As has been widely discussed in the academic literature, one of the most important channels is the portfolio balance channel.5 This theory relies on the premise that financial assets are imperfect substitutes in investors’ portfolios, and, as a result, a rise in the demand for a particular financial asset relative to its supply – reflecting the Federal Reserve’s asset purchase programs, for example – will increase its price and reduce its yield. After selling that asset to the Federal Reserve, investors may rebalance their portfolios by investing in other assets, raising the prices of those assets, lowering their yields, and easing overall financial conditions. The Federal Reserve’s asset purchase programs were designed to remove risk from the portfolios of private investors. For example, Treasury and agency MBS purchases remove duration risk, thereby lowering longer-term interest rates and reducing private sector borrowing costs. Furthermore, agency MBS purchases also remove prepayment risk in the market. Since homeowners can prepay their mortgage at any time, MBS investors do not know when they will receive their cash flows. Investors generally demand an extra return to bear this risk, which is incorporated into MBS yields and in part passed along to borrowers. The removal of a considerable amount of this risk by the Fed’s purchases would be expected to lower MBS rates by lowering this extra return, thereby reducing primary mortgage rates, stimulating demand for housing and prompting increased refinancing activity.

14  Selling dollar rolls when concerns arise about the availability of certain TBA contracts is conceptually similar to making SOMA Treasury holdings available to the market through our securities lending program. One key difference is that the Desk offers settled Treasury holdings to the market through its securities lending program, whereas the Desk only rolls unsettled MBS holdings. BIS central bankers’ speeches  5  directive, with the goal of supporting a stronger economic recovery in the context of price stability. References Fleming, Michael (2000). “The Benchmark U.S. Treasury Market: Recent Performance and Possible Alternatives.” Federal Reserve Bank of New York Economic Policy Review, Vol. 6, no. 1 (April): 129–45. Fleming, Michael (2002). “Are Larger Treasury Issues More Liquid? Evidence from Bill Reopenings.” Journal of Money, Credit, and Banking, Vol. 34, no. 3 (August): 707–35. Gagnon, Joseph, Matthew Raskin, Julie Remache, and Brian Sack (2010). “Large-Scale Asset Purchases by the Federal Reserve: Did They Work?” Federal Reserve Bank of New York Staff Reports, no. 441, March. Hancock, Diana, and Wayne Passmore (2011). “Did the Federal Reserve's MBS Purchase Program Lower Mortgage Rates?” Journal of Monetary Economics, Vol. 58 (July): 498–514. Krishnamurthy, Arvind, and Annette Vissing-Jorgensen (2011). “The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy.” Brookings Papers on Economic Activity, no. 2: 215–65. Li, Canlin, and Min Wei (2012). “Term Structure Modelling with Supply Factors and the Federal Reserve’s Large Scale Asset Purchase Programs.” Finance and Economics Discussion Series 2012–37. Washington: Board of Governors of the Federal Reserve System, May.