basis points (based on estimates in Table 4) or 30 basis points (based on estimates in Table 5). In their event study, Bauer and Rudebusch (2013) aggregate the daily changes in their estimates of expected future short rates on all key QE I announcement days and obtain a cumulative “signalling”effect between zero and 60 basis points for different maturity horizons. They do not report a “signaling” effect for the average expected future short rate over next ten years, but from their Figure 2, such an average would be very close to 30 basis points, almost identical to the implied estimates here.
I also experimented with adding other potential determinants, for instance variables representing quantity of outstanding Treasury securities. The coefficient estimates are not statistically significant. Another possible determinant is foreign official purchases of U.S. Treasury securities; however, previous studies have not found a large and significant effect on bond yields by such purchases (Rudebusch, Swanson, and Wu 2006).