After more than fifteen years of unconventional monetary policy and trillions of dollars in central bank balance sheet expansion, a striking theoretical gap persists: economists cannot agree on why quantitative easing works. The empirical evidence suggests it does something—asset prices respond, term premia compress, financial conditions ease—but the underlying transmission mechanism remains contested terrain.

This uncertainty matters beyond academic curiosity. If QE works primarily through portfolio rebalancing, then the composition and duration of purchased assets becomes paramount. If signaling dominates, then communication strategies may substitute for actual purchases. If credit easing in dysfunctional markets drives effectiveness, then targeting matters more than scale. Each theoretical channel implies different optimal policy design, different exit strategies, and different side effects.

The literature has evolved considerably since the Federal Reserve's initial large-scale asset purchases in 2008. We now possess extensive empirical studies across multiple countries and episodes. Yet rather than convergence toward a unified framework, research has revealed the coexistence of multiple mechanisms operating with varying intensity across different market conditions. Understanding these channels—their theoretical foundations, empirical support, and policy implications—has become essential for evaluating how central bank balance sheets function as macroeconomic stabilization tools.

The portfolio balance channel represents the most direct mechanism through which QE might affect the real economy. When central banks purchase long-duration assets—primarily government bonds—they remove duration risk from private portfolios. Investors who sold these assets now hold cash or short-term reserves, creating a portfolio imbalance. If investors have preferences over portfolio composition beyond expected returns, they will rebalance toward remaining long-duration and risky assets.

This rebalancing drives up prices of substitute assets—corporate bonds, equities, mortgage-backed securities—thereby lowering yields across the risk spectrum. The mechanism requires a departure from Modigliani-Miller irrelevance and Ricardian equivalence. In frictionless markets with perfect substitutability, central bank asset swaps would prove irrelevant. Investors would simply adjust their portfolios to offset central bank actions, leaving equilibrium prices unchanged.

The theoretical foundation rests on preferred habitat models, where investors have segmented demand across maturities or asset classes. Vayanos and Vila's influential framework formalizes this intuition: risk-averse arbitrageurs cannot fully eliminate supply effects because they demand compensation for absorbing duration risk. When central banks reduce the supply of long-duration assets available to private investors, term premia must fall to clear markets.

Empirical evidence generally supports the existence of portfolio balance effects. Event studies around QE announcements consistently find significant term premium compression—the Federal Reserve's first LSAP program appeared to reduce ten-year Treasury yields by roughly 50-100 basis points through this channel. Studies examining cross-sectional asset price responses find patterns consistent with imperfect substitutability: assets more similar to purchased securities show larger price effects.

However, quantifying the magnitude proves challenging. The portfolio balance channel predicts effects proportional to the stock of purchases relative to outstanding supply, suggesting persistent impacts. Yet distinguishing these stock effects from flow effects during active purchase periods remains empirically difficult. Furthermore, the channel's potency depends on the degree of market segmentation—which may vary across financial conditions and erode as investors develop substitution strategies.

Takeaway

QE's portfolio balance mechanism requires that assets be imperfect substitutes—a violation of textbook finance theory that empirical evidence increasingly supports, though the magnitude of these frictions determines policy effectiveness.

An alternative interpretation holds that QE works primarily through its informational content rather than mechanical portfolio effects. Asset purchases may signal the central bank's commitment to maintaining accommodative policy longer than markets previously expected. This signaling channel operates through expectations of future short rates rather than current portfolio rebalancing.

The theoretical logic begins with a fundamental asymmetry: central banks possess superior information about their own future policy intentions and reaction functions. When they engage in large-scale asset purchases, they may reveal information about how long they expect to keep policy rates at the effective lower bound. If markets update toward expecting prolonged accommodation, long rates fall immediately through the expectations component of the yield curve.

More subtly, purchases may serve as a commitment device rather than pure information revelation. Central banks that accumulate large portfolios of long-duration assets face capital losses if they raise rates unexpectedly. This exposure creates incentive compatibility—markets can trust accommodation signals because deviation becomes costly. The portfolio itself becomes a form of forward guidance made credible through self-imposed constraints.

Empirically distinguishing signaling from portfolio balance effects proves enormously difficult. Both channels predict declining long-term yields following QE announcements. Krishnamurthy and Vissing-Jorgensen's careful decomposition of yield changes around Federal Reserve announcements found significant signaling effects operating alongside portfolio balance mechanisms—perhaps accounting for half the total yield decline in some episodes. They identified signaling through movements in rates at horizons beyond the likely duration impact of purchases.

The policy implications diverge substantially from portfolio balance logic. If signaling dominates, then communication about purchases may matter more than purchases themselves. A credible commitment to future accommodation could substitute for actual balance sheet expansion. Conversely, if purchases work through signaling, then their effectiveness depends critically on market interpretation—the same policy implemented with different communication could produce different outcomes. This channel also suggests that QE's impact diminishes as central banks develop more sophisticated forward guidance tools that can deliver commitment without portfolio accumulation.

Takeaway

If QE works primarily as a signaling device, then central bank communication strategy becomes inseparable from balance sheet policy—the message may matter as much as the mechanism.

The third major transmission channel—credit easing—differs fundamentally from broad portfolio balance effects. Rather than simply removing duration from well-functioning markets, credit easing involves central bank intervention in specific market segments experiencing dysfunction. The mechanism operates through liquidity provision, price discovery, and the rehabilitation of market function itself.

During financial crises, particular markets may experience severe dislocations: bid-ask spreads explode, trading volumes collapse, and prices deviate dramatically from fundamental values. These dysfunctions reflect coordination failures, information asymmetries, and amplifying feedback loops rather than fundamental solvency concerns. When central banks purchase assets in these markets—mortgage-backed securities in 2008-2009, corporate bonds during COVID—they provide a backstop bid that can break adverse equilibria.

The theoretical rationale draws on multiple-equilibrium models where markets can coordinate on either functional or dysfunctional states. Central bank intervention serves as a coordination device, convincing private participants that liquidity will be available and prices will be supported. Importantly, the announcement of willingness to intervene may prove as effective as actual purchases by shifting expectations about market conditions.

Empirical evidence strongly supports credit easing effectiveness during crisis episodes. The Federal Reserve's interventions in commercial paper, money market funds, and asset-backed securities markets during 2008 rapidly normalized spreads and restored market function. The March 2020 announcement of corporate bond purchases produced immediate spread compression before substantial purchases occurred—consistent with an expectations-based mechanism rather than pure portfolio displacement.

However, credit easing differs from conventional QE in crucial respects. Its appropriate domain is crisis intervention rather than ongoing stimulus. The targets should be markets experiencing identifiable dysfunction, not simply markets where policymakers prefer lower yields. Extending credit easing logic to normal times risks distorting price discovery, encouraging excessive risk-taking, and creating dependency on central bank backstops. The distinction between removing duration risk from functioning markets and providing liquidity to dysfunctional ones implies different analytical frameworks, different success metrics, and different exit considerations.

Takeaway

Credit easing succeeds by breaking adverse market equilibria during crises—a fundamentally different mechanism from steady-state QE that implies different targeting, different timing, and different exit strategies.

The persistence of theoretical disagreement about QE transmission mechanisms reflects genuine complexity rather than analytical failure. The evidence increasingly suggests that all three channels—portfolio balance, signaling, and credit easing—operate simultaneously, with their relative importance varying across episodes, market conditions, and policy design choices. No single unified theory fully captures the phenomenon.

This complexity carries significant implications for policy design. Optimal QE strategy depends on which channels dominate in current conditions. During market dysfunction, credit easing through targeted intervention may offer high returns. When signaling effectiveness is strong, communication may partially substitute for purchases. When portfolio balance dominates, scale and composition of purchases matter most.

Central banks have pragmatically operated across all channels, adjusting strategy as understanding evolves. The theoretical uncertainty that remains need not paralyze policy—it instead demands intellectual humility about mechanisms and careful attention to the conditional effectiveness of different approaches. QE works, but through channels that interact in ways we are still learning to understand.