NEW DELHI – Markets are in turmoil once again, following the US Federal Reserve’s indication that it might reduce its bond purchases toward the end of the year. The intensity of the market reaction was surprising, at least given the received wisdom about how the Fed’s quantitative-easing policy works. After all, the Fed was careful to indicate that it would maintain its near-zero interest-rate policy and would not unload its bond holdings.
The dominant theory of how quantitative easing works is the portfolio-balance approach. Essentially, by buying long-term Treasury bonds from private investors’ portfolios, the Fed hopes that these investors will rebalance their portfolios. Because a risky asset has been removed and replaced with safe central-bank reserves, investors’ unmet risk appetite will grow, the price of all risky assets (including remaining privately-held long-term Treasury bonds) will rise, and bond yields will fall.