Introduction

The global financial crisis has led to dramatic actions by central banks. Initially, many central banks responded to the crisis by rapidly cutting interest rates and undertaking measures to address liquidity issues in interbank funding markets. But the bankruptcy of Lehman Brothers, the threat of failure of AIG and other related events led to a deepening of the crisis. Credit markets that previously had been relatively unaffected by the crisis subsequently froze. At the same time, the global real economy collapsed. Central banks responded by lowering interest rates aggressively. Moreover, as policy rates reached their effective lower bound, some central banks responded with additional initiatives, first via credit easing and then more dramatically, by introducing large-scale asset purchase programmes. These latter measures sought to lower interest rates further out the yield curve and thus stimulate the macro economy.

There is considerable debate with respect to the effectiveness of these interventions by central banks, in terms of both the effect of asset purchases on long-term interest rates and the ultimate impact on the real economy (Borio and Disyatat, 2009). The focus of this analysis is on the former question. On the one hand, the yield on UK ten-year gilts fell substantially on the day of the announcement of the purchase programme (Figure 7.1). Likewise, US long-term interest rates initially responded dramatically to the announcement of large-scale asset purchases, falling nearly fifty basis points (Figure 7.2). On the other hand, subsequent increases in long-term interest rates were interpreted by some observers as evidence that quantitative easing was not particularly effective. Clearly, a more rigorous analysis is needed, one that accounts for other factors that may influence yields, including inflation expectations, the supply of government debt, future expected short-term rates, investors’ views on risk premia and the overall state of the macroeconomy.