In November, the FOMC announced that it intended to expand the SOMA portfolio by purchasing an additional $ billion of longer-term Treasury securities through the end of the second quarter of 2011, bringing the intended level of domestic securities holdings to $ trillion. Those decisions were aimed at providing more monetary policy stimulus to the economy. The FOMC saw the additional stimulus as warranted because it viewed the progress toward its mandated objectives of full employment and price stability as disappointingly slow. 1 In effect, the Committee was using the size and composition of its balance sheet as a policy instrument, given that it had already employed its traditional means of easing monetary policy – decreasing short-term interest rates – to the fullest extent possible. Federal Reserve Chairman Bernanke has noted that the intention of asset purchases is similar to that associated with changes in short-term interest rates, in that they are meant to affect economic activity by influencing broader financial conditions. 2 But while the intention of the recent policy decisions may be similar to traditional monetary policy adjustments, the implementation of them is not. These policy decisions involve what are presumably some of the largest and most rapid portfolio adjustments that have ever taken place by any single financial market participant. To put it in perspective, note that these recent policy decisions involve the Federal Reserve purchasing, over an eight-month period, more Treasury securities than the amount currently held by the entire U.S. commercial banking system.

The policy decisions made by the FOMC in August and November were intended to influence financial conditions in a manner that would support the economic recovery and return employment and inflation, over time, to levels consistent with the FOMC’s objectives. One way that this might occur is through a portfolio balance channel. 12 Under this view, removing duration risk from the market would tend to keep longer-term real interest rates lower than they otherwise would be and would encourage investors to move into other types of assets, thereby making broader financial conditions more accommodative. These intended effects were apparent in financial markets from mid-August to early November, when investors increasingly anticipated the Federal Reserve’s decision to expand its balance sheet. Over that period, longer-term real interest rates declined, breakeven inflation rates moved up toward more normal levels, equity prices rose notably and risk spreads on many credit instruments narrowed. This configuration of asset price movements is the pattern that is typically associated with additional monetary policy easing. Since early November, one of the notable developments in financial markets has been the sharp increase in longer-term interest rates. At first glance, this change may seem at odds with the portfolio balance channel. However, it is important to understand the factors that led to the increase in interest rates in the current circumstances. The upward movement in longer-term interest rates in large part reflects the greater optimism among investors about the outlook for economic growth.