Tuesday, December 27, 2011

Monetary Policy & Credit Easing pt. 1: Background & Theoretical Considerations

An Introduction & Literary Review

Monetary Policy in the United States has traditionally been set to meet two objectives as defined in Federal Reserve Act; price stability and maximum employment.  In order to meet these goals the Federal Reserve manipulates the federal funds rate (FF) through a process called Open Market Operations (OMOs).  Unfortunately, when a recession is brought about by financial crisis this tool lose its potency and the economy enters into a "Liquidity Trap".  In a liquidity trap the FF is effectively at zero, and additional support is necessary to blunt the fall in asset prices and reduce measures of heightened financial stress. The Federal Reserve has recently enlisted a range of tools that are meant to provide further accommodation when their primary tool, the FF hits the lower bound.  These include manipulation of both the size and composition of its balance sheet, informational easing and paying interest on excess reserves.  We seek to formally investigate how these tools impact two important measures of financial stress, the long-term and short-term risk premia. 

There have been a slew of recent studies which seek to estimate the effects of Large Scale Asset Purchases (LSAP's) on Treasury Rates. Using an event-study methodology that exploits both daily and intra-day data, Krishnamurthy and Vissing-Jorgensen 2011 estimate the effects of both Quantitative Easing 1 and 2.  They find a large and significant drop in nominal interest rates on long-term safe assets (Treasuries, Agency bonds, and highly-rated corporate bonds).  

Sack, Gagnon, Raskin and Remache 2011 estimate the effects of large-scale asset purchases on the 10-year term preimium.  They use both an event-study methodology and a Dynamic OLS regression with Newey-West standard errors. They present evidence that the purchases led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that were not included in the purchase programs. Importantly, they find that these reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than lower expectations of future short-term interest rates.  

In 1966 Franco Modigliani and Richard Sutch wrote a seminal piece on Monetary Policy titled ``Innovations in Interest Rate Policy." In the paper the authors estimate the effects of ``Operation Twist", a policy by the Federal Reserve and the Kennedy Administration aimed at affecting the term structure of the yield curve.  In summary they find that the targeting of longer maturities has a rather minimum effect on the spread between short-term and long-term government debt securities.    

Bernanke, Reinhart and Sack 2004, estimate the effects of ``non-standard policies" when the Federal Funds Rate hits the lower bound.  They find that the communications policy can be used to effectively lower long-term yields when short-term interest rates are trapped at zero. They also find evidence supporting the view that asset purchases in large volume by a central bank would be able to affect the price or yield of the targeted asset.  This research was most likely the basis for the Feds actions taken over the course of the latest U.S. financial crises.  

Theoretical Model, Assumptions & Further Details

A risk premium is the amount a debt issuer has to pay in order to borrow above the interest rates on the safest of assets for a given maturity, m. By comparing interest rates on debt with the same maturity we are able to isolate the part of the spread that stems from duration risk from the other factors that influence the risk of default.  Additionally, by using only nominal debt instruments we remove elements in the spread that stem from inflation compensation.  

Risk premiums are thus defined as follows:

r_{m}^{premium} = r^{RR}_{m} - r^{Rf}_{m


 r_{m}^{premium} = Risk Premium for time till maturity, m

r^{RR}_{m}= Risky interest rate on nominal debt, for time till maturity, m

 r^{Rf}_{m} = Risk free interest rate for nominal debt, for time till maturity, m

In order to see what factors influence r_{m}^{premium} we have to analyze what moves the interest paid on the risk free interest rate, r^{Rf}_{m}, which is usually defined as some sort of United States Government debt, and the interest rate that carries risk, r^{RR}_{m}.  

Uncertainty and financial stress go hand in hand as  well documented in Charles P. Kindleberger's "Manias, Panics and Financial Crisis".  Historically during periods of high uncertainty, asset prices fluctuate wildly as more cautious investors cling to the safest assets (known as flight to safety) and the more bold investors bargain shop. Investors sell assets that carry r^{RR}_{m} and purchase those that carry r^{Rf}_{m}.  This causes the r_{m}^{premium} to increase dramatically and it becomes relatively more expensive for firms to access the capital markets to meet their funding needs.  There is a shortage of credit or credit crunch as debt issuers struggle to find buyers of their debt. 

In expansionary times the two interest rates that determine the risk premium move towards each other thus decreasing the risk premia.  Investors feel more confident and become hungry for yield, this leads to movement away from the risk-less lower interest carrying assets into riskier assets with a higher yield.  This pushes down the yield on the riskier assets and pushes the yield on the riskless assets up, thus making the return on these assets similar.   

Room For Policy

During periods of financial stress the Federal Reserve can reduce the risk premia and thus ease credit conditions by moving either r^{Rf}_{m} or r^{RR}_{m}.  The Fed has relied on the "portfolio balance channel" in order to reduce the financial stress felt by credit worthy firms.  As the Fed purchases Treasuries, yield hungry and  "crowded out" investors may purchase assets with similar credit ratings (like bonds with a AAA rating) in order to capture that increased yield differential thus lowing the yield on these assets.  
Brian P. Sack, Executive Vice President of the Federal Reserve, provided a great description of the Portfolio Balance Channel in a 2010 speech given at the CFA Institute Fixed Income Management Conference:
Under that view (portfolio balance channel view), our (the Fed) asset holdings keep longer-term interest rates lower than otherwise by reducing the aggregate amount of risk that the private markets have to bear. In particular, by purchasing longer-term securities, the Federal Reserve removes duration risk from the market, which should help to reduce the term premium that investors demand for holding longer-term securities. That effect should in turn boost other asset prices, as those investors displaced by the Fed’s purchases would likely seek to hold alternative types of securities.
All other things being equal the risk premia should decrease because the U.S. Treasury market is the most liquid market on earth. So the decrease in Treasury yields should be less than that of the less-liquid and risk-bearing assets.  

The Fed can also influence the risk premia by purchasing the risk bearing asset directly.  Examples of this include its implementation of the Commercial Paper Funding Facility (CCFF) and Agency Mortgage-Backed Securities Purchase Program (ABMBSPP).

Credit Easing is another channel the Federal Reserve has looked to exploit. Credit Easing policies involve changing the composition of the Fed's Balance Sheet from risk-less assets to riskier ones, all while keeping its size constant. Operationally it involves selling risk-free assets like 3 month T-bills to finance the purchase of risk-bearing assets like 3 month Commercial Paper. These assets have the same maturity m and the goal of the operation is accomplished as it circumvents the need to reduce the size of balance sheet. These policies lead to lower risk premiums as they increase the rate r^{Rf}_{m} on the risk-free asset being sold and decrease the r^{RR}_{m}, or interest rate on the risky asset being bought in the risk-free assets place.  This leads to additional easing as investors feel more certain that the market value of these assets will be supported by the Fed's holdings.  Removing the uncertainty leads to these riskier assets being transformed into less risky ones, thus increasing the appeal for them in periods of tumultuous financial stress.

In the next post we will delve into defining our dependent variables which seek to explicitly capture in risk premia while also looking at a few of our independent variables.  

Please people keep dancing into the new year,

Steven J.

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