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

Where,

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

Where, 

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. 

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} 

Where,

 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.

Janet Yellen and the Fed's New Approach to Asset Bubbly

     I love Janet Yellen because she is an academic and a Hyman P. Minsky follower on the Federal Reserves Board of Governors.  In a recent speech titled "The Federal Reserve's Asset Purchase Program", Yellen breaks down the Fed's decision to engage in a second round of asset purchases while offering the best research available.  She delves into the beverage curve- which is the relationship between unemployment and job vacancies- to talk about both structural and cyclical factors affecting unemployment.  Additionally, she details the Fed's new attempts at monitoring quantitative easing effects on credit flows and asset bubbles.  This is a revolutionary and remarkable change in procedure at the Fed because before this crises the Fed would have completely denied looking at asset price movements and credit in making its decisions.  This signals a significant shift in the attitude and mindset that recognizes that markets are not always efficient or rational, especially when it comes to asset prices.  In evaluating the dangers of the Fed's latest round of quantitative easing, Yellen mentioned the following asset price and credit indicators:

With respect to the stock market:

"In the stock market, for example, price-to-earnings ratios, by some measures, remain below their averages over the past several decades, and other valuation measures also indicate that equity prices are not significantly out of alignment with past norms."

Then looking at the Price-to-rent ratio for the housing market:

"In the real estate market, price-to-rent ratios for both residential and commercial real estate are now within a reasonable range of their long-run averages, in contrast to the severe misalignment that occurred prior to the crisis. Again, there is little sign here of imbalances relative to fundamentals, at least if history is used as a guide."

In the Bond market we have seen the obvious bubble created by the fed when it intervenes into the market and buys up treasuries:

"In fixed-income markets, narrow risk spreads and risk premiums could be signs of excessive risk-taking by investors, and indeed spreads on corporate bonds have dropped dramatically since the financial crisis, as the economic outlook has improved and investor sentiment has picked up. Risk premiums on nonfinancial corporate bonds, as measured by forward spreads far in the future, are relatively low compared with historical norms, although other indicators for this market do not point to overvaluation." 

Yellen even mentions identifying financial imbalances by focusing more directly on measuring credit flows and exposure to credit risk! In this area the risks are mute:

"Thus, there is little evidence that financial institutions are significantly expanding the level of credit and liquidity provided to households and businesses on net. Indeed, given the current very low level of interest rates and the continuation of the economic recovery, credit flows remain stubbornly sluggish."

The Fed even created a new survey called the Senior Credit Officer Opinion Survey on Dealer Financing Terms to monitor leverage:

"To monitor leverage provided by dealers to financial market participants, last June the Federal Reserve launched the Senior Credit Officer Opinion Survey on Dealer Financing Terms. This survey provides information on credit terms and availability of various forms of dealer-intermediated financing, including funding for securities positions and over-the-counter derivatives. The survey results suggest that over the past several months there has been some easing of terms applicable to financing for a range of counterparty types and many types of collateral, as well as an increase in demand from clients to fund most types of securities. These results indicate that the availability and use of leverage by nonbank financial institutions increased somewhat last year."

The Fed is on track to be extremely successful in the long-run.  Although, the additional asset purchases are a dangerous move given that the Fed has created and set in motion a bond bubble.  The asset purchases explicitly say to the financial markets that the Fed will not be afraid to use this tool in the future, which may in itself create a moral hazard for the bond market.  The thing that I love best about Janet Yellen's speech must be the explicit statement about using adaptive regulation to target financial imbalances versus using the extremely blunt federal funds rate.  Janet wants to work closely with other regulators to monitor systemic risk and nip asset inflation in the bud.  I wrote about this a while back (June 21,2010 to be exact)  thus making me especially delighted that someone on the board has formed the same views (albeit independently):

"We are working with other regulators to make the financial system more robust and are attentive in our supervision to developments that may affect systemic risk. If evidence of financial imbalances were to develop, I believe that supervision and regulation should provide the first line of defense so that monetary policy can concentrate on its longstanding goals of price stability and maximum employment. That said, we cannot categorically rule out using monetary policy to address financial imbalances, given the damage that they can cause."