Monetary Policy & Credit Easing pt. 2: Defining Our Variables

IN order to get a more complete picture of how monetary policy influences credit conditions we will estimate its effects on both long-term and short-term risk premia.  Our first dependent variable is the short-term risk premia and our second is the long-term risk premium. We will be testing the effects of monetary policy on both risk premias over two separate time periods. The first is from 4/1/71to 7/1/97 and the second is from 4/1/01 to 4/1/11.  We use two different time periods to more strongly capture the influence of the different monetary policy tools that were prevalent to each respective time period.  For example, the first time period was a time characterized by the Federal Reserve's indirect manipulation of the federal funds rate to influence other short-term rates like the prime bank loan rate and rates on short-term commercial paper.  In direct contrast, the second time periods estimation recognizes the Fed's manipulation of both the size and composition of its balance sheet as well as it's use of the federal funds rate to influence short-term market rates.

First Dependent Variable: Short-term Risk Premium & Commercial Paper

Commercial Paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. We will be focusing on 90 day Commercial Paper. Commercial Paper is a money-market security issued by large banks and corporations to get money to meet short term debt obligations, and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their Commercial Paper at a reasonable price. Additionally, Commercial Paper rates increase with maturity so they also have a duration risk associated with the price they fetch in the market place. Since this type of security is typically considered pretty risk free and has virtually zero rollover risk its deviation from the three-month Treasury bill rate seems like an appropriate measure of the short-term risk premium.  The 3 Month T-bill is used as our risk-free asset because it is considered to have zero default risk and is highly liquid. Moreover, T-bills are used for short-term financing purposes which makes its use very similar to that of Commercial Paper. The short-term risk premium is thus operationalized as follows:

SR^{premium}_{t}= CP3M_{t} – TB3MS_{t}

Where,

SR^{premium}_{t} = Short-term Risk Premium at time, t

CP3M_{t}= 3-Month Commercial Paper Rate at time, t

TB3MS_{t}=3-Month Treasury Bill: Secondary Market Rate at time, t

Data Issues

For the 3-Month Treasury Bill series we use the following from FRED:

(a) 3-Month Treasury Bill: Secondary Market Rate (TB3MS), Monthly, 1934-01-01 to 2011-09-01

The 3-Month Commercial paper series is unfortunately not so easy to deal with.  For one the series stops in 1997 and breaks off into two separate time series:

(b) 3-Month Commercial Paper Rate (DISCONTINUED SERIES) (CP3M), Monthly, 1971-04-01 to 1997-08-01

The two separate series include the financial commercial paper rate and the non-financial commercial paper rate:


(c) 3-Month AA Financial Commercial Paper Rate (CPF3M), Monthly, 1997-01-01 to 2011-09-01


(d) 3-Month AA Nonfinancial Commercial Paper Rate (CPN3M), Monthly, 1997-01-01 to 2011-09-01

To reconcile these issues, we take the average of the two and use them for the estimation of the Fed's policies over the second time period.

Second Dependent Variable: Long-term Risk Premium For Corporate Debt

For our long-term risk premium we choose to employ the 10 year Treasury Note rate as our risk-free rate because it shares the full promise of repayment by the United States Government.  Moody's Aaa rated securities aren't so lucky and therefore carry a risk premium associated with them. Although, the risk-premium for longer-term securities includes several things that are more acute under stress than our counterpart short-term risk premium. These include a heightened duration risk, liquidity risk and default risk.  We would expect our estimation of monetary policy effects on this variable to be more accurate as it theoretically should fluctuate more in response to actions taken by the Federal Reserve. The long-term risk premium is defined as follows:

LR^{premium}_{t}= BAA_{t} – GS10_{t}

where,

LR^{premium}_{t} =Long-term Risk Premium at time, t

BAA_{t} =Moody's Seasoned Baa Corporate Bond Yield at time, t

GS10_{t} =10-Year Treasury Constant Maturity Rate at time, t

Data Issues

All of the data here comes from FRED and there series details are listed as follows:

(a) Moody's Seasoned Baa Corporate Bond Yield (BAA), Monthly, 1919-01-01 to 2011-09-01


(b) 10-Year Treasury Constant Maturity Rate (GS10), Monthly, 1953-04-01 to 2011-09-01

Independent Variables: The Federal Reserve's Monetary Policy Toolbox

Our independent variables seek to capture the many tools the Federal Reserve can and has employed throughout its history.  This includes capturing the effects of traditionally unorthodox tools such as the manipulation of both the size (known as quantitative easing) and the composition (known as credit easing) of the Fed's balance sheet as well as capturing the effect from our more well known tools like changing the federal funds rate.  We will also seek to determine the effects of interest paid on reserves.


Accounting For The Size Of The Fed's Balance Sheet & Quantitative Easing

Our first and in the authors opinion most important independent variable seeks to capture the Fed's balance sheet effects on risk premiums.  It will be defined as the Feds holdings of credit market assets as a percentage of the total amount of assets held.  The more the Fed supports credit markets the larger this percentage will be.  It captures the balance sheets size as a percentage of the total market balance sheet. It is available over both our sample time periods and is therefore of pinnacle convenience to our analysis.  One special component of the balance sheet has been the holding of Treasury Securities. Before November of 2008, the Federal Reserve maintained a relatively small portfolio of between $700 billion and $800 billion in Treasury securities- an amount largely determined by the volume of dollar currency that was in circulation. In late November 2008 the Federal Reserve announced that it would purchase up to $600 billion of agency debt and agency mortgage-backed securities (MBS). In March 2009, it enlarged the program to include cumulative purchases of up to $1.75 trillion of agency debt, agency MBS, and longer-term Treasury securities. As mentioned previously, the use of the balance sheet for financial easing was initiated because the Federal Reserves main policy instrument, the federal funds rate had effectively reached the zero lower bound in late 2008.

Operationally we define this variables as:

FedBalance^{size}_{t}={CreditAssets^{Fed}_{t}\ CreditAssets_{t}^{total}}x 100

where,

FedBalance^{size}_{t}= the percentage of the total credit market assets the Fed owns at time, t

CreditAssets^{Fed}_{t}= Total Credit Market Assets Held by Domestic Financial Sectors - Monetary Authority (MATCMAHDFS) at time, t

CreditAssets_{t}^{total}= Total Credit Market Assets Held (TCMAH) at time, t

This variable is the percentage of the total credit market assets that the Fed holds. Its coefficient is meant to be negative so that as it increases market interest rate risk premiums decrease. It accounts for the effects of the size of the Fed's balance sheet. We expect this variable to have a negative effect on both short-term and long-term risk premia and therefore:

H_{0}: ß ≥ 0 vs. H_{a}: ß ≤ 0

Data issues

The data for this variable is available for extraction from FRED and are detailed as follows:

(a) Total Credit Market Assets Held (TCMAH), Quarterly, End of Period, Not Seasonally Adjusted, 1949-10-01 to 2011-04-01


(b) Total Credit Market Assets Held by Domestic Financial Sectors - Monetary Authority (MATCMAHDFS), Quarterly, End of Period, Not Seasonally Adjusted, 1949-10-01 to 2011-04-01