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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.
July 18, 2016
What’s Moving the Market’s Views on the Path of Short-Term Rates?
As today's previous macroblog post highlighted, it seems that the United Kingdom's vote to leave the European Union—commonly known as the Brexit—got the attention of business decision makers and made their business outlook more uncertain.
How might this uncertainty be weighing on financial market assessments of the future path for Fed policy? Several recent articles have opined, often citing the CME Group's popular FedWatch tool, that the Brexit vote increased the probability that the Federal Open Market Committee (FOMC) might reverse course and lower its target for the fed funds rate. For instance, the Wall Street Journal reported on June 28 that fed funds futures contracts implied a 15 percent probability that rates would increase 25 basis points and an 8 percent probability of a 25 basis point decrease by December's meeting. Prior to the Brexit vote, the probabilities of a 25 basis point increase and decrease by December's meeting were roughly 50 percent and 0 percent, respectively.
One limitation of using fed funds futures to assess market participant views is that this method is restricted to calculating the probability of a rate change by a fixed number of basis points. But what if we want to consider a broader set of possibilities for FOMC rate decisions? We could look at options on fed funds futures contracts to infer these probabilities. However, since the financial crisis their availability has been quite limited. Instead, we use options on Eurodollar futures contracts.
Eurodollars are deposits denominated in U.S. dollars but held in foreign banks or in the foreign branches of U.S. banks. The rate on these deposits is the (U.S. dollar) London Interbank Offered Rate (LIBOR). Because Eurodollar deposits are regulated similarly to fed funds and can be used to meet reserve requirements, financial institutions often view Eurodollars as close substitutes for fed funds. Although a number of factors can drive a wedge between otherwise identical fed funds and Eurodollar transactions, arbitrage and competitive forces tend to keep these differences relatively small.
However, using options on Eurodollar futures is not without its own challenges. Three-month Eurodollar futures can be thought of as the sum of an average three-month expected overnight rate (the item of specific interest) plus a term premium. Each possible target range for fed funds is associated with its own average expected overnight rate, and there may be some slippage between these two. Additionally, although we can use swaps market data to estimate the expected term premium, uncertainty around this expectation can blur the picture somewhat and make it difficult to identify specific target ranges, especially as we look farther out into the future.
Despite these challenges, we feel that options on Eurodollar futures can provide a complementary and more detailed view on market expectations than is provided by fed funds futures data alone.
Our approach is to use the Eurodollar futures option data to construct an entire probability distribution of the market's assessment of future LIBOR rates. The details of our approach can be found here. Importantly, our approach does not assume that the distribution will have a typical bell shape. Using a flexible approach allows multiple peaks with different heights that can change dynamically in response to market news.
The results of this approach are illustrated in the following two charts for contracts expiring in September (left-hand chart) and December (right-hand chart) of this year for the day before and the day after Brexit. With these distributions in hand, we can calculate the implied probabilities of a rate change consistent with what you would get if you simply used fed funds futures. However, we think that specific features of the distributions help provide a richer story about how the market is processing incoming information.
Prior to the Brexit vote (depicted by the green curve), market participants were largely split in their assessment on a rate increase through September's FOMC meeting, as indicated by the two similarly sized modes, or peaks, of the distribution. Post-Brexit (depicted by the blue curve), most weight was given to no change, but with a non-negligible probability of a rate cut (the mode on the left between 0 and 25 basis points). For December's FOMC meeting, market participants shifted their views away from the likelihood of one additional increase in the fed funds target toward the possibility that the FOMC leaves rates where they are currently.
The market turmoil immediately following the vote subsided somewhat over the subsequent days. The next two charts indicate that by July 7, market participants seem to have backed away from the assessment that a rate cut may occur this year, evidenced by the disappearance of the mode between 0 and 25 basis points (show by the green curve). And following the release of the June jobs report from the U.S. Bureau of Labor Statistics on July 8, market participants increased their assessment of the likelihood of a rate hike by year end, though not by much (see the blue curve). However, the labor report was, by itself, not enough to shift the market view that the fed funds target is unlikely to change over the near future.
One other feature of our approach is that comparing the heights of the modes across contracts allows us to assess the market's relative certainty of particular outcomes. For instance, though the market continues to put the highest weight on "no move" for both September and December, we can see that the market is much less certain regarding what will happen by December relative to September.
The greater range of possible rates for December suggests that there is still considerable market uncertainty about the path of rates six months out and farther. And, as we saw with the labor report release, incoming data can move these distributions around as market participants assess the impact on future FOMC deliberations.
June 06, 2016
After the Conference, Another Look at Liquidity
When it comes to assessing the impact of central bank asset purchase programs (often called quantitative easing or QE), economists tend to focus their attention on the potential effects on the real economy and inflation. After all, the Federal Reserve's dual mandate for monetary policy is price stability and full employment. But there is another aspect of QE that may also be quite important in assessing its usefulness as a policy tool: the potential effect of asset purchases on financial markets through the collateral channel.
Asset purchase programs involve central bank purchases of large quantities of high-quality, highly liquid assets. Postcrisis, the Fed has purchased more than $3 trillion of U.S. Treasury securities and agency mortgage-backed securities, the European Central Bank (ECB) has purchased roughly 727 billion euros' worth of public-sector bonds (issued by central governments and agencies), and the Bank of Japan is maintaining an annual purchase target of 80 trillion yen. These bonds are not merely assets held by investors to realize a return; they are also securities highly valued for their use as collateral in financial transactions. The Atlanta Fed's 21st annual Financial Markets Conference explored the potential consequences of these asset purchase programs in the context of financial market liquidity.
The collateral channel effect focuses on the role that these low-risk securities play in the plumbing of U.S. financial markets. Financial firms fund a large fraction of their securities holdings in the repurchase (or repo) markets. Repurchase agreements are legally structured as the sale of a security with a promise to repurchase the security at a fixed price at a given point in the future. The economics of this transaction are essentially similar to those of a collateralized loan.
The sold and repurchased securities are often termed "pledged collateral." In these transactions, which are typically overnight, the lender will ordinarily lend cash equal to only a fraction of the securities value, with the remaining unfunded part called the "haircut." The size of the haircut is inversely related to the safety and liquidity of the security, with Treasury securities requiring the smallest haircuts. When the securities are repurchased the following day, the borrower will pay back the initial cash plus an additional amount known as the repo rate. The repo rate is essentially an overnight interest rate paid on a collateralized loan.
Central bank purchases of Treasury securities may have a multiplicative effect on the potential efficiency of the repo market because these securities are often used in a chain of transactions before reaching a final holder for the evening. Here's a great diagram presented by Phil Prince of Pine River Capital Management illustrating the role that bonds and U.S. Treasuries play in facilitating a variety of transactions. In this example, the UST (U.S. Treasury) securities are first used as collateral in an exchange between the UST securities lender and the globally systemically important financial institution (GSIFI bank/broker dealer), then between the GSIFI bank and the cash provider, a money market mutual fund (MMMF), corporation, or sovereign wealth fund (SWF). The reuse of the UST collateral reduces the funding cost of the GSIFI bank and, hence, the cost to the levered investor/hedge fund who is trying to exploit discrepancies in the pricing of a corporate bond and stock.
Just how important or large is this pool of reusable collateral? Manmohan Singh of the International Monetary Fund presented the following charts, depicting the pledged collateral at major U.S. and European financial institutions that can be reused in other transactions.
So how do central bank purchases of high-quality, liquid assets affect the repo market—and why should macroeconomists care? In his presentation, Marvin Goodfriend of Carnegie Mellon University concluded that central bank asset purchases, which he terms "pure monetary policy," lower short-term interest rates (especially bank-to-bank lending) but increase the cost of funding illiquid assets through the repo market. And Singh noted that repo rates are an important part of the constellation of short-term interest rates and directly link overnight markets with the longer-term collateral being pledged. Thus, the interaction between a central bank's interest-rate policy and its balance sheet policy is an important aspect of the transmission of monetary policy to longer-term interest rates and real economic activity.
Ulrich Bindseil, director of general market operations at the ECB, discussed a variety of ways in which central bank actions may affect, or be affected by, bond market liquidity. One way that central banks may mitigate any adverse impact on market liquidity is through their securities lending programs, according to Bindseil. Central banks use such programs to lend particular bonds back out to the market to "provide a secondary and temporary source of securities to the financing market...to promote smooth clearing of Treasury and Agency securities."
On June 2, for example, the New York Fed lent $17.8 billion of UST securities from the Fed's portfolio. These operations are structured as collateral swaps—dealers pledge other U.S. Treasury bonds as collateral with the Fed. During the financial crisis, the Federal Reserve used an expanded version of its securities lending program called the Term Securities Lending Facility to allow firms to replace lower-quality collateral that was difficult to use in repo transactions with Treasury securities.
Finally, the Fed currently releases some bonds to the market each day in return for cash, through its overnight reverse repo operations, a supplementary facility used to support control of the federal funds rate as the Federal Open Market Committee proceeds with normalization. However, this release has an important limitation: these operations are conducted in the triparty repo market, and the bonds released through these operations can be reused only within that market. In contrast, if the Fed were to sell its U.S. Treasuries, the securities could not only be used in the triparty repo market but also as collateral in other transactions including ones in the bilateral repo market (you can read more on these markets here). As long as central bank portfolios remain large and continue to grow as in Europe and Japan, policymakers are integrally linked to the financial plumbing at its most basic level.
To see a video of the full discussion of these issues as well as other conference presentations on bond market liquidity, market infrastructure, and the management of liquidity within financial institutions, please visit Getting a Grip on Liquidity: Markets, Institutions, and Central Banks. My colleague Larry Wall's conference takeaways on the elusive definition of liquidity, along with the impact of innovation and regulation on liquidity, are here.
January 31, 2014
A Brief Interview with Sergio Rebelo on the Euro-Area Economy
Last month, we at the Atlanta Fed had the great pleasure of hosting Sergio Rebelo for a couple of days. While he was here, we asked Sergio to share his thoughts on a wide range of current economic topics. Here is a snippet of a Q&A we had with him about the state of the euro-area economy:
Sergio, what would you say was the genesis of the problems the euro area has faced in recent years?
The contours of the euro area’s problems are fairly well known. The advent of the euro gave peripheral countries—Ireland, Spain, Portugal, and Greece—the ability to borrow at rates that were similar to Germany's. This convergence of borrowing costs was encouraged through regulation that allowed banks to treat all euro-area sovereign bonds as risk free.
The capital inflows into the peripheral countries were not, for the most part, directed to the tradable sector. Instead, they financed increases in private consumption, large housing booms in Ireland and Spain, and increases in government spending in Greece and Portugal. The credit-driven economic boom led to a rise in labor costs and a loss of competitiveness in the tradable sector.
Was there a connection between the financial crisis in the United States and the sovereign debt crisis in the euro area?
Simply put, after Lehman Brothers went bankrupt, we had a sudden stop of capital flows into the periphery, similar to that experienced in the past by many Latin American countries. The periphery boom quickly turned into a bust.
What do you see as the role for euro area monetary policy in that context?
It seems clear that more expansionary monetary policy would have been helpful. First, it would have reduced real labor costs in the peripheral countries. In those countries, the presence of high unemployment rates moderates nominal wage increases, so higher inflation would have reduced real wages. Second, inflation would have reduced the real value of the debts of governments, banks, households, and firms. There might have been some loss of credibility on the part of the ECB [European Central Bank], resulting in a small inflation premium on euro bonds for some time. But this potential cost would have been worth paying in return for the benefits.
And did this happen?
In my view, the ECB did not follow a sufficiently expansionary monetary policy. In fact, the euro-area inflation rate has been consistently below 2 percent and the euro is relatively strong when compared to a purchasing-power-parity benchmark. The euro area turned to contractionary fiscal policy as a panacea. There are good theoretical reasons to believe that—when the interest rate remains constant that so the central bank does not cushion the fall in government spending—the multiplier effect of government spending cuts can be very large. See, for example, Gauti Eggertsson and Michael Woodford, “The Zero Interest-rate Bound and Optimal Monetary Policy,” and Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo, "When Is the Government Spending Multiplier Large?”
Theory aside, the results of the austerity policies implemented in the euro area are clear. All of the countries that underwent this treatment are now much less solvent than in the beginning of the adjustment programs managed by the European Commission, the International Monetary Fund, and the ECB.
Bank stress testing has become a cornerstone of macroprudential financial oversight. Do you think they helped stabilize the situation in the euro area during the height of the crisis in 2010 and 2011?
No. Quite the opposite. I think the euro-area problems were compounded by the weak stress tests conducted by the European Banking Association in 2011. Almost no banks failed, and almost no capital was raised. Banks largely increased their capital-to-asset ratios by reducing assets, which resulted in a credit crunch that added to the woes of the peripheral countries.
But we’re past the worst now, right? Is the outlook for the euro-area economy improving?
After hitting the bottom, a very modest recovery is under way in Europe. But the risk that a Japanese-style malaise will afflict Europe is very real. One useful step on the horizon is the creation of a banking union. This measure could potentially alleviate the severe credit crunch afflicting the periphery countries.
Thanks, Sergio, for this pretty sobering assessment.
By John Robertson, a vice president and senior economist in the Atlanta Fed’s research department
Editor’s note: Sergio Rebelo is the Tokai Bank Distinguished Professor of International Finance at Northwestern University’s Kellogg School of Management. He is a fellow of the Econometric Society, the National Bureau of Economic Research, and the Center for Economic Policy Research.
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November 20, 2013
The Shadow Knows (the Fed Funds Rate)
The fed funds rate has been at the zero lower bound (ZLB) since the end of 2008. To provide a further boost to the economy, the Federal Open Market Committee (FOMC) has embarked on unconventional forms of monetary policy (a mix of forward guidance and large-scale asset purchases). This situation has created a bit of an issue for economic forecasters, who use models that attempt to summarize historical patterns and relationships.
The fed funds rate, which usually varies with economic conditions, has now been stuck at near zero for 20 quarters, damping its historical correlation with economic variables like real gross domestic product (GDP), the unemployment rate, and inflation. As a result, forecasts that stem from these models may not be useful or meaningful even after policy has normalized.
A related issue for forecasters of the ZLB period is how to characterize unconventional monetary policy in a meaningful way inside their models. Attempts to summarize current policy have led some forecasters to create a "virtual" fed funds rate, as originally proposed by Chung et al. and incorporated by us in this macroblog post. This approach uses a conversion factor to translate changes in the Fed's balance sheet into fed funds rate equivalents. However, it admits no role for forward guidance, which is one of the primary tools the FOMC is currently using.
So what's a forecaster to do? Thankfully, Jim Hamilton over at Econbrowser has pointed to a potential patch. However, this solution carries with it a nefarious-sounding moniker—the shadow rate—which calls to mind a treacherous journey deep within the hinterlands of financial economics, fraught with pitfalls and danger.
The shadow rate can be negative at the ZLB; it is estimated using Treasury forward rates out to a 10-year horizon. Fortunately we don't need to take a jaunt into the hinterlands, because the paper's authors, Cynthia Wu and Dora Xia, have made their shadow rate publicly available. In fact, they write that all researchers have to do is "...update their favorite [statistical model] using the shadow rate for the ZLB period."
That's just what we did. We took five of our favorite models (Bayesian vector autoregressions, or BVARs) and spliced in the shadow rate starting in 1Q 2009. The shadow rate is currently hovering around minus 2 percent, suggesting a more accommodative environment than what the effective fed funds rate (stuck around 15 basis points) can deliver. Given the extra policy accommodation, we'd expect to see a bit more growth and a lower unemployment rate when using the shadow rate.
Before showing the average forecasts that come out of our models, we want to point out a few things. First, these are merely statistical forecasts and not the forecast that our boss brings with him to FOMC meetings. Second, there are alternative shadow rates out there. In fact, St. Louis Fed President James Bullard mentioned another one about a year ago based on work by Leo Krippner. At the time, that shadow rate was around minus 5 percent, much further below Wu and Xia's shadow rate (which was around minus 1.2 percent at the end of last year). Considering the disagreement between the two rates, we might want to take these forecasts with a grain of salt.
Caveats aside, we get a somewhat stronger path for real GDP growth and a lower unemployment rate path, consistent with what we'd expect additional stimulus to do. However, our core personal consumption expenditures inflation forecast seems to still be suffering from the dreaded price-puzzle. (We Googled it for you.)
Perhaps more important, the fed funds projections that emerge from this model appear to be much more believable. Rather than calling for an immediate liftoff, as the standard approach does, the average forecast of the shadow rate doesn't turn positive until the second half of 2015. This is similar to the most recent Wall Street Journal poll of economic forecasters, and the September New York Fed survey of primary dealers. The median respondent to that survey expects the first fed funds increase to occur in the third quarter of 2015. The shadow rate forecast has the added benefit of not being at odds with the current threshold-based guidance discussed in today's release of the minutes from the FOMC's October meeting.
Moreover, today's FOMC minutes stated, "modifications to the forward guidance for the federal funds rate could be implemented in the future, either to improve clarity or to add to policy accommodation, perhaps in conjunction with a reduction in the pace of asset purchases as part of a rebalancing of the Committee's tools." In this event, the shadow rate might be a useful scorecard for measuring the total effect of these policy actions.
It seems that if you want to summarize the stance of policy right now, just maybe...the shadow knows.
By Pat Higgins, senior economist, and
Brent Meyer, research economist, both of the Atlanta Fed's research department
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May 23, 2012
The three faces of postcrisis monetary policy
The latest edition of the San Francisco Fed's Economic Letter (written by Michael Bauer)has a nice review of the different channels through which the Fed's Large Scale Asset Purchase (LSAP) programs—QE, or quantitative easing more popularly—are thought to work:
"Central bank LSAPs potentially may affect interest rates through at least three channels. Notably, all three channels can broadly affect longer-term interest rates, extending beyond those securities that the central bank announces it will purchase:
- A portfolio balance channel, because the supply of long-maturity bonds available to private investors is reduced. The reduced supply of longer-term securities targeted by the Fed lowers the amount of interest rate risk in investor portfolios. That in turn decreases the risk premium that they require to hold both the targeted securities and other assets of similar duration. Longer-term interest rates are lowered across the board as a result. Gagnon et al (2011) emphasize this channel for QE1.
- A signaling channel, which arises when the Fed's announcements are interpreted as signals of its intent to hold down short-term interest rates further into the future. Bauer and Rudebusch (2011) argue that this channel played an important role for QE1.
- A market functioning channel, because QE1 provided relief when conditions in financial markets were dire, liquidity very low, and panic widespread. The Fed's intervention calmed investor fears. Thus, the intervention substantially supported a range of asset prices, including MBS and corporate bonds, lowering their yields."
The article references include links to the Gagnon et al. paper and the Bauer and Rudebusch paper, but none to any studies addressing the "market functioning channel." So I'll provide one: "Did the Federal Reserve's MBS Purchase Program Lower Mortgage Rates?" by Diana Hancock and Wayne Passmore, both senior staff members for the Federal Reserve of Board of Governors. According to Hancock and Passmore, the market functioning channel is key to appreciating the impact of QE1:
"We use empirical pricing models for MBS yields in the secondary mortgage market and for mortgage rates paid by homeowners in the primary mortgage market to measure how distorted mortgage markets were prior to the Federal Reserve's intervention, and the course of market risk premiums during the restoration to normal market functioning...
"We argue that this return to normal pricing occurred because the Federal Reserve's announcement signaled a strong and credible government backing for mortgage markets in particular and for the financial system more generally...
"More specifically, we estimate that the Federal Reserve's MBS purchase program over the course of 16 months reestablished normal market pricing in the MBS market and resulted in lower mortgage rates of roughly 100 to 150 basis points for purchasing houses. Most of the decline in mortgage rates occurred between the announcement of the program, on November 25, 2008, and the implementation of the program in the first quarter of 2009. After this point, both mortgage rates and risk premiums remained relatively stable until the end of the Federal Reserve MBS purchase program."
Hancock and Passmore note that the portfolio balance channel may have played a role after the completion of the QE1 purchases once market functioning had normalized, but the biggest bang was that renormalization itself.
Bauer's observations align with Hancock and Passmore's conclusions:
"QE1 had very pronounced effects on interest rates. The key announcements led to decreases of close to one percentage point. The announcements not only lowered yields on targeted Treasury securities and MBS, but also on corporate bonds...
"The two other programs, QE2 and MEP [maturity extension program], also affected yields of securities that were not targeted for Fed purchases... Generally though, QE2 and MEP affected interest rates much less than QE1 did. One reason is that bond market functioning had largely returned to normal. In addition, expectations of future short-term interest rates were already very low when these programs were announced, leaving little room for further signaling effects. Finally, QE2 and MEP were smaller than QE1."
Earlier this week, in a speech delivered in Tokyo at the Institute of Regulation and Risk, Federal Reserve Bank of Atlanta President Dennis Lockhart provided his view on this evidence:
"In my view, these [the QE1] purchase programs played an important role in the transition away from the emergency lending facilities created earlier in the crisis. The emergency credit facilities worked well to stem the downward spiral of the immediate post-Lehman period. Financial markets began the process of repair during the first half of 2009 but were still suffering from relatively serious liquidity pressures. The QE1 operation sustained the liquidity support that had been previously provided by lending through the emergency facilities.
"Because asset purchases largely replaced emergency loans made during the crisis, the net increase in the Fed's balance sheet was relatively modest. In this sense, the quantitative easing label is misleading. The intent and effect of the policy was not to inject a new and sizable quantity of reserves into the economy. Rather, the effect was to sustain liquidity in still struggling and fragile financial markets, particularly those related to residential real estate. For that reason, I prefer the term ‘credit easing' to describe this policy action."
However, the smaller impact of QE2 leads Lockhart to a different conclusion regarding the largest contribution of that program:
"I view QE2 differently. The FOMC [Federal Open Market Committee] formally announced QE2 in November 2010, with its decision to purchase $600 billion in longer-term Treasury securities. However, the policy was signaled in an important speech from Federal Reserve Chairman Ben Bernanke in August of that year. The circumstances at the time were dominated by a falling trend in measured inflation, weakening inflation expectations, and rising probabilities of outright deflation. Each of these developments was effectively reversed as the expectations for QE2 took root, expectations that were ultimately validated by FOMC action.
"Unlike QE1, QE2 did materially expand the size of the Federal Reserve's balance sheet. In my view, this distinction is important. The intent and effect of the two rounds of asset purchases were different. QE1 served to maintain liquidity at a time when financial markets were exceptionally unsettled. In contrast, QE2 was a more traditional monetary action to preserve price stability."
In a sense, this places the effects of QE2 in the signaling channel category, albeit with an emphasis on inflation expectations rather than interest rates directly.
Bauer's article also covers post-QE2 policy—the maturity extension program (MEP, or "Operation Twist") and the insertion of specific calendar dates (currently at least late 2014) to provide forward guidance on the period of time that the FOMC anticipates that the federal funds rate will remain at exceptionally low levels. Lockhart also describes these policies in terms of the "signaling channel," though in these cases with interest rate effects front and center:
"In terms of intent and effect, I think of the explicit forward guidance and the MEP in similar terms. We have entered a phase of the recovery in which sustained monetary accommodation is warranted in order to preserve and advance what is still modest progress on employment and economic growth. Importantly, this modest progress is occurring in the context of what, for me, is acceptable performance with respect to our price stability mandate. Actions that reinforce the maintenance of policy accommodation are appropriate. It is through that lens that I view the MEP and explicit forward guidance on policy rates."
Lockhart's remarks provide his perspective on three somewhat distinct policy challenges—market dysfunction, disinflationary pressures, and a need to sustain monetary policy accommodation—that motivate his support for the three major policy initiatives of the postcrisis period:
"Let me summarize this brief tour of postcrisis monetary policy. I view the sequence of nontraditional monetary policy actions as tailored responses to the particular needs of the economy and financial system at the time they were implemented. My conclusion is that by and large policy actions have been appropriate to the diagnosis of circumstances at the time. And in my assessment they have worked pretty well."
In this light, President Lockhart delivers his policy punch line:
"I have reframed to some extent the original question of what more can be done around the point that policy actions must be matched to circumstances. The challenge policymakers face is judging appropriateness of a tool for circumstances. As popular as it might be in some quarters to rule out further LSAPs (QE3, as it is known), I do not think this option can be taken off the table. QE3 will work under the right circumstances. But I don't believe such circumstances prevail at this time."
By Dave Altig, executive vice president and research director at the Atlanta Fed
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January 06, 2012
In the interest of precision
As you may have heard, the minutes of the December 13 meeting of the Federal Open Market Committee (FOMC) contained the news that, starting with this month's meeting, committee members will be jointly publishing not only their personal projections for gross domestic product growth, unemployment, and inflation, but also the monetary policy assumptions that underlie those forecasts. In an article published earlier this week, the enhancement to these projections, known as the Summary of Economic Projections (SEP), was described in the Wall Street Journal this way (with my emphasis added):
"Federal Reserve officials this month will begin detailing their plans for short-term interest rates, a move that could show that the central bank's easy-money policies will remain in place for years and give the economy a boost."
A similar description appeared in the Journal yesterday (again, emphasis added):
"The Fed has just taken a historic step towards increasing its transparency and accountability by saying it will begin to release interest-rate projections several years out at the conclusion of its next policy meeting on Jan. 25. This means Fed officials will soon let the world know exactly what path they believe interest rates will follow—and they, after all, set the path of interest rates."
I added the emphasis in both of those passages because I think the highlighted language isn't quite right. Here is the actual language that appears in the FOMC minutes:
"In the SEP, participants' projections for economic growth, unemployment, and inflation are conditioned on their individual assessments of the path of monetary policy that is most likely to be consistent with the Federal Reserve's statutory mandate to promote maximum employment and price stability, but information about those assessments has not been included in the SEP.…
"… participants decided to incorporate information about their projections of appropriate monetary policy into the SEP beginning in January. Specifically, the SEP will include information about participants' projections of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP also will report participants' current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions."
The minutes are pretty clear about what this information is intended to convey…
"Most participants agreed that adding their projections of the target federal funds rate to the economic projections already provided in the SEP would help the public better understand the Committee's monetary policy decisions and the ways in which those decisions depend on members' assessments of economic and financial conditions."
…and what it is not intended to convey (here too, emphasis added):
"Some participants expressed concern that publishing information about participants' individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants' projections of the target federal funds rate as signaling the Committee's intention to follow a specific policy path rather than as indicating members' conditional projections for the federal funds rate given their expectations regarding future economic developments. Most participants viewed these concerns as manageable…"
In fact, the first Journal piece mentioned above does document some of the expressed concerns near the end of the article. For example:
"… some might mistakenly see the forecasts as an ironclad commitment, rather than a projection that could change as economy evolves."
That caveat does speak to concerns of some FOMC participants that the projections would establish a specific policy path. But the issue is about more than maintaining flexibility in the face of changing economic conditions. The broader point is that the new information in the SEPs, according to the minutes, is not intended to be a device for signaling the policy path that the FOMC, by official vote, intends to pursue.
This may seem like a small detail. But when it comes to the central bank's communications tools, even the small details matter.
By Dave Altig, senior vice president and research director at the Atlanta Fed
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September 30, 2011
Fed Treasury purchases: How big is big?
In his July 13 testimony to Congress, Federal Reserve Chairman Ben Bernanke discussed the large-scale asset purchase program to buy $600 billion of longer-term Treasury securities that started in November 2010 and was completed in June 2011. The chairman noted:
"The Federal Reserve's acquisition of longer-term Treasury securities boosted the prices of such securities and caused longer-term Treasury yields to be lower than they would have been otherwise. In addition, by removing substantial quantities of longer-term Treasury securities from the market, the Fed's purchases induced private investors to acquire other assets that serve as substitutes for Treasury securities in the financial marketplace, such as corporate bonds and mortgage-backed securities. By this means, the Fed's asset purchase program—like more conventional monetary policy—has served to reduce the yields and increase the prices of those other assets as well. The net result of these actions is lower borrowing costs and easier financial conditions throughout the economy."
Chairman Bernanke went on to observe in a footnote in his prepared remarks from that testimony:
"The Federal Reserve's recently completed securities purchase program has changed the average maturity of Treasury securities held by the public only modestly, suggesting that such an effect likely did not contribute substantially to the reduction in Treasury yields. Rather, the more important channel of effect was the removal of Treasury securities from the market, which reduced Treasury yields generally while inducing private investors to hold alternative assets (the portfolio reallocation effect). The substitution into alternative assets raised their prices and lowered their yields, easing overall financial conditions."
In a similar way, the maturity extension program—dubbed "Operation Twist" by some—announced by the Federal Open Market Committee last week is designed to further remove longer-term Treasury securities from the market, a move that, other things being equal, should put downward pressure on longer-term rates. Jim Hamilton at Econbrowser has taken a stab at estimating the effects and concludes that it is likely to be modest. Atlanta Fed President Dennis Lockhart shared a similar sentiment, described in more detail later in this posting, in a speech earlier this week.
So what share of outstanding marketable long-term Treasury securities (excluding those held to maturity on government accounts) does the Federal Reserve hold? The following chart shows that the Fed's share of marketable long-term securities with more than five years to maturity increased substantially as a result of the $600 billion asset purchase program between November 2010 and June 2011 (see the chart). This large run-up confirms the point made by Chairman Bernanke that this program removed a considerable supply of longer-term securities from the market (relative to what it would have been otherwise).
The new maturity extension program will replace $400 billion of shorter-dated Treasury securities that the Fed holds with an equal face-value amount of longer-term securities, and this move will further increase the Fed's relative holdings of marketable longer-term Treasury securities. As President Lockhart noted in his speech, the impact of this program cannot be known precisely, but he expects it to have a modest, positive influence:
"The Fed's maturity extension program and additional mortgage-backed securities purchases are meant to further ease financial conditions ceteris paribus, other things being equal. Of course, other things almost certainly will not stay equal, and other factors will influence what really happens to rates and spreads as policy intent encounters the real world….
"In my view, the maturity extension program along with the MBS purchases represents a measured, incremental attempt to add more support to the recovery. It's not a fix for everything that ails the economy, but it should help."
By John Robertson, vice president and senior economist in the Atlanta Fed's research department
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December 17, 2010
What's behind the recent rise in Treasury yields?
David Beckworth, who blogs at Macro and Other Market Musings, posted a comment regarding macroblog's post "What might monetary policy success look like?" from December 2. Beckworth's comment specifically mentioned this chart…
… as part of this question:
"How did you create the latter figure [shown above]? Using the Fed's own constant maturities series (for both the nominal and real yield), the figure I come up with is less impressive. It shows a turnaround in inflation expectations about the time QE2 is promoted by Fed officials, but then inflation expectations stall and remain far from the 'mandate-consistent inflation rate.'
"Here is a post where I placed one such graph."
And here's the graph of expected inflation from Beckworth's post:
The series shown in the Beckworth chart has a different economic meaning than the chart shown in the original macroblog post (as was suggested by another commentator to our earlier post).
The chart Beckworth shows in his referenced blog post is the five-year Treasury Inflation-Protected Securities (TIPS) spread (the difference in nominal and real Treasury yields at five-year maturities). And so when he states, "This figure shows average annual expected inflation over the next five years has been flatlining around 1.55% over most of November" it means just that: it's examining the next five-year period (2010–15). I've reposted below an updated version of this chart, along with the 10-year TIPS spread. Since Beckworth's comment on macroblog, the five-year TIPS spread has widened about 13 basis points, depending on the measure you're using.
The chart used in the December 2 macroblog post is a different measure altogether. It's the five-year/five-year forward break-even inflation rate—not the TIPS spread. This chart shows a measure of expected inflation in the five-year period beginning five years from now. So this chart shows what investors expect to be the cumulative change in the consumer price index beginning in November 2015 through November 2020. Put another way, it's the realized inflation that would provide an equivalent return to both the nominal Treasury securities and the real TIPS securities. An updated picture is provided below.
Thus we're talking about apples and oranges in two respects: (1) these two charts cover different periods (2010–15 versus 2015–20); and (2) the two calculations themselves are different (taking a simple nominal-real spread versus the 5-year/5-year forward calculation).
Now what's the point of all of this, besides highlighting the minutiae of measuring inflation expectations? Resurrecting Beckworth's question and answering it help illuminate the recent concern about increases in Treasury yields. Indeed, since the November Federal Open Market Committee (FOMC) meeting, longer-dated yields have risen considerably, with the 10-year bond's yield up 86 basis points, for example. But the recent movements in nominal and real yields can be placed in two categories: (A) from when the Federal Reserve began signaling consideration of further asset purchases (late August) to the November FOMC meeting, and (B) the post-November FOMC meeting period. In period A, nominal yields were relatively flat while real yields declined somewhat, indicating a healthy rise in inflation expectations from the lows seen this summer (this change is shown by the increase in the TIPS spreads and breakeven inflation rates during the period). In period B, the rise in nominal yields has been primarily driven by a rise in real yields (not unanchored inflation expectations).
As Martin Wolf wrote in Tuesday's Financial Times on this issue, "To understand what is going on, we need to distinguish the role of shifts in real interest rates from that of shifts in inflation expectations." As is evident in the charts, and in one of Beckworth's most recent posts, real rates have risen alongside nominal rates—a sign that inflation expectations are now relatively stable.
By Andrew Flowers, senior economic research analyst in the Atlanta Fed's research department
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February 16, 2010
Do we need to rethink macroeconomic policy?
The aftermath of a crisis is always fertile ground for big thoughts. Big thinking is exactly what we get from Olivier Blanchard (the International Monetary Fund's director of research) and his colleagues Giovanni Dell'Aricca and Paolo Mauro, in their new overview of the financial crisis and what it means for how we think about and, more importantly, practice macroeconomic policy. Titled, appropriately enough, "Rethinking Macroeconomic Policy," one of the more provocative parts of their analysis was highlighted in the Wall Street Journal:
"Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.
"At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further."
"None of the major Macro work ever done, from Barro forward, has ever found damage to economic growth from 4% inflation."
I suppose that the modifier "major" provides something of an escape clause, but as a general proposition there is at least some evidence that 2% is preferable to 4%. From the IMF itself, for example, there is this…
"The threshold level of inflation above which inflation significantly slows growth is estimated at 1–3 percent for industrial countries and 11–12 percent for developing countries. The negative and significant relationship between inflation and growth, for inflation rates above the threshold level, is quite robust..."
… which confirms the results of an earlier IMF study:
"Our more detailed results may be summarized briefly. First, there are two important nonlinearities in the inflation-growth relationship. At very low inflation rates (around 2–3 percent a year, or lower), inflation and growth are positively correlated. Otherwise, inflation and growth are negatively correlated…"
To be sure, there are plenty of studies suggesting modest increases in the rate of inflation from the levels currently targeted by many central banks would not be problematic—here, for example. But the point is that the evidence is not clear cut that an increase from an average rate of inflation in the neighborhood of 2 percent to the neighborhood of 4 percent would be innocuous. And there is always this element, noted by John Taylor in the aforementioned Wall Street Journal article:
"John Taylor, a Stanford University monetary-policy specialist who served in the Bush administration Treasury department, says that inflation could become hard to constrain if the target is raised. 'If you say it's 4%, why not 5% or 6%?' Mr. Taylor said. 'There's something that people understand about zero inflation.' "
So, the issue comes down to whether the uncertain costs of raising the average inflation rate is justified by the goal of avoiding the zero bound. At Free Exchange, the blog of The Economist, there is some skepticism:
"… the value of avoiding the zero bound depends on the seriousness of the macroeconomic situation. From the vantage point of 2010, a higher target rate seems like a great idea, but economic crises this severe are rare events. Even if there are only small costs to a 3% target relative to a 2% target, they may not be worth the trouble if the goal is to avoid serious trouble once every 80 years.
"There is a concern that with a higher level of inflation, inflation will become more volatile and expectations less anchored. At the same time, the higher target might not be enough to handle a recession as deep as the most recent downturn; to achieve the equivalent of a Taylor rule indicated -5% federal funds target without being constrained by the zero lower bound, the Fed would need to target inflation at at least 7%. Separately, these criticisms seem compelling, but taken together they cancel each other out."
Those are good arguments in my view, but my doubts about running policy to avoid the zero bound run even deeper. Among the lessons taken from the financial crisis, I include this: The "zero bound problem" was not all that big of a problem at all.
The Federal Open Market Committee moved the federal funds rate target to its effective lower bound (0 to ¼ percent) on Dec. 16, 2008. After a very rough start to 2009, gross domestic product (GDP) growth improved substantially in the second quarter. By the third quarter, growth was positive and, as far as we currently know, clocked in near 6 percent in the fourth. Is this the stuff of zero bound disaster?
In fact, Blanchard and company acknowledge that…
"It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap."
… but follow up with this:
"But it is clear that the zero nominal interest rate bound has proven costly."
Clear? Proven? I don't see it, and the IMF authors, in my view, explain why the zero bound problem was of limited relevance in the recent crisis:
"Markets are segmented, with specialized investors operating in specific markets. Most of the time, they are well linked through arbitrage. However, when, for some reason, some of the investors withdraw from that market (be it because of losses in some of their other activities, loss of access to some of their funds, or internal agency issues), the effect on prices can be very large. In this sense, wholesale funding is not fundamentally different from demand deposits, and the demand for liquidity extends far beyond banks. When this happens, rates are no longer linked through arbitrage, and the policy rate is no longer a sufficient instrument for policy." (I added the emphasis.)
The highlighted passage, of course, does not say "the policy rate is no longer a necessary instrument," and I certainly cannot prove that the trajectory of the economy in 2009 wouldn't have been better if only we had another 100 to 200 basis points in the tool kit. But color me a skeptic, and put me down on the petition to not experiment with higher inflation to avoid a problem that was not so clearly a problem.
By Dave Altig, senior vice president and research director at the Atlanta Fed
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