Wednesday, December 28, 2011

Monetary Policy & Credit Easing pt. 3: Accounting For The Composition of The Fed's Balance Sheet & Credit Easing

Credit Easing shifts the composition of the balance sheet away from default-free assets towards assets with credit risk. An example of Credit Easing which is pertinent to our testing the effects of monetary policy on commercial paper is the Commercial Paper Funding Facility. Implementation of this facility involved the U.S. central bank selling T-bills and purchasing commercial paper of similar maturity.  This shift in composition leaves the size and average maturity of bank assets on the Fed's balance sheet unchanged. When the Fed purchases an asset like commercial paper, it lowers the supply of this asset to private investors. This scarcity has the effect of boosting its price and pushing down its yield. In the absence of private demand for the risky asset, the Feds purchase makes credit available where no alternative existed. The composition effect will be captured by our second time period estimation (from 4/1/01 to 4/1/11) of Monetary Policy's effects as all of the credit easing policies employed by the Fed occurred over this time period. A little background on the implementation of these polices is introduced below.

Implementation of Credit Easing and Large Scale Asset Purchases*
*This section draws heavily from Sack 2010

The Federal Reserve holds the assets it purchases in the open market in its System Open Market Account (SOMA).  Historically, SOMA holdings have consisted of nearly all Treasury securities, although small amounts of agency debt have been held. Purchases and sales of SOMA assets are called outright open market operations (OMOs).  Outright OMOs, in conjunction with repurchase agreements and reverse repurchase agreements, traditionally were used to alter the supply of bank reserves in order to influence the federal funds rate.  Most of the higher-frequency adjustments to reserve supply were accomplished through repurchase and reverse repurchase agreements, with outright OMOs conducted periodically to accommodate trend growth in reserve demand. OMOs were designed to have a minimal effect on the prices of securities included in its operations.  It is the Fed's way of not distorting prices on debt instruments and thus protecting its independence from political pressure.  To this end, OMOs tended to be small in relation to the markets for Treasury bills and Treasury coupon securities. Large Scale Asset Purchases, however aimed to have a noticeable impact on the interest rates being purchased as well as on other assets with similar characteristics. In order to lower market interest rates, Large Scale Asset Purchases were designed to be large relative to the markets for these assets.  As mentioned in Gagnon, Raskin, Remache and Sack 2010:
Between December 2008 and March 2010, the Federal Reserve will have purchased more than $1.7 trillion in assets. This represents 22 percent of the $7.7 trillion stock of longer-term agency debt, fixed-rate agency MBS, and Treasury securities outstanding at the beginning of the LSAPs.
In the following discussion of the independent variables selected to capture this effect please note that they are all defined as Federal Reserves holdings as a percentage of the total market value outstanding.  In this way we can quantify how much the Fed's holdings relative to the total market supply of these assets impacted market risk premia.

Large Scale Asset Purchases were focused on four main securities:

1. Agency Debt

2. Mortgage Backed Securities

3. Treasury Securities

4. Commercial Paper

Although we do not explicitly account for these Treasury Purchases, we rely on our main balance sheet variable to capture their effects. The first asset to account for which is especially pertinent to our short-term risk premia variable is commercial paper.

Commercial Paper

Accounting for commercial paper and the Commercial Paper Funding Facility LLC, we will use the Fed's holdings as a percentage of the total commercial paper outstanding. The Commercial Paper Funding Facility LLC, like all of the Fed's Credit Easing tools was only functional during our second estimation period  (4/1/01 to 4/1/11). That is why it will only be used as a variable over that estimation period. Operationally:

Commercial Paper^{Fed}_{t}={CPaper^{Fed}_{t}\ CPaper_{t}^{total}}x 100

Commercial Paper^{Fed}_{t}= the percentage of the total commercial paper outstanding the Fed owns at time, t

CPaper^{Fed}_{t}= Net Portfolio Holdings of Commercial Paper Funding Facility LLC (WACPFFL) at time, t

CPaper_{t}^{total}= Commercial Paper Outstanding (COMPOUT) at time, t

We expect this variable to be negatively related to short-term risk premia over our estimation period. The reason being that increased Fed support in this market should have directly reduced the spread between commercial paper and Treasury bills.  Especially if the Fed sold T-bills to purchase short-term commercial paper and asset backed commercial paper.  Therefore the following hypothesis test is appropriate:

H_{0}:ß ≥ 0 vs. H_{a}: ß < 0 

With respect to the long-term risk premia, we should expect this monetary policy action to have a negligible effect.  This is because this policy was aimed at impacting short-term commercial paper and not longer-term rates:

H_{0}: ß = 0 vs. H_{a}: ß ≠ 0

Data Issues

The following data sets are pulled from FRED and their details are as follows:

(a) Assets - Net Portfolio Holdings of Commercial Paper Funding Facility LLC (DISCONTINUED SERIES) (WACPFFL), Weekly, As of Wednesday, Not Seasonally Adjusted, 2002-12-18 to 2010-08-25

(b) Commercial Paper Outstanding (COMPOUT), Weekly, Ending Wednesday, Seasonally Adjusted, 2001-01-03 to 2011-10-26

This required the following data transformation within FRED:

{(WACPFFL\1000)\ COMPOUT}x100

Mortgage-Backed Securities & Agency Debt

In order to account for the Feds holdings Agency Debt and Mortgage Backed Securities as a percentage of the total outstanding we use the following variable:

Agency Debt & MBS^{Fed}_{t} = {FADS^{Fed}_{t} + MBS^{Fed}_{t}\ DomesticFinancial_{t}^{Total}}x 100

Agency Debt & MBS^{Fed}_{t}= Feds holdings of agency debt and Mortgage-Backed Securities as a percentage of the total outstanding at time, t

FADS^{Fed}_{t}= Fed's holdings of Federal Agency Debt Securities (WFEDSEC) at time, t

MBS^{Fed}_{t}= Fed's holdings of Mortgage-Backed Securities (WMBSEC) at time, t

DomesticFinancial_{t}^{Total}=  Domestic Financial Sectors holdings of Agency- and GSE-Backed Mortgage Pools (AGSEBMPTCMAHDFS) at time, t

This variable, theoretically should have almost no impact on both long-term and short-term risk premiums. The reason is Agency Debt and MBS are not highly correlated with either of our dependent variables, in fact it wasn't meant to impact these measures. It was however meant to influence 30 year mortgage rates which much research has shown it did in fact help ease.  We include this variable only because it was a major part of the Fed's credit easing policy and that future models with measures of housing affordability as their dependent variable would be able to use the variables listed in this paper to show Fed support of the housing market. 
The beta coefficient in front of this independent variable is therefore expected to have no significant relation to either long-term or short-term risk premiums as defined in this paper:

H_{0}: ß = 0 vs. H_{a}: ß ≠ 0

We fully expect to not reject the null hypothesis for both of our models.

Data Issues

The data for the above variables comes from the following financial time-series from FRED:

(a) Total Credit Market Assets Held by Domestic Financial Sectors - Agency- and GSE-Backed Mortgage Pools (AGSEBMPTCMAHDFS), Quarterly, End of Period, Not Seasonally Adjusted, 1949-10-01 to 2011-04-01

(b) Reserve Bank Credit - Securities Held Outright - Federal Agency Debt Securities (WFEDSEC), Weekly, Ending Wednesday, Not Seasonally Adjusted, 2002-12-18 to 2011-10-26

(c) Reserve Bank Credit - Securities Held Outright - Mortgage-Backed Securities (WMBSEC), Weekly, Ending Wednesday, Not Seasonally Adjusted, 2009-01-14 to 2011-10-26

Please keep dancing and wait for our next post which finishes defining our independent variables,

Steven J. 

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