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The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.


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December 16, 2016


The Impact of Extraordinary Policy on Interest and Foreign Exchange Rates

Central banks in the developed countries have adopted a variety of extraordinary measures since the financial crisis, including large-scale asset purchases and very low (and in some cases negative) policy rates in an effort to boost economic activity. The Atlanta Fed recently hosted a workshop titled "The Impact of Extraordinary Monetary Policy on the Financial Sector," which discussed these measures. This macroblog post discusses the highlights of three papers related to the impact of such policy on interest rates and foreign exchange rates. A companion Notes from the Vault reviews papers that examined how those policies may have affected financial institutions, including their lending.

Prior to the crisis, central banks targeted short-term interest rates as a way of influencing the rest of the yield curve, which in turn affected aggregate demand. However, as short-term rates approached zero, central banks' ability to further cut their target rate diminished. As a substitute, the central banks of many developed countries (including the Federal Reserve, the European Central Bank, and the Bank of Japan) began to undertake large-scale purchases of bonds in an attempt to influence longer-term rates.

Central bank asset purchases appear to have had some beneficial effect, but exactly how these purchases influenced rates has remained an open question. One of the leading hypotheses is that the purchases did not have any direct effect, but rather served as a signal that the central bank was committed to maintaining very low short-term rates for an extended period. A second hypothesis is that central bank purchases of longer-dated obligations resulted in long-term investors bidding up the price of remaining longer-maturity government and private debt.

The second hypothesis was tested in a paper  by Federal Reserve Board economists Jeffrey Huther, Jane Ihrig, Elizabeth Klee, Alexander Boote and Richard Sambasivam. Their starting point was the view that a "neutral" policy would have the Fed's System Open Market Account (SOMA) closely match the distribution of the stock of outstanding Treasury securities. In their statistical tests, they find support for the hypothesis that deviations from this neutrality should influence market rates. In particular, they find that the term premium in longer-term rates declines significantly as the duration of the SOMA portfolio grows relative to that of the stock of outstanding Treasury debt.

The central banks' large-scale asset purchases not only took longer-dated assets out of the economy, but they also forced banks to increase their holdings of reserves. Large central banks now pay interest on reserves (or in some cases charge interest on reserve holdings) at an overnight rate that the central bank can change at any time. As a result, these purchases can significantly reduce the average duration (or maturity) of a bank's portfolio below what the banks found optimal given the term structure that existed prior to the purchases. Jens H. E. Christensen from the Federal Reserve Bank of San Francisco and Signe Krogstrup from the International Monetary Fund have a paper  in which they hypothesize that banks respond to this shortening of duration by bidding up the price of longer-dated securities (thereby reducing their yield) to restore optimality.

The difficulty with testing Christensen and Krogstrup's hypothesis is that in most cases central banks were expanding bank reserves by buying longer-dated securities, thus making it difficult to disentangle their respective effects. However, in 2011 the Swiss National Bank undertook a series of three policy moves designed to produce a large, rapid increase in bank reserves. Importantly, these moves were an attempt to counter perceived overvaluation of the Swiss franc and did not involve the purchase of longer-dated bonds. In a follow-up empirical paper , Christensen and Krogstrup exploit this unique policy setting to test whether Swiss bond rates declined in response to the increase in reserves. They find that the third and largest of these increases in reserves was associated with a statistically and economically significant fall in term premia, implying that the increase did lower longer-term rates.

Although developed countries' monetary policy has focused on their domestic economies, these policies can have significant spillovers into emerging countries. Large changes in the rates of return available in developed countries can lead investors to shift funds into and out of emerging countries, causing potentially undesirable large swings in the foreign exchange rate of these emerging countries. Developing countries' central banks may try to counteract these swings via intervention in the foreign exchange market, but the effectiveness of sterilized intervention is the subject of some debate. (Sterilized intervention occurs when the central bank buys or sells foreign currency, but then takes offsetting measures to prevent these from changing bank reserves.)

Once again, determining whether exchange rates are influenced and, if so, by what mechanism can be econometrically difficult. Marcos Chamon from the International Monetary Fund, Márcio Garcia from PUC-Rio, and Laura Souza from Itaú Unibanco examine the efforts of the Brazilian Central Bank to stabilize the Brazilian real in the aftermath of the so-called "taper tantrum." The taper tantrum is the name given to the sharp jump in U.S. bond yields and the foreign exchange rate value of the U.S. dollar after the May 23, 2013, statement by Board Chair Ben Bernanke that the Federal Reserve would slow (or taper) the rate at which it was purchasing Treasury bonds (see a brief essay by Christopher J. Neely). Chamon, Garcia, and Souza's paper  takes advantage of the fact that Brazil preannounced its intervention policy, which allows them to separate the impact of the announcement to intervene from the intervention itself. They find that the Brazilian Central Bank's intervention was effective in strengthening the value of the real relative to a basket of comparable currencies.

All three of the studies faced the difficult challenge in linking specific central bank actions to policy outcomes, and each tackled the challenge in innovative ways. The evidence provided by the studies suggests that central banks can use extraordinary policies to influence interest and foreign exchange rates.

December 16, 2016 in Exchange Rates and the Dollar , Interest Rates , Monetary Policy | Permalink

Comments

The assumption of your analysis ignores the excess bank reserves globally. For the first time in modern history since the Great Depression, the supply of excess bank reserves is greater than 0, currently at $2 trillion in the US. When excess bank reserves are greater 0 the interest rate paid on cash naturally goes to 0%. During the Great Depression and after 2008, the lack of demand for capital causes monetary policy to find new tools. Quantitative easing was advertised as stimulative but in reality was meant to act as a buyer last resort protecting the banking system from illiquidity. The unintended consequence is the weakening of the currency as the monetary base increases.

In the past, monetary tools were used to influence interest rates when the supply and demand of excess bank reserves were in an equilibrium at 0. A central bank could easily disrupt the equilibrium to affect interest rates with a very small balance sheet. Currently, the Fed must use its historically large $4 trillion balance sheet to pay interest on excess bank to raise interest rates. No longer can central bank influence interest rates without dealing with the excess bank reserves and lack of demand for capital.

Monetary policy must find the path for the greatest economic growth with low inflation and moderate long-term interest rates. When viewed through the lenses of excess bank reserves; the behavior of interest rates, the creation of capital and the mathematics, all fall into place. When the supply of cash is greater than demand the interest rate paid for cash naturally trades at 0% without central bank intervention. When cash trades near 0%, a small move in interest rates has a large nonlinear impact due to the effect of leverage on capital. During this period, global competition for good jobs and the lack of demand for capital keeps inflationary pressures at a minimum. Any interest rate paid or charged on the excess cash by the central banks is artificial and runs the risk of harming the economy or even worse creating asset bubbles. When central banks allow interest rates on cash to naturally be at 0%, this stimulates the economy until demand picks up again and interest rates naturally rise.

http://www.unicornfunds.com/macro/whitepaper_monetarypolicyforaglobaleconomy.html

Posted by: Peter del Rio | December 22, 2016 at 01:41 AM

Monetary policy must find the path for the greatest economic growth with low inflation and moderate long-term interest rates. When viewed through the lenses of excess bank reserves; the behavior of interest rates, the creation of capital and the mathematics, all fall into place. When the supply of cash is greater than demand the interest rate paid for cash naturally trades at 0% without central bank intervention. When cash trades near 0%, a small move in interest rates has a large nonlinear impact due to the effect of leverage on capital. During this period, global competition for good jobs and the lack of demand for capital keeps inflationary pressures at a minimum. Any interest rate paid or charged on the excess cash by the central banks is artificial and runs the risk of harming the economy or even worse creating asset bubbles. When central banks allow interest rates on cash to naturally be at 0%, this stimulates the economy until demand picks up again and interest rates naturally rise.

http://www.unicornfunds.com/macro/whitepaper_monetarypolicyforaglobaleconomy.html

Posted by: Peter del Rio | December 22, 2016 at 01:49 AM

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