The policy decisions of several of the world’s largest central banks turn on a tricky empirical judgement – the effect of quantitative easing purchases on government bond yields. In the UK, the empirics have got much harder.
- When QE was first introduced, the UK Monetary Policy Committee (MPC) announcements about the amount of assets the Bank of England intended to purchase contained significant news for market expectations.
As such, market reaction to these announcements could be used to estimate the effect of QE on gilt yields (for example see Joyce et al. 2011).
- Over time, market participants learned how the MPC’s QE decisions depend on the economic outlook.
Subsequent MPC announcements thus contained less news about gilt purchases and this made it harder to identify the impact of QE from these events.
A new empirical approach
Our recent research overcomes this identification problem by analysing the reaction of gilt yields to so-called operational market notices (Banerjee et al. 2012).
When the Bank purchases gilts in reverse auctions, it distinguishes different groups of gilts depending on their remaining maturity. These groupings or ‘auction maturity sectors’ are specified in advance and have only been changed infrequently and then for operational reasons (e.g. to prevent the Bank from owning large proportions of specific parts of the yield curve). In essence, this establishes a distribution of purchases across maturities that can be expected for any given aggregate level of QE buying.
Our approach is to focus on changes in the distribution stemming from unanticipated operational market notices. It is these changes to the auction maturity sectors (summarised in Table 1) that are the source of the three natural experiments used in this article to identify the impact of QE.
Although this approach might not capture all of the effects of QE on gilt yields, it can help to identify a part of the effect. Furthermore, because the notices (in March 2009, August 2009, and February 2012) span the period of QE purchases, they can also be used to determine if the strength of this effect has changed over time.
Table 1. Changes in auction maturity sectors
Quantifying the news in market notices
To assess the reaction of gilt yields to changes in the auction maturity sectors, a measure of the news contained in these market notices is calculated. This measure, which is referred to as the ‘local supply surprise’, captures the difference between expected purchases of each gilt before and after the market notice (measured relative to the outstanding amount of gilts of similar maturity remaining in the private sector).
Figure 1. Relationship between local supply surprise and two-day change in gilt yields, February 2012
Figure 2. Relationship between local supply surprise and two-day change in gilt yields, August 2009
Figure 3. Relationship between local supply surprise and two-day change in gilt yields, March 2009
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Sources: DMO, Thomson Reuters, Bank of England and Bank calculations
The relationship between the local supply surprise and gilt yields
Figures 1 to 3 plot the ‘local supply surprise’ (blue line) against the change in gilt yields (green diamonds) for each of the three market notices.1
In all three instances, the pattern of changes in gilt yields matches the local supply surprise. This supports the view that local supply effects are one of the channels through which QE affects gilt yields. That said, the relationship is not perfect, so it is likely other channels also play a part. For instance, in March 2009 there was a significant reduction in yields at longer maturities, even though none of the purchases were initially conducted in this part of the yield curve.
As well as through local supply effects, QE could affect gilt yields by:
- Changing the amount of ‘duration-risk’ in the market;
- Signalling a change in the expected path of Bank Rate; or
- Improving market liquidity.
It is not possible to separately identify the other effects. But it is possible to control for their joint effect, so a regression can be used to isolate the local supply effects.
Details of the estimation
For each of the three market notices, a separate regression is estimated. The dependent variable is the change in gilt yields after each market notice (for all conventional gilts in issue). The first explanatory variable is the local supply surprise. To account for the other channels, a constant term and the duration of each bond are also included.
In each case, the local supply surprise coefficient is negative and significantly different from 0; consistent with the local supply channel operating. The estimated local supply coefficients are of a similar order of magnitude for all three events, and the hypothesis that they are the same cannot be rejected. So the strength of the local supply channel of QE does not appear to have changed significantly since gilt purchases were introduced in 2009.
There are quite large differences between the constant and duration coefficients across the events. But it is difficult to interpret the size of these coefficients as there are reasons to think that they may be conflating the other channels from QE to gilt yields.
Putting the results in context
To put the regression estimates in context, two approaches are used to compare the contribution of the local supply variable to the overall change in gilt yields. The results suggest that the local supply channel is an important mechanism which may explain around half of the impact of QE on gilt yields. Therefore the natural experiments approach is useful for identifying a considerable portion of the effect of QE.
These results are similar to estimates for the first round of Large Scale Asset Purchases in the US. D’Amico et al. (2011) find that around two-thirds of the fall in US government bond yields could be explained by the local supply channel, albeit using a different methodology.
The other channels from QE to gilt yields have not been separately identified, so it is not possible to draw conclusions about how they may have changed. Furthermore, the impact on gilt yields is only the first leg of the transmission to spending and inflation. Therefore, even though the strength of the local supply channel does not appear to have changed, the analysis cannot necessarily be used to draw conclusions about the wider economic effects of QE.
The reaction of gilt yields to these market notices closely matches the news they contained about the way in which future purchases were expected to be distributed across gilts of different maturities. This is consistent with an important role for the local supply channel. The regression estimates suggest this channel can account for around half of the reduction in gilt yields due to QE, so the approach is useful for identifying a considerable portion of the impact of QE on gilt yields.
The estimated strength of the local supply channel is broadly similar across the three market notices. These events span the period of QE purchases, so the strength of this particular channel does not appear to have changed significantly since QE was introduced in early 2009.
Banerjee, R, S Daros, D Latto, and N McLaren (2012), “Using changes in auction maturity sectors to help identify the impact of QE on gilt yields”, Bank of England Quarterly Bulletin, 52(2):129-137.
Joyce, M, A Lasaosa, I Stevens, and M Tong (2011), “The financial market impact of quantitative easing in the United Kingdom”, International Journal of Central Banking, 7(3):113-161.
1 As in Joyce et al. (2011) a two-day window is used to measure the change in gilt yields; and the change in yields for the March 2009 announcement is combined with the change following the February 2009 Inflation Report so as to capture the full impact of the introduction of QE.