In «The Federal Reserve's Large-scale Asset Purchase Programmes: Rationale and Effects» 2012 paper, there's the following sentence:

According to the pure expectations theory of the term structure, targeting three separate interest rates should succeed if and only if the private sector's expectations of the path of the short rate are aligned in a way that precisely generates the targeted
configuration of rates. In this environment, for a given expected path for the short-term rate, direct intervention in longer maturity Treasury markets could not contribute to achieving the peg.

Why is it that intervening in the long-term market would not help achieve the peg?

Any help would be appreciated.


2 Answers 2


The issue isn't so much that intervening in the long-term market wouldn't help, but rather that under rational expectations all the return rates on government bonds are determined by the same process, and thus have to be consistent with each other and converge to the same rates. What D'Amico et al. seem to be suggesting is that the Federal Reserve tried to enforce mutually inconsistent rates on bonds with different maturities, such that there was a sequence of operations on bonds with short-term maturities (what I think they're calling "an expected path for the short-term rate") which would yield a return either above or below that of bonds with different maturities.

What it seems that they're really saying is that, under rational expectations, the FED would have had really just one policy instrument: the interest rate at any time. Bonds with different maturities just had to conform to that rate. But in practice, the FED tried to enforce a set of different rates, one each for each kind of maturity, which the authors think it's doable because the variance of bond prices is lower than what would be expected under rational expectations (hence the "the slightest fluctuation in expectations of the short-rate path would immediately imperil the peg" bit).

  • $\begingroup$ Why do you say that because the authors think that the «variance of bond prices is lower» the enforcement of the different rates was doable? $\endgroup$ Jun 22, 2017 at 18:28
  • $\begingroup$ by the way, I gave you +1 $\endgroup$ Jun 22, 2017 at 20:04
  • $\begingroup$ @Anoldmaninthesea. Well, they sort of said that themselves when they suggested that "the slightest fluctuation in expectations [...] would immediately imperil the peg". Under rational expectations, the change in prices of long maturation bonds would be just the change of short maturation bonds divided by the discount factor between them. Since the discount factor is between one and zero, it's just the short change multiplied by some factor. Even if the FED could easily and precisely change long-term interest rates, in practice this would throw policy-making out of the window. $\endgroup$
    – ejQhZ
    Jun 23, 2017 at 19:59
  • $\begingroup$ If bond prices systematically go either above or below what would be expected if the price changes of long maturation bonds were just a multiplied price changes of short maturation bonds, that means that there must be something else is going on. If they systematically go above, I don't know whether there's much to do policy-wise, but if they systematically go below what would expected, policy instruments become more effective. And if it's credible that investors are treating bonds with different maturities differently, then the FED might be able to enforce a set of different interest rates. $\endgroup$
    – ejQhZ
    Jun 23, 2017 at 20:08

The argument is that under rate expectations, all bonds should have the same return over different horizons. The implication is that bond yields will equal (roughly) the geometric average of the short rate (adjusting for various yield conventions).

If they try to peg a particular bond issue at a yield that is inconsistent with the path of short rates, that is assumed to be impossible. The mechanism why this would hold is straightforward.

  • If the pegged yield is too low, the issue would have a negative expected return versus cash (short-term instruments). The private sector would sell all of that bond to the central bank. The Fed would end up owning the entire amount outstanding of that issue (which makes its "market price" a philosophical question). This might be referred to as a run on the bond yield peg.
  • If the pegged yield was too high relative to expectations, bond market participants would keep buying the issue until the central bank has no more to sell. It would then lose its ability to influence the market price lower (assuming the central bank does not want to get involved in short-selling).

In practice, the uncertainty around rate expectations by investors prevented such extreme outcome during the period when the Federal Reserve bond yield peg was credible. (Since no one is completely sure about the expected path of short rates, investors will not dump their entire bond portfolio, or proceed to buy up all of the central bank's holdings.) However, once the commitment to keep short rates low was questioned by the Fed, the peg was abandoned before such a "run" started.

  • $\begingroup$ BRian thanks for your answer. Why do you say it was the uncertainty around the rate expectations that prevented such extreme outcomes? The paper, after the quote in the original question, states that the pegging was abandoned after aggregate demand started to put upward pressure (inflation). They do not speak of uncertainty... Thanks for your help ;) $\endgroup$ Jun 22, 2017 at 18:37
  • $\begingroup$ by the way I gave you +1 $\endgroup$ Jun 22, 2017 at 20:05

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