We experimentally investigate the effect of a central bank buying bonds for cash in a quantitative easing (QE) operation. In our experiment, the bonds are perfect substitutes for cash and have a ...constant fundamental value which is not affected by QE in the rational expectations equilibrium. We find that QE raises bond prices above those in the benchmark treatment without QE. Subjects in the benchmark treatment learned to trade the bonds at their fundamental value but those in treatments with QE became more convinced after repeated exposure to the same treatment that QE boosts bond prices. This suggests the possibility of a behavioural channel for the observed effects of actual QE operations on bond yields.
Abstract The paper shows, in a simple analytical framework, the existence of a deflationary bias in an economy with a low natural rate of interest, a zero lower bound (ZLB) constraint on nominal ...interest rates and a discretionary Central Bank (CB) with an inflation mandate. The presence of the ZLB prevents the CB from offsetting negative shocks to inflation whereas it can offset positive shocks. This asymmetry pushes average inflation below the target which in turn drags down inflation expectations and reinforces the likelihood of hitting the ZLB. We show that this deflationary bias is particularly relevant for a CB with a symmetric dual mandate (i.e., minimizing deviations from inflation and employment), especially when facing demand shocks. But a strict inflation targeter cannot escape the suboptimal deflationary equilibrium either. The deflationary bias can be mitigated by targeting “shortfalls” instead of “deviations” from maximum employment and/or using flexible average inflation targeting. However, changing monetary policy strategy risks inflation expectations becoming entrenched above the target if the natural interest rate increases.
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