How does the Fed lower long-term interest rates?
- The Federal Reserve owns about $1.7T in US treasury securities (e.g. bonds issued by the federal government), which is about a trillion more than they owned before the quantitative easings of 2008 and 2010.
- When the Federal Reserve starts buying longer term US treasury securities, this obviously increases the demand for those securities.
- Note that US treasury securities include: Treasury Bills, Treasury Notes, Treasury Bonds. All of these are fixed income securities and so they yield some predetermined constant amount on some predetermined schedule.
- As demand for securities goes up, so does their price.
- And if the price of a fixed-income security goes up (say, from X to X+k) then its relative yield (yield amortized over the cost of the security) decreases.
- Say a given Treasury bond is going to pay $30 every 6 months for 30 years. If we buy that bond for $X then our yield per dollar invested (i.e. relative yield) will be higher than if we buy it for some amount >$X. Because the yield itself (the amount we’re earning) is fixed.
(($30 * 2 * 30)/$X) > (($30 * 2 * 30)/($X+k)).
What happens when long-term interest rates go down?
- The interest rates of many other securities (not issued by the federal government) are pegged to the Treasury interest rate. When Federal interest rates go down, then all such securities will have lower rates of return (since they will earn less interest than when the rates were higher).
- This will cause investors to seek other investment vehicles, which have higher rates of return, e.g. stocks. This will cause stock prices to rise, which will cause consumers’ stock portfolios to increase in value, which will make consumers feel wealthier and consequently spend more.
- This is called “the wealth effect”.
- Also, when long-term interest rates decrease, that means credit is cheaper, which encourages more borrowing and could encourage more hiring.
- This whole cascading effect is intended to stimulate the economy (by stimulating spending).
Other things the Fed might do to stimulate the economy
There are limitations to what can be accomplished by lowering interest rates. After all, if there aren’t credit-worthy borrowers (to take out the loans) or businesses willing to take advantage of low-cost loans (due to uncertainty about the future) then further lowering interest rates (by itself) is unlikely to produce stimulative effects.
- The Fed could also decrease the interest rate it pays to banks on the banks’ excess reserves. That might cause banks to look elsewhere (somewhere with higher returns) to park that money.
- Or if the Fed raises the target for inflation that might encourage folks to spend more now since their money will be worth less (relative to the cost of goods) later.
Some other notes
Interest rates of long-term treasuries are at historical lows (point: not much further to drop)
- The yield for a 10-year Treasury note:
- The yield for the 30-year U.S. Treasury bond:
* The yield for the 30-year U.S. Treasury bond generally has declined since the early 1980s. Note that there is no data for yield for 2003, 2004, and 2005 because the U.S. Treasury had suspended issuing 30-year bonds during those years. Source: Federal Reserve Board.