Understanding the Impact of Large Scale Asset Purchases on Long-Term Government Bond Yields: The Quantitative Easing Paradox

Abstract

Empirical event studies estimate that Large Scale Asset Purchases (LSAP) push down long-term interest rates through the portfolio balance channel. However, since portfolio reallocation takes time to materialise, a longer horizon may be more appropriate to assess the effects of LSAP. With a longer horizon in mind, a deep look at historical experiences leads to the quantitative easing paradox: LSAP raise long-term government bond yields, while a premature exit lowers long-term government bond yields. To solve this puzzle, this paper argues that LSAP mainly raise the government term premium. In the wake of a severe economic and financial crisis, the period of heightened risk aversion and the safe asset shortage weigh on the government term premium. Through the portfolio balance channel, LSAP increase the supply of safe assets and decrease the demand of money at the same time, thereby lifting the government term premium. Finally, a new econometric method introduced by Brodersen et al. (2014), which infers the causal impact of LSAP on the term premium, confirms that LSAP have a significant positive effect on long-term government bond yields.