Quantitative Easing and the Yield Curve

Under normal conditions, central banks conduct monetary policy by adjusting a short-term policy rate. When that rate approaches its effective lower bound, however, there is little room left for conventional rate cuts. Quantitative easing (QE) offers another way to loosen monetary conditions. The central bank purchases large quantities of long-term securities (usually government bonds) thereby increasing their prices and lowering their yields.

To understand QE, it helps to separate a long-term bond yield into two components. The first is the average short-term interest rate investors expect over the life of the bond. The second is the term premium: the additional compensation investors demand for holding a longer-term asset whose price may fluctuate. QE can reduce long-term yields by affecting either component, although the relative importance of each is difficult to measure.

The signaling channel operates through expected short-term rates. By announcing a large and potentially prolonged asset-purchase program, a central bank may convince investors that its policy rate will remain low for longer than previously expected. The portfolio-balance channel instead operates through the term premium. When the central bank removes long-duration bonds from the market, private investors hold less interest-rate risk and rebalance toward other assets, pushing down yields more broadly.

QE will therefore tend to flatten the yield curve if it lowers long-term yields while the short end remains anchored near zero. The result is not automatic, however. If investors believe QE will successfully raise growth and inflation, expected future interest rates may increase, placing upward pressure on longer-term yields. A QE announcement can thus lower yields immediately while contributing to a steeper curve later as the economic outlook improves.

The effect of QE depends on both the size of the purchases and the message they convey. Markets care about which assets are being purchased, how long the program will last, and what it implies about future policy. This is why tapering or ending QE can move yields even before the central bank sells any bonds. QE affects the yield curve not simply by creating money, but by changing the supply, distribution, and expected path of interest-rate risk.