Tuesday, October 01, 2013

Quantitative Easing Steady, But Bond and Gold Prices Spike

The Federal Reserve's decision on September 18th to continue purchasing $85 billion in longer-term bonds each month took financial markets by surprise. Collective wisdom expected that the Fed would begin tapering its purchases of U.S. Treasury bonds and mortgage-backed securitiesa policy first begun in the aftermath of the financial crisis and known as quantitative easingand thus, slowing its expansion of the money supply. Instead the Federal Open Market Committee, which determines monetary policy for the Fed, decided that unemployment was still high enough and inflation still low enough to justify a continued expansion of the money supply at the current rate.

It remains to be seen whether the policy will have its intended effect on the economy, but its impact on financial markets can be seen in price spikes at the time of the announcement.

Because market participants expected the Federal Reserve to demand fewer US Treasuries in the future, the price for bonds in the future was expected to be lower than now. In turn, the expectation of lower prices in the future had decreased demand for bonds now, putting downward pressure on current bond prices. If the Fed had acted as the market anticipated, the Fed’s announcement would have had only a minimal impact on prices. When the Fed instead indicated that it would maintain its demand for bonds, buyers and sellers of bonds realized that the future price of bonds would be higher than they expected, and since the future price was going to be higher, owning bonds now suddenly became more attractive. As a result, the current demand for bonds increased, pushing the price of bonds up. This price change can be seen in the graph of an indicator of average bond prices, which shot up just after 2pm Eastern time, when the Federal Reserve made its September 18th announcement.

(Click image to enlarge.)

Because the effective interest rates paid by bonds decrease when bond prices increase (check your textbook or watch this video from the Khan academy for an explanation of the inverse relationship between bond prices and interest rates), the yield on longer-term US Treasury bonds declined on Sept 18, as can be seen in the screenshot below.

(Click image to enlarge.)

Also notice how low the short-term interest rate is: one-hundredth of 1% for 1-month U.S. Treasury bills. This extremely low rate is another sign of the Federal Reserve's desire to stimulate the economy. In fact, if it could set short-term interest rates lower, it probably would. Instead, since nominal interest rates cannot go below 0% (if they did, you would be paying banks to keep your money with them), the Federal Reserve purchases longer-term bonds in an attempt to give the economy extra stimulus beyond extremely low short-term interest rates.

If the Fed is unable to reverse it later, this extra monetary stimulus will lead to higher inflation. Since gold is traditionally a hedge against inflation (that is, an asset that maintains its real value when prices increase), fears of higher inflation tend to increase the price of gold. As a result, the spike in bond prices due to the Fed’s announcement was accompanied by a spike in gold prices. (Note: the difference in timing on the horizontal axes of the graphs is due to differences in time zone and how often data on prices is collected.)

In an upcoming post, I'll look at how the Fed's decision to extend quantitative easing changed foreign exchange rates, which was actually how I was alerted that the Fed had made a surprise announcement in the first place.

Discussion questions:
  1. How do you think the Fed's decision to extend quantitative easing affected the foreign exchange market? Did the US dollar appreciate or depreciate?

  2. What other markets might have seen dramatic changes due to the Fed's decision?

  3. Ben Bernanke, the Chairman of the Federal Reserve, has stated that he wants monetary policy to be more transparent. What does the financial market's reaction to the Federal Reserve's announcement suggest about the transparency of monetary policy?

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