Central Bank Bond Purchases and US Interest Rates

Do bond purchases by the People’s Bank of China (or the Bank of Japan or SAMA or [fill in the blank]) lower US interest rates? Clearly “no” is not quite an acceptable answer, but the answer is not quite as much of a “yes” as many people think.

In the short run the Fed has a target for the short-term interest rate. If the PBoC buys Treasury bills, the Fed will sell enough Treasury bills to keep the interest rate essentially unchanged.

What about the long-term interest rate? Certainly it’s true that, if the PBoC makes, out of the blue, a decision to buy long-term bonds instead of bills, those purchases will tend to push down the long-term interest rate. But why would the PBoC make such a decision? Presumably for the same reason that a domestic bondholder might typically make such a decision: the difference between the long-term rate and expected short-term rates over the life of the long-term bond is big enough (and in the right direction) to compensate for the risk of holding a longer maturity asset. Is there any reason to think that the PBoC has different maturity preferences than a typical domestic US investor? If anything, the PBoC takes more risk than a domestic investor by extending maturities. If long-term rates are high enough to be attractive to the PBoC, they should be, if anything, even more attractive to a domestic investor, which means, if the PBoC weren’t there to buy, domestic investors would have provided the same demand, and the interest rate would be the same.

Of course, Chinese demand will affect the long-term interest rate if it affects the expected path of short-term interest rates. And it probably does, but the influence is not entirely straightforward. China’s bond purchases are a side effect of China’s dollar purchases, and the dollar purchases have the intended effect of strengthening the dollar. The strong dollar makes US exports less attractive and imports more attractive, which reduces the level of aggregate demand in the US economy, and, as a result, the Fed is ultimately likely to follow a looser monetary policy, so interest rates do go down.

So intervention by China (or Japan or Saudi Arabia or wherever) does have the net effect of reducing US interest rates. At any particular time, though, the effect of such intervention is likely to be swamped by the effects of other business cycle phenomena. For example, dollar purchases (and the attendant bond purchases) by foreign central banks increased dramatically between 2002 and 2005, but so did US interest rates. In 2002, the US was experiencing the effects of the tech bust; in 2005 the US was experiencing the effects of the housing boom. Intervention was a factor – probably pushing interest rates farther down in 2002 and keeping them from rising quite as high in 2005 (and 2006) – but it wasn’t the main part of the story. In general, if you want to find out what’s going to happen to US interest rates, foreign central bank intervention is not the thing to look at.