Question

Explain the effect of Fed’s substantial trading in the MBS market during QE.

Answer 1

The Federal Reserve’s use of large-scale asset purchases since the recent financial crisis has been the focus of a rapidly expanding body of literature. Thus far, most studies have concentrated on evaluating the efficacy of large-scale asset purchase programs—also known as quantitative easing (QE). This focus on the efficacy of QE is understandable in light of the unprecedented nature of QE, the condition of the economy and financial markets, and the stated goals of QE. Federal Reserve and other central banks that relied on QE programs to achieve their mandates after policy rates reached their effective lower bounds in the years following the financial crisis. In fact, several central banks in advanced economies continue to rely on QE programs amid sluggish recoveries, and may look to QE in the future if there is a return to the zero lower bound. One potential cost of conducting additional [large-scale asset purchases] is that the operations could lead to a deterioration in market functioning or liquidity in markets where the Federal Reserve is engaged in purchasing. More specifically, if the Federal Reserve becomes too dominant a buyer in a certain market, trading among private participants could decrease enough that market liquidity and price discovery become impaired. Federal Reserve securities purchases can potentially generate contrasting effects on market functioning and liquidity depending on the type of asset purchased and the market environment at the time of purchases. As briefly mentioned above, it is possible for large central bank purchases to improve measures of liquidity and market functioning. This outcome is most likely during a time of severe market disruption and insufficient demand for the purchased securities, such as a market freeze during or immediately following a financial crisis.QE can provide an ongoing source of demand for illiquid assets. As a result of this persistent flow of demand, dealers and other investors may be more willing to take larger positions in the purchased securities or make markets in them more actively. In this way, QE can provide assurance to market participants that they will be able to sell assets to the Federal Reserve. Thus, even if relatively few market participants are willing to trade, measures of liquidity such as bid-ask spreads and trading volumes may improve. This dynamic is the most likely explanation for the improvement in MBS market functioning observed during the first half of QE1.However, liquidity premiums have been relatively low since 2010. How might QE affect liquidity when there is substantially less turmoil? To answer this question, it is useful to consider the effect of QE purchases on the stock of the purchased asset available to the public. If QE purchases substantially reduce the supply of securities available to the public, QE could have deleterious consequences for market functioning. For instance, if a more scarce security trades less frequently and/or increases market makers’ costs to pursue offsetting trades, lower supply engendered by QE can result in longer inventory holding periods, higher costs for market makers, and reduced overall trading as dealers and other investors become less willing to hold an increasingly scarce security. In this scenario, QE can lead to a less robust market in the purchased securities, causing measures of market functioning to deteriorate. Notably, the sheer size of the purchases required to carry out QE programs may cause deterioration in liquidity and market functioning for similar reasons, even if the supply of the traded security is ample. For instance, if market makers incur higher costs as a result of hedging or offsetting very large Federal Reserve trades, trading activity that would have otherwise taken place may be crowded out. Additionally, to the extent that MBS dealers rely on the pipeline of mortgage originators for readily available MBS supply, large Federal Reserve purchases could cover expected originations, limiting dealers’ willingness or ability to trade with other counterparties.