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Over the last 15 years, the Federal Reserve has purchased more than $8 trillion worth of assets under a policy known as quantitative easing, or QE. And one of the main aims of QE is to lower the interest rates that firms and other agents in the economy face in the hopes of stimulating the real economy.
One channel through which this QE policy might work in theory is the portfolio rebalancing channel. What is the portfolio rebalancing channel? The idea is that when the Federal Reserve buys, for example, government bonds, investors that previously held those government bonds will sell them to the Fed, and in turn they will go on to purchase other bonds with similar characteristics instead. For example, corporate bonds. This increase in demand for those corporate bonds is in turn going to increase the prices on those bonds and thus lower the yields, or rates, on those bonds. And that in turn hopefully should lower the cost of capital that firms face in the corporate bond market, and thus stimulate the economy.
And the aim of the paper is to test whether QE actually works through this portfolio rebalancing channel. So to test this portfolio rebalancing channel, I construct shocks that capture unexpected purchases by the Fed of Treasurys during its QE operations.
And so I find that Treasurys that experienced a greater QE shock, i.e., that were unexpectedly more purchased by the Fed, experienced a greater decline in their yields following a given QE operation. The next finding is that investors that held these unexpectedly purchased Treasurys sell them and rebalance heavily into corporate bonds. And this rebalancing causes corporate bond yields to decline overall.
I also find that corporate bonds that are likelier to be rebalanced into experience a greater decline in their yields. So I find that investors tend to rebalance into corporate bonds within the investment-grade universe, but within that universe, the rebalancing is actually very broad based. And I also find that investors tend to rebalance into corporate bonds with similar maturities to Treasurys that were purchased by the Fed. And this is in line with the theory that investors tend to buy bonds with similar characteristics to those that were bought by the Fed. So I find that firms that experience greater demand for their bonds due to this rebalancing in turn issue more bonds in the corporate bond market and at lower yields.
So in a nutshell, firms are able to borrow more and at lower interest rates in the corporate bond market. So we see that firms use the funds raised to increase their cash buffers and even increase their investment. And this is in line with the Fed-stated goal of QE, which is to stimulate the real economy. And so this suggests that quantitative easing is actually able to lower interest rates that firms face in the corporate bond market, and they seem to use the funds raised to increase their investment.
