Since the advent of the Great Recession, the Federal Reserve has been on quite the spending spree, purchasing huge quantities of long-term treasury bonds and mortgage-backed securities (MBS) under a plan known as “quantitative easing.” The goal? By temporarily pumping money into the financial system, the Fed hopes to lower interest rates, making loans easier to come by for everyone.

Effects of Quantitative Easing
So has quantitative easing worked? According to Arvind Krishnamurthy, a professor of finance at the Kellogg School, it has—but its effects have not been as widespread as advertised. The Fed has espoused that its purchasing practices have effectively lowered all interest rates, says Krishnamurthy—and indeed, “broad-brush, that appears when you first look at the data. But when you start dissecting things, that’s not what happened.”

Namely, Krishnamurthy—along with colleague Annette Vissing-Jorgensen of the University of California, Berkeley—found that the effects of the Fed’s purchases aren’t bringing down all long-term interest rates equally. “The treasury purchases are having a big effect on the treasury yields, but a smaller impact on yields that are further from the treasury market,” explains Krishnamurthy. In other words, the average business looking to take out a loan just isn’t helped much by these treasury purchases. Similarly, the effects of the Fed’s purchases of MBS are largely restricted to MBS yields.

There is, however, an important difference between treasury yields and MBS yields. “The mortgage-backed security yields are much closer to yields directly relevant for economic activity, because household mortgage rates are very closely tied to the mortgage-backed security yield,” Krishnamurthy explains.  Because the strength of the housing market is so closely tied to the health of the entire economy, the Fed gets more bang for its buck when it invests in MBS.

A Plan Going Forward
Yet, oddly enough, the MBS that the Fed already has on its books aren’t doing much of anything for the average citizen. That’s because the Fed’s existing holdings do little to increase demand for the next batch of MBS being sold—and thus the interest rates a new mortgage borrower could expect to see. This makes the Fed’s plans to purchase future securities more important than its existing portfolio.

So, as the economy continues to improve, how should the Fed go about putting the brakes on quantitative easing? Krishnamurthy has some recommendations—though he prefers the term “template,” and encourages the Fed to conduct a similar exercise, plugging in its own numbers.

“Since the treasury purchases are having less effect than the mortgage purchases, they should be the first to go,” says Krishnamurthy. Next, the Fed should sell off its existing portfolio of MBS—while continuing to purchase new MBS. Then and only then should the Fed consider putting an end to its MBS purchases.

Related Reading: You can read Krishnamurthy’s new paper—along with his responses to some heated discussion generated by the findings—here on his website. The research, which was presented last week in Jackson Hole at a symposium hosted by the Federal Reserve Bank of Kansas City, has been featured in numerous media outlets including the New York Times, Wall Street Journal, and Financial Times.

Photo credit: Rdsmith4 at Wikimedia.