The Effect of the Federal Reserve’s Securities Holdings on Longer-term Interest Rates

Abstract

In an effort to promote more accommodative financial conditions following the financial crisis of 2008 and the ensuing recession, and at a time when the conventional monetary policy tool--the federal funds rate--was at its effective lower bound, the Federal Reserve conducted large-scale asset purchases (LSAPs) and a maturity extension program (MEP). By increasing the amount of longer-term Treasury securities and agency MBS on the Federal Reserve's balance sheet, and thereby reducing the amount of longer-term Treasury securities and agency MBS that the public would have held otherwise, these purchase programs put downward pressure on longer-term interest rates. This note outlines a way to estimate by how much Federal Reserve securities holdings resulting from these purchase programs reduce longer-term interest rates. In particular, we estimate the term premium effect (TPE) on the 10-year Treasury yield. Currently, our model suggests that the cumulative effect of the Federal Reserve's LSAPs and MEP results in a reduction in the 10-year Treasury yield term premium of about 100 basis points. By the end of 2017, the term premium will be held down by about 85 basis points. The slight narrowing of the TPE reflects the average maturity of the Federal Reserve's portfolio declining and the cessation of reinvestments drawing nearer.

Keywords: Federal Reserve, monetary policy, term premium effect

JEL Classification: E5