"QE2" may soon be ending. Unless you've been living under a rock for the past few months, you're probably aware that Quantitative easing is a monetary policy tool used by our central bank to stimulate the economy because conventional monetary policy has become ineffective. The central bank creates money by buying government bonds and other financial assets, in order to increase the money supply and the excess reserves of the banking system.[1] This action also raises the prices of the financial assets bought and simultaneously lowers their yield.
Many people are wondering what happens when QE2 ends? Will there be a QE3, QE4, ... QEn? And, what impact will the end have on interest rates?
For a hint, let's look at the historical relationship between short US rates and longer term US interest rates. Please remember that the slope of the yield curve and the spreads between short term and long term rates may (sometimes wildly) fluctuate in "stable" and "normal" times, so any insights that we glean from our graph are tentative at best. We're not sure where interest rates are heading, nor are we certain what the slope of the yield curve will resemble in the future. However -- from the graph above -- it appears that QE1 and QE2 may have impacted the short end of the curve much more than the longer end, which isn't news to anyone -- that was the intent of QE. Because the Fed had cut short term rates to the bone, they looked farther out on the yield curve to (attempt to) push rates lower. (Mark Thoma wrote a simply excellent overview back in 2010).
Our goal isn't too critique Fed policy. We're simply examining the rough relationship between long and short term interest rates in order to gauge what a reflux to normalcy might look like. The curve may stay the same for decades or it could invert next week: Some outcomes may be more probably than others, but we feel it is important to consider the historical relationships when we form our views concerning future contingent possibilities.
