RESEARCH & ANALYSIS
(In order of most recent update)
Real Yields and the Transmission of Central Bank Balance-Sheet Policies
Draft, November 2021
I show that, while a lower bound on the short-term policy rate limits the response of nominal yields to central bank bond purchases, real yields, which are more relevant for the macroeconomy, do not face such a constraint. I then study the potential for policies like quantitative easing (QE) to affect real yields and macroeconomic variables using an equilibrium, no-arbitrage framework where investors care about both inflation and duration risk. As long as the policy rate can be expected to respond aggressively to inflation, buying nominal bonds has a larger effect on real yields than buying real bonds. Thus, under normal circumstances, nominal QE is a more efficient way of providing stimulus than real QE. But the effects of nominal QE diminish as nominal rates decline; indeed, a quantitative version of the model suggests that nominal QE purchases were less effective in 2020 than in 2009. In a future recession where r* has fallen even further, nominal QE could stop working altogether, while central banks could still provide stimulus by buying real bonds---or, equivalently, by lending to financial institutions at an inflation-indexed rate.
Securities Financing and Asset Markets: New Evidence
(with Tomas Breach)
Working paper, revised, September 2021
Using new survey data on bilateral securities funding, we document that financing rates, collateral haircuts, lending maturities, and position limits move together over time and across asset classes. Liquidity of the underlying securities, as opposed to their volatility or credit risk, is the main driver of funding terms, although dealer balance-sheet constraints also appear to play a role. Instrumenting with dealers' self-reported reasons for changing terms, we find that funding conditions had little effect on cash securities markets between 2011 and 2019, but the tightening of terms during the COVID-19 crisis likely impaired liquidity and reduced asset returns to some degree.
Credit Risk, Liquidity, and Lies (with Kurt Lewis)
International Journal of Central Banking, October 2020
We examine the relative effects of credit risk and liquidity in the interbank market using bank-level panel data on Libor submissions and CDS spreads and allowing for the possibility that Libor-submitting firms may strategically misreport their funding costs. We find that interbank spreads were very sensitive to credit risk at the peak of the crisis. However, liquidity premia constitute the bulk of those spreads on average, and Federal Reserve interventions coincide with improvements in liquidity at short maturities. Accounting for misreporting, which is large at times, is important for obtaining these results.
Note: This paper previously circulated under the title "What Drives Bank Funding Spreads?"
(with Jeff Campbell, Anna Orlik, and Rebecca Zarutskie)
FEDS Working paper, August 2020
We review two nonstandard uses of the policy rate tool, which provide additional stimulus when interest rates are close to or at the effective lower bound—forward guidance and negative interest rate policy. In particular, we survey the use of these tools since the start of the Great Recession, review evidence of their effectiveness, and discuss key considerations that confront monetary policymakers while using them.
Note: This is a (lightly edited) staff memo presented to the FOMC and released as part of the conclusion of its comprehensive monetary-policy framework review.
(with Alejandro Drexler)
Draft, February 2020
We test the risk-shifting (``asset substitution") hypothesis using data on property-casualty insurance companies. The main sources of losses for these firms are natural disasters and similar exogenous events, providing us with a strong instrument for financial distress. Following such losses, insurers try to rebuild capital, but some are better able to do so than others. Stock companies replace equity relatively quickly and show no evidence of asset substitution. Mutual companies, which cannot issue equity, ratchet up their use of reinsurance (which can be thought of as low-quality capital) and increase the riskiness of their investment portfolios, consistent with asset substitution. Our results point to a complex interplay between capital constraints, organizational structure, and risk-taking incentives.
(with Travis Nesmith, Anna Paulson, and Todd Prono)
Working Paper, November 2019
By stepping between bilateral counterparties, a central counterparty (CCP) transforms credit exposure. CCPs generally improve financial stability. Nevertheless, large CCPs are by nature concentrated and interconnected with major global banks. Moreover, although they mitigate credit risk, CCPs create liquidity risks, because they rely on participants to provide cash. Such requirements increase with both market volatility and default; consequently, CCP liquidity needs are inherently procyclical. This procyclicality makes it more challenging to assess CCP resilience in the rare event that one or more large financial institutions default. Liquidity-focused macroprudential stress tests could help to assess and manage this systemic liquidity risk.
Draft, October 2019
This paper studies a class of optimizing, no-arbitrage models in which the term structure of interest rates depends on the maturity structure of assets held by investors. The key assumption is that the stochastic discount factor is a function of the return on wealth. Portfolio choice matters for asset prices because it affects the distribution of this return. Such models are inherently nonlinear, and I propose a numerical algorithm for solving them. As an illustration, I solve and estimate a model in which investors price inflation and consumption risk in addition to wealth risk, with short-term rates are determined by a version of a Taylor rule. The equilibrium duration of investors' portfolio is treated as an unobserved factor. This factor is largely responsible for the nominal term premium and is correlated with the quantity of Treasury debt held by the public. Shocks to the factor that are roughly equivalent to the Federal Reserve's large-scale asset purchases reduce the ten-year nominal term premium by about 70 basis points on impact and lead to moderate increases in consumption.
Journal of Financial Economics, December 2019
With risk-averse arbitrageurs and an effective lower bound on nominal rates, nonlinear interactions among short-rate expectations, bond supply, and term premia emerge in equilibrium. These interactions, which are absent from affine models, help explain the observed behavior of the yield curve near the ELB, including evidence about unconventional monetary policy. The impact of both short-rate expectations and bond supply are attenuated at the ELB. However, in simulations of the post-crisis experience in the U.S., shocks to investors' duration-risk exposures have much smaller effects than shocks to the anticipated path of short rates. The latter shocks matter, in part, because of the reduction in interest-rate volatility associated with a longer expected stay at the ELB -- a novel channel of unconventional policy.
How Have Banks Responded to Changes in the Yield Curve? (with Jonathan Wu)
FRB Chicago Fed Letter, November 2018
Between December 2015 and September 2018, a cumulative increase in the federal funds rate of 200 basis points was accompanied by a compression of 125 basis points in the difference between the yields on three-month and ten-year U.S. Treasury securities. We examine some of the effects of the flatter yield curve on the banking sector and how they compare with the effects of similar interest rate configurations in the past.
What Does Anticipated Monetary Policy Do? (with Stefania D'Amico)
Working paper, revised April 2017
Applying sign and zero restrictions to survey forecasts embedded in a VAR, we study the economic effects of news about future monetary policy—the type of shock induced by credible forward guidance. We find that such policy has large, immediate, and persistent effects on inflation and real activity, that these effects are larger than those of unanticipated monetary policy, and that the economic responses grow larger as the horizon of the news moves farther into the future. Our results also suggest that conventional monetary-policy shocks themselves are effective only because they shift interest-rate expectations.
Corporate Cash Flow and Its Uses (with Tim Larach)
Chicago Fed Letter, July 2016
We decompose corporate cash flow into its primary components to examine how funds are being internally allocated and to elucidate current trends in corporate behavior. By historical standards, capital investment has been low and shareholder payouts have been high over the past few years, although these patterns do not seem so abnormal once recent economic and financial conditions are factored in. That said, corporate debt levels are now somewhat higher than we would expect given the rather tepid economic recovery from the Great Recession.
Macroeconomic Sources of Recent Interest-Rate Fluctuations (with Stefania D'Amico and Min Wei)
FEDS Notes, June 2016
We use a new statistical method to attribute daily changes in U.S. Treasury yields and inflation compensation to changes in investor beliefs about domestic and foreign growth, inflation, and monetary policy. We find that, while foreign developments have been important drivers of U.S. yields and expected inflation over the last decade, the recent divergence between U.S. and European monetary policy has had little effect. Instead, the behavior of asset prices seems consistent with positive "aggregate supply shocks." One candidate for such shocks is the large decline in energy prices experienced since June 2014.
Working paper, revised May 2015
I examine how the maturity structure of outstanding government liabilities affects the nominal yield curve under a variety of assumptions about investor objectives. In the class of models I consider, equilibria are arbitrage free, expectations are rational, and assets are valued only for their pecuniary returns. Nonetheless, a portfolio-balance mechanism arises through the dependence of the pricing kernel on the return on wealth. This mechanism results in a positive relationship between the duration of bondholders' portfolios and the price of interest-rate risk. Quantitatively, the models suggest that the effects of shifting Treasury supply on yields can be substantial for example, the increase in the average maturity of U.S. government debt that occurred between 1976 and 1988 may have raised the ten-year yield by 50 basis points. On the other hand, partly reflecting an attenuation of portfolio-balance effects when interest rates are near zero, the Federal Reserves asset purchase programs likely had a fairly small impact on the yield curve by removing duration from the market.
Derivatives and Collateral at U.S. Life Insurers (with Kyal Berends)
Economic Perspectives, January 2015
Although insurers represent a relatively small part of the derivatives markets, they are an interesting case study, in part because they report very detailed information about their derivatives positions and associated collateral in quarterly regulatory filings. We exploit these data to study how derivatives are used by insurers and analyze the likely impact of regulatory reforms on their business models.
Flow and Stock Effects of Large-Scale Treasury Purchases: Evidence on the Importance of Local Supply (with Stefania D'Amico)
Journal of Financial Economics, May 2013
The Federal Reserve’s 2009 program to purchase $300 billion of US Treasury securities represented an unprecedented intervention in the Treasury market and provides a natural experiment with the potential to shed light on the price elasticities of Treasuries and theories of supply effects in the term structure. Using security-level data on Treasury prices and quantities during the course of this program, we document a ‘local supply’ effect in the yield curve—yields within a particular maturity sector responded more to changes in the amounts outstanding in that sector than to similar changes in other sectors. We find that this phenomenon was responsible for a persistent downward shift in yields averaging about 30 basis points over the course of the program (the “stock effect”). In addition, except at very long maturities, purchase operations caused an average decline in yields in the sector purchased of 3.5 basis points on the days when those operations occurred (the “flow effect”). The sensitivity of our results to security characteristics generally supports a view of segmentation or imperfect substitution within the Treasury market during this time.
A Value-at-Risk Approach to Commercial Real Estate Portfolio Stress Testing at US Commercial Banks (with John Hall, David Kern, Kevin Lee, and Tim Yeager)
Journal of Risk Management in Financial Institutions, December 2011
The December 2006 federal regulatory guidance on commercial real estate (CRE) requires banks with significant concentrations in CRE lending to employ appropriate risk-management techniques to measure and manage the risk. Using vector autoregression techniques on historical CRE foreclosure rates, the authors develop a value-at-risk CRE portfolio stress-test methodology. They document the build-up of CRE concentrations in bank loan portfolios and explain how banks can use a spreadsheet-based simulation methodology to measure their portfolio risk across the entire loan portfolio.
Distress in the Financial Sector and Economic Activity (with Mark Carlson and Kurt Lewis)
BE Journal of Economic Analysis & Policy, June 2011
We construct daily market-based measures of distance to default for large U.S. financial institutions since 1973. These measures have significant predictive power for institution bankruptcy more than one year in advance. We aggregate the distances to default across institutions to provide an index of the overall health of the financial-services industry. We show that deteriorations in this Financial Institution Health Index are associated with tighter lending standards and higher interest rates on bank loans and precede declines in employment and industrial production. We argue that this points to the condition of financial institutions as an independent source of macroeconomic variability, distinct from traditional accelerator mechanisms.
Profits and Balance Sheets of U.S. Commercial Banks in 2007 (with Bill Bassett)
Federal Reserve Bulletin, June 2008
The U.S. commercial banking industry faced significant challenges in 2007, including continued deterioration in the performance of subprime mortgage-related assets and a more general reassessment by investors of structured finance instruments. Those developments contributed to significant strains in financial markets and dislocations in bank funding markets over the second half of the year. Moreover, economic growth slowed late in the year, and the outlook for 2008 worsened. The turmoil in financial markets hampered banks' securitization programs and their ability to syndicate leveraged loans, which put considerable pressure on the balance sheet capacity and liquidity positions of some banks. Profitability -- especially in the final quarter of 2007 -- fell noticeably from the very high levels posted in recent years. The drop in profits, reflecting primarily lower trading revenue and significantly higher provisions for loan losses, was more pronounced at large banks, but the net income of smaller banks also declined markedly.
Journal of Money, Credit, and Banking, March 2008
Using 20 years of panel data, I demonstrate that high‐risk banks have consistently paid more than safe banks for interbank loans and have been less likely to use these loans as a source of liquidity. The economic importance of this effect was relatively small until the mid‐1990s, when regulatory and institutional changes began to impose more of the costs of bank failure on uninsured creditors. Subsequently, interbank‐market price discipline roughly doubled, and risk‐based rationing effects increased by a factor of six. In imposing this discipline, lenders seem to care most about credit risk at borrowing institutions.
Note: This paper previously circulated under the title "Discipline and Liquidity in the Market for Federal Funds"
Financial Market Perceptions of Recession Risk (with Andy Levin and Roberto Perli)
Working paper, August 2007
Over the Great Moderation period in the United States, we find that corporate credit spreads embed crucial information about the one-year-ahead probability of recession, as evidenced by both in-and out-of-sample fit. Furthermore, the incidence of false positive predictions of recession is dramatically reduced by utilizing a bivariate model that includes a measure of credit spreads along with the slope of the yield curve; indeed, these bivariate models provide much better forecasting performance than any combination of univariate models. We also find that optimal (Bayesian) model combination strongly dominates simple averaging of model forecasts in predicting recessions.
In Search of the Natural Rate of Unemployment (with James Morley)
Journal of Monetary Economics, March 2007
The natural rate of unemployment can be measured as the time-varying steady state of a structural vector autoregression. For post-War US data, the natural rate implied by this approach is more volatile than most previous estimates, with its movements accounting for the bulk of the variation in the unemployment rate, as well as substantial portions of the variation in aggregate output and inflation. These movements, in turn, can be related to variables associated with labor-market search theory, including unemployment benefits, labor productivity, real wages, and sectoral shifts in the labor market. There is also a strong negative relationship between inflation and the corresponding measure of cyclical unemployment, supporting the existence of a short-run Phillips curve.
(with Dan Nuxoll and Tim Yeager)
FRB St. Louis Review, January 2006
Since 1990, the banking sector has experienced enormous legislative, technological, and financial changes, yet research into the causes of bank distress has slowed. One consequence is that traditional supervisory surveillance models may not capture important risks inherent in the current banking environment. After reviewing the history of these models, the authors provide empirical evidence that the characteristics of failing banks have changed in the past ten years and argue that the time is right for new research that employs new empirical techniques. In particular, dynamic models that use forward-looking variables and address various types of bank risk individually are promising lines of inquiry. Supervisory agencies have begun to move in these directions, and the authors describe several examples of this new generation of early-warning models that are not yet widely known among academic banking economists.