By Steven K. Beckner

(MNI) – The San Francisco Federal Reserve Bank’s top economist
argues that “forward guidance” about the future of the path of the
federal funds rate can be an effective tool for easing monetary policy,
in a research paper released Monday.

San Francisco Fed director of research Glenn Rudebusch, writing in
the Bank’s Nov. 21 Economic Letter, says the Fed’s past large-scale
asset purchases, or quantitative easing, worked not just by reducing
bond supplies but also by signaling the Fed’s intent to keep short-term
interest rates low.

Rudebusch, writing with fellow San Francisco Fed economist Michael
Bauer, said that quantitative easing both through a “portfolio balance
channel” and a “signalling channel” and said the those two channels have
a roughly equal impact on long-term interest rates.

When the Fed buys longer term securities, it reduces the supply of
those securities, pushing up their prices and lowering their yields. The
Fed staffers write that “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.”

But that’s not the only way that asset purchases ease policy,
Rudebusch and Bauer contend.

“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,” they write.
“Such a turn of events would decrease long-term interest rates by
lowering average expectations of future short-term interest rates.”

Analyzing bond yield behavior following the various QE1 and QE2
announcements, Rudebusch and Bauer say “the five-year yield cumulatively
fell 0.97 percentage point and the 10-year yield 0.89 percentage
point.”

“Estimates from our preferred model imply that changes in
expectations contributed significantly to the decreases in yields,” they
say.

“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,” they add.

The San Francisco Fed economists write that “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,” they continue. “The
relative contributions of the two channels appear roughly equal in the
United States.”

Based on their estimates of the expectational or signaling effect
of the Q.E. announcements, Rudebusch and Bauer conclude 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.”

** Market News International **

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