DP11005 Forward Guidance in the Yield Curve: Short Rates versus Bond Supply

Author(s): Robin Greenwood, Samuel G Hanson, Dimitri Vayanos
Publication Date: December 2015
Keyword(s): central banks, forward guidance, limited arbitrage, quantitative easing, yield curve
JEL(s): E43, E52, G12, H63
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11005

We present a model of the yield curve in which the central bank can provide market participants with forward guidance on both future short rates and on future Quantitative Easing (QE) operations, which affect bond supply. Forward guidance on short rates works through the expectations hypothesis, while forward guidance on QE works through expected future bond risk premia. If a QE operation is expected to be undone in the near term, then its announcement will have a hump-shaped effect on the yield and forward-rate curves; otherwise the effect may be increasing with maturity. Humps associated to QE announcements typically occur at maturities longer than those associated to short-rate announcements, even when the effects of the former are expected to last over a shorter horizon. We use our model to re-examine the empirical evidence on QE announcements in the US.