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Policy Hub: Macroblog provides concise commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues for a broad audience.

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July 6, 2022

Workshop on Monetary and Financial History: Day Two

In yesterday's post, I discussed the first day of the Atlanta Fed's two-day virtual workshop on monetary and financial history. In today's post, I'll discuss the workshop's second day, which began with presentations by Maylis Avaro (University of Pennsylvania) and Caroline Fohlin (Emory University).

Avaro's paper Adobe PDF file format, coauthored with Vincent Bignon (Banque de France), examined the historical (19th-century) credit policies of the Banque de France using a comprehensive dataset of credits that the Banque extended during one year (1898). In its credit operations, the Banque attempted to offset regional economic shocks by providing directed credit to the affected regions. It provided credit only against collateral, and it intensely monitored counterparties, especially for riskiness of their business model. Econometric analyses show that the Banque tended to extend credit at branches experiencing regional shocks, but usually only to parties judged to be sufficiently prudent. This analysis also shows that the Banque favored banks over nonfinancial firms and existing over new counterparties. Avaro concluded by arguing that this historical example illustrates the potential benefits of central bank credit operations when appropriate risk management can limit moral hazard.

The discussant for this paper was Angela Redish (University of British Columbia). Redish argued Adobe PDF file format that the credit operations documented in the paper were somewhat different from what might be expected in other lender-of-last-resort situations, in which market disruptions might hinder assessments of risk and impair the value of collateral. Redish also questioned why private banks did not lend against the same sorts of collateral as the Banque, suggesting that some of the Banque's lending success might have been the result of its market power as the monopoly issuer of banknotes within France.

Fohlin's presentation Adobe PDF file format described a research program, undertaken with Stephanie Collet (Deutsche Bundesbank), to construct a comprehensive dataset of interwar German stock prices. Fohlin's presentation focused on data from the 1920s. These data span a number of major disruptions to the German economy, including the 1921–23 hyperinflation, the 1927 stock market crash, and the rise of the Nazi party. Volatility of individual stock prices and bid-ask prices were high during this unsettled period. Despite this volatility, micro analysis of the data shows that the German stock market was surprisingly liquid for most of the sample, with buy orders typically exceeding sell orders. Another surprise was that shares of new companies were as liquid as those of existing companies. Market illiquidity increased during the late 1920s, however, in the wake of the 1927 stock market bubble and ensuing market crash.

The discussant was Eugene White (Rutgers University), who suggested that the data collected by the authors could be applied to a number of interesting research topics. For example, the data could provide additional perspective on the performance of the interwar stock market if its performance were contrasted with the pre-1913 market. A greater understanding of the institutional background of the market—for example, regulatory structure and stock voting rights—would also be useful. White also questioned how much the release from wartime capital controls in1919 was behind the apparent vitality of the 1920s market. Finally, White suggested that the authors investigate the impact of Reichsbank regulatory policy, margin requirements in particular, on market liquidity.

Looking back, and ahead
The fourth session of the workshop consisted of a panel discussion of the past and future of money. The panelists were François Velde (Federal Reserve Bank of Chicago), Gary Gorton (Yale University), and Marc Flandreau (University of Pennsylvania),

Velde's presentation Adobe PDF file format considered possible roles for central bank digital currencies (CBDC) in the context of historical examples of monetary innovation. Velde observed that central banks arose from earlier, coin-based monetary systems, to fill gaps in those systems, first through giro transfers (a type of payment transfer between banks) and later through circulating currency. Originally most central banks only dealt with large-value payments, and even today most central banks are not retail-oriented. That could change with CBDCs, Velde noted, especially if future CBDCs incorporate innovative features such as smart contracts, although the property rights of information collected on CBDC users will be a contentious policy issue. Another unresolved issue regarding CBDCs is their role with respect to private digital currencies. Velde argued that competition between public and private moneys could be beneficial. Velde concluded by noting the monetary innovations are often the product of accidents or strong underlying trends, rather than conscious policy choices.

Gorton's presentation Adobe PDF file format focused on new forms of private money and associated policy issues. Gorton argued that all private money inherently has the problem of information asymmetry and that the classic solution to this problem is to create money with a par value so that its value does not have to constantly be reassessed in market transactions. Typically, par money is debt that is backed by other debt. This solution creates another problem, Gorton argued, which is that debt-backed money can be subject to runs and sudden loss of value when confidence is lost in the money's backing. Stablecoins—digital tokens that have safe asset backing—are susceptible to the same problems as paper-based forms of private money, as recent runs on stablecoins show. Gorton concluded by drawing on the history of paper currency to suggest that the only viable long-term solution to the run problem will be central bank monopoly of digital token issue.

Flandreau's presentation considered the impact of monetary innovations on international currency competition. Flandreau rejected the "unipolar" and "multipolar" interpretations of monetary history literature (basically, a tendency to converge toward one or more dominant currencies), instead arguing that the true nature of monetary evolution has been one of currency competition regimes. As an example, he cited a currency competition regime that centered around the bill of exchange, an important international payment instrument from the 14th through the early 20th centuries. Major European currencies competed for international status within this regime by developing dense markets for bills of exchange. However, latecomers to this currency competition (Germany, Japan, and the United States) increased their competitiveness through new infrastructure, such as international branch banking, and new payment instruments, such as telegraphic transfers. These innovations supported the rise of the US dollar as an international currency when bills of exchange fell from use during the 1930s. Flandreau saw this history as illustrating the idea that currency regimes depend on their underlying financial infrastructure and monetary instruments.

The conference's fifth session featured paper presentations by Sasha Indarte (University of Pennsylvania) and Marc Weidenmier (Chapman University). Indarte's paper Adobe PDF file format analyzed a dataset of sovereign bond defaults from 1869 to 1914, which was matched to a dataset of sovereign bond prices during the same period. Indarte described how a critical aspect of sovereign bond issue during this period was the reputation of the party underwriting the bond in the London financial markets. Econometric analyses show the presence of underwriter-related spillovers. More specifically, default of one sovereign bond issue typically depressed the prices of bonds with the same underwriter, after taking into account other observable factors. The reputation spillover effect is economically significant and evident for at least two years following a default. Indarte concluded by observing that this same pattern of underwriter spillover effects might be present in modern contexts such as syndicated lending.

Jonathan Rose (Federal Reserve Bank of Chicago) provided the discussion Adobe PDF file format . Rose noted that the effect of underwriter reputation, while well documented in the paper, was perhaps more critical in historical than modern contexts (citing mortgage-backed securities as an example), due to the sovereign bonds' lack of regulation or credit enhancement features. Rose also raised the possibility of self-selection in the data sample, with weaker bond issuers seeking out underwriters who were more willing to risk their reputations.

Weidenmier presented Adobe PDF file format new data series of US industrial production in the decades surrounding the Civil War (1840–1900), taken from a recent paper coauthored with Joseph David (Vanguard Group). The data series uses hand-collected, city-level data and are separated by Northern and Southern states. The data show that growth in Northern-state industrial production was little affected by the war. Southern-state industrial production, on the other hand, fell precipitously during the war and did not return to prewar levels until about 1875. Capital-intensive industrial production in Southern states was especially slow to recover. However, rapid growth resumed in the 1880s, perhaps because of the resolution of uncertainty regarding investor property rights following the end of Reconstruction.

The discussant for this paper was Mark Carlson (Board of Governors), who noted Adobe PDF file format that some of the regional differences documented in the paper might have been the result of the population's westward expansion, which was more pronounced in the North. He also suggested that the quality of some of the immediate postwar data in the South might have been poor, possibly biasing statistical results. Those concerns aside, a striking feature of the data is that the North did not see a postwar contraction, as occurred in the United States after World War II. Finally, Carlson proposed that the observed regional differentials might be attributable to the disruption of the banking system that the South experienced during the Civil War and its immediate aftermath.

The conference's final panel was a discussion of the evolution of the Fed's mission and governance. The panelists were Sarah Binder (George Washington University), Lev Menand (Columbia University), and Ned Prescott (Federal Reserve Bank of Cleveland).

Binder began the panel with an analysis Adobe PDF file format of the Fed's political independence drawn from her recent book with Mark Spindel. Binder proposed that the conventional view of the Fed as an agency insulated from short-term political pressures is incorrect, arguing that this view is overly rooted in struggles to control inflation during the 1970s and 1980s. Moreover, it overlooks both the historical importance of financial crises in shaping the Fed and the partisan context in which the Fed operates. Under this view, the Fed and Congress display interdependence, the Fed gaining political support and the Congress gaining the Fed's ability to quickly react in crises, as well as to absorb blame for unfavorable economic outcomes. Binder went on to argue that this interdependence has driven the structural evolution of the Fed, in the form of cycles whereby successive crises result in Congressional reforms of the Fed. Sensitivity of Fed policymakers to this cycle of reform has influenced many Fed policy decisions, Binder noted, its structural independence notwithstanding.

Menand's presentation Adobe PDF file format focused on the role of the Fed within the broader legal framework of the US monetary system. Although some legal scholars see the Fed as a "hodgepodge agency" with many unrelated functions, Menand argued that the Fed's role is a coherent one within the US monetary tradition, which "outsources" money creation to independent entities, including chartered commercial banks but, since 1913, also the Fed. The structure of the Fed also resonates with the US tradition of geographic diffusion of banking, as well as the tradition of bank supervision. In addition, independence of the Fed from the executive branch coheres with the general US tradition of outsourcing the task of money creation. However, Menand proposed that more recently, the Fed has ventured beyond its traditional boundaries through its interactions with shadow banks, which are entities that issue deposit-like liabilities but lack bank charters. Menand concluded by arguing that Fed actions to support shadow banks during financial disruptions in 2008 and 2020 have eroded traditional political limits regarding what the Fed is expected to accomplish.

Prescott's presentation Adobe PDF file format focused on the evolution of the research function at the Reserve Banks, drawing on a recent paper Adobe PDF file format coauthored with Michael Bordo. Prescott described how research was not emphasized at the Reserve Banks until the 1951 Treasury-Fed Accord, which granted the Federal Open Market Committee more independence in setting monetary policy. Prescott noted that during the 1950s and 1960s, this independence led to an increased emphasis on research, in part because more economists had become Reserve Bank presidents. During this period, the St. Louis Fed assumed the role of a "dissenting Reserve Bank," articulating policy positions based on monetarist ideas. During the 1970s, research conducted at the Minneapolis Fed fostered new approaches to monetary policy that incorporated the concept of rational expectations. Later, ideas promoted by researchers at the Richmond Fed (policy transparency) and the Cleveland Fed (inflation targeting) also came to influence Fed policymaking. Prescott concluded with the observation that these historical examples illustrate the value of the Fed's decentralized structure, in which alternative approaches to policy can be formulated and incorporated into the policy process.

July 5, 2022

Workshop on Monetary and Financial History: Day One

On May 23 and 24, the Federal Reserve Bank of Atlanta hosted a workshop on monetary and financial history. The workshop was organized by Atlanta Fed economist William Roberds, in cooperation with Michael Bordo (Rutgers University) and Warren Weber (Federal Reserve Bank of Minneapolis, retired). The workshop featured seven paper presentations, along with three panel discussions and a keynote lecture.

Exploring fiscal-monetary interaction
The first session of day one of the workshop featured three papers that examine interactions between monetary and fiscal policy.

The first paper Adobe PDF file format of the session was presented by Michael Bordo and Oliver Bush (Bank of England) and coauthored with Ryland Thomas (Bank of England). Their paper examines causes of the 1970s inflation in the United Kingdom, which was higher than in other advanced economies at the time. Bordo and Bush presented structural decompositions of the 1970s UK inflation. These decompositions suggest that a combination of fiscal responses to external shocks and passive monetary policy was the principal causal factor. The same decompositions suggest that fiscal reforms enacted during the 1980s and early 1990s enabled the Bank of England to reduce inflation to more acceptable levels.

In the discussion Adobe PDF file format, Joshua Hausman (University of Michigan) proposed that the authors emphasize narrative aspects of this historical episode. What economic models were most conducive to policies that led to double-digit inflation? Given that other countries were using the same models, why did reliance on these models result in worse inflation outcomes in the UK than elsewhere? Hausman also noted that the lower inflation rates achieved from the 1980s onward did not lead to uniformly better economic outcomes, in the form of higher trend economic growth, lower unemployment, and higher growth of real wages.

The fiscal-monetary theme continued with the second paper Adobe PDF file format of the session, which was presented by George Hall (Brandeis University) and co-authored with Thomas Sargent (New York University). Their paper compares the financing of US government expenditures associated with the COVID-19 pandemic to the financing of World Wars I and II, which gave rise to expenditures of comparable magnitude. Hall presented an accounting framework that decomposes wartime financing into three main components: taxes, debt, and money creation. This decomposition indicates that in contrast to expenditures during the two world wars, COVID-19 expenditures have been funded very little by taxes and largely by debt. Also different from the world wars is the fact that much of the COVID-19 debt has taken the form of monetary assets, interest-bearing Fed reserves, and reverse repos. Hall suggested that the experience of the world wars indicates that inflation will eventually amortize much of the debt induced by COVID-19.

The Hall and Sargent paper was discussed Adobe PDF file format by Chris Meissner (University of California, Davis). Meissner argued that the COVID-19 shock was different from the world wars insofar as it was largely unanticipated, simultaneously global, and associated with widespread financial market disruptions. For this reason, reliance on debt funding might have been a more appropriate policy than for either of the war episodes. However, Meissner also suggested that reliance on debt financing might have significantly reduced the United States' ability to respond to future external shocks.

The final paper Adobe PDF file format of the first session was presented by Eric Leeper (University of Virginia) and coauthored with Margaret Jacobson (Board of Governors) and Bruce Preston (University of Melbourne). Their paper focuses on the performance of the US economy during the Great Depression and argues that the economy's initial recovery in the early years of the Roosevelt administration can be attributed to fiscal expansion combined with the repeal of the gold standard. Leeper argued that latter policy enabled the Fed to finance much of Roosevelt's fiscal expansion via unbacked bonds, but that the recovery was then paused by more restrictive fiscal policies adopted after 1937.

Kris Mitchener (Santa Clara University) discussed Adobe PDF file format this paper in the context of the large literature on the Great Depression, which has generally emphasized monetary rather than fiscal policy as a driving force in the initial Roosevelt recovery. Mitchener noted that for this reason, the paper's fiscal-monetary focus represents a new explanation of the post-1933 recovery. However, Mitchener also noted that during the Depression, most individual Treasury bond holdings were limited to higher-income households and that this heterogeneity would matter for the paper's arguments. In addition, banks held many bonds, and it would be desirable to model the effects of fiscal expansion on banks' balance sheets. Additionally, Mitchener recommended that the authors consider the effects of US policies on its international trade.

Putting inflation into historical perspective
The second session of the conference featured a panel discussion of the current inflationary outlook in the context of earlier inflationary episodes. The panelists were Robert Hetzel (Federal Reserve Bank of Richmond, retired), Jeremy Rudd (Board of Governors), and Mickey Levy (Berenberg Capital Markets).

Hetzel proposed that there are enough commonalities of the current situation with historical episodes—particularly the inflationary acceleration experienced in the 1960s and 1970s—for the Federal Open Market Committee to consider formally integrating monetary history into the policymaking process. He argued Adobe PDF file format that this integration would lead to a more transparent statement of the FOMC's monetary standard.

Drawing on his experience at the Richmond Fed during the 1970s, Hetzel recalled the Federal Reserve's intense resistance at that time to explicitly articulating policy objectives. He argued that although there have since been improvements, the Federal Open Market Committee (FOMC) could better articulate a monetary standard through integration of historical perspectives into policymaking. More specifically, this proposal would include (1) establishment of a committee of monetary historians that would report directly to the FOMC, (2) a restructuring of the Teal Book (the briefing document prepared by the Board of Governors staff for FOMC meetings) to include a historical breakdown of how the economy got to its current state, and (3) replacement of the FOMC's current Summary of Economic Projections, which reports a collection of individual forecasts, with a consensus FOMC forecast that would be informed by consultations with the historian committee in part (1) of the proposal and the historical breakdown in part (2).

Rudd's presentation Adobe PDF file format focused on potential changes in underlying inflation dynamics observed since the start of the COVID-19 pandemic. Rudd observed that prepandemic, Fed policymakers had been able to rely on stable long-term trend inflation in the US economy, as well as a flat Phillips curve (a negative correlation between unemployment and inflation), although the factors giving rise to these favorable conditions were not well understood. This lack of understanding has hindered Fed policymaking post-COVID, when inflation has increased in part due to large relative price shocks, creating uncertainty as to whether trend inflation has now moved higher. To overcome this uncertainty, Rudd argued that it might be useful to examine historical episodes and, particularly, the increase in trend inflation observed during the late 1960s.

Rudd proposed that the underlying dynamics in the 1960s were different from those of the current economy, because of less anchored long-term inflation trends and a steeper Phillips curve. Hence, we should reject a repeat of 1960s-style overheating as an explanation for the recent pickup in inflation. A commonality with the 1960s, however, is that policies adopted then seemed reasonable at the time, and policymakers didn't foresee them as fostering persistent inflation. A major question for policymakers, then as now, is whether the recent acceleration in inflation reflects a fundamental shift in the structure of the economy. Rudd concluded by noting that by the time this question is answered, reversing any increase in trend inflation could be difficult.

Levy's discussion Adobe PDF file format focused on a recent research paper coauthored Michael Bordo. The paper surveys cyclical patterns of Fed policymaking over its entire history, from 1914 until present. Bordo and Levy argue that in these cycles, the Fed has had a general tendency to wait too long to remove monetary accommodation. They cite four factors behind this tendency: shifting doctrines about how monetary policy should be conducted, ambiguity surrounding the Fed's dual mandate, misreads of data on the state of the economy, and political pressures.

Levy proposed that these same factors have been present in the most recent policy cycle, leading to delayed removal of accommodation. Movement to a neutral level of policy interest rates will now be difficult, he argued, and—given current negative real interest rates—a hard landing has a high probability. Levy concluded with three recommendations for Fed policy going forward. First, the Fed should place more emphasis on rules-based policy (for example, a type of Taylor rule) as a benchmark. Second, the Fed should adopt a less ambiguous interpretation of its dual mandate. Third, the Fed should pay more attention to the lessons of history and incorporate these lessons into its policy doctrine.

The conference's keynote lecture Adobe PDF file format was delivered by Barry Eichengreen (University of California, Berkeley). Eichengreen's presentation surveyed the evolution of payments instruments over the past millennium, from medieval-era banknotes in China to today's digital forms of payment. A theme of the presentation was increasing technological efficiency: transactions in paper money were more efficient than the physical transfer of coins, and modern types of electronic transactions are more efficient still. The shift towards digital forms of payment has recently accelerated, Eichengreen observed, because of the COVID-19 epidemic, which led consumers to prefer online forms of payment. This shift has occurred in virtually every nation with a sufficiently advanced cellphone network, but especially in Sweden, which coincidentally was also an early adopter of printed banknotes.

Eichengreen noted that a factor that has worked against more widespread adoption of advanced digital forms of payment is that in most countries (with exceptions such as Sweden) these are not ubiquitous. Network externalities may soon lead to the emergence of dominant private forms of digital payment, however, but such dominance could result in monopoly pricing and the need for regulation. Blockchain technology alone will not by itself resolve issues with digital payments. Stablecoins have the potential to supplant paper currency for many purposes, but monetary history teaches that fractionally backed stablecoins might be susceptible to runs, again suggesting a role for regulation.

The lecture concluded with the observation that retail-level central bank digital currencies (CBDCs) might offer advantages in terms of ubiquity and stability, but CBDCs would simultaneously pose operational challenges for central banks and could encourage disintermediation of commercial banks. For these reasons, Eichengreen suggested that CBDCs are more likely to be issued at the wholesale level—for example, to commercial banks—and these banks would in turn manage CBDC transactions that their customers initiate.

In his closing remarks, Eichengreen argued that although paper currency has been a ubiquitous form of money only within a relatively short period of human history, its advantages mean that it will likely persist even as digital forms of payment become more widespread. As the latter become more prevalent, strong network externalities will necessitate government involvement, both through the provision of CBDCs and the regulation of private forms of money.

In tomorrow's post, I'll cover the presentations and discussions in the workshop's second day.

June 23, 2022

Financial Markets Conference 2022: Exploring the Financial Sector

Note: This is the second of two posts discussing the Atlanta Fed's 2022 Financial Markets Conference. You can read the first part of the conference summary here.

The Atlanta Fed's 2022 Financial Markets Conference, A New Era of Financial Innovation and Disruption: Challenges and Opportunities, featured policy panels, academic paper presentations, and keynote speakers exploring various developments having a significant impact on the financial system. This Policy Hub: Macroblog post covers some of the key takeaways from the discussion of three challenges facing the financial sector: central bank digital currency (CBDC); environmental, social and corporate governance investing; and cybersecurity. All three discussions highlighted how the answers to some seemingly straightforward questions involve a host of complex considerations. (My companion Policy Hub: Macroblog post focused on discussions of the current monetary policy environment, with a focus on shrinking the Fed's balance sheet.) More information on all of the sessions is available at the conference agenda page, which has links to the various sessions' videos, papers, and other presentations.

Which CBDC, If Any, Is Right for the United States?
The issue of whether the central bank should issue a digital currency, and what form such a CBDC should take, is a topic that central banks around the world have been studying with varying degrees of interest, sparked in part by the development of cryptocurrencies. The intensity of that interest increased dramatically with the announcement by Facebook, now renamed Meta, that it was developing a stablecoin called Libra, later changed to Diem. (A stablecoin is a currency that maintains a fixed value relative to some other asset, especially a sovereign currency such as the U.S. dollar.) Meta has since stopped development of Diem and sold its assets. However, the questions surrounding a CBDC remain. The FMC's CBDC panel video fileOff-site link pointed out that this seemingly simple question involves a variety of deep, complex issues for policymakers to consider.

The panel was led off by Nellie Liang, undersecretary for domestic finance at the US Department of the Treasury, who provided broad context for the discussion. Her remarks Adobe PDF file format and slides Adobe PDF file format discussed President Biden's executive order for government departments to study the issues associated with digital assets.

Afterward, Charles Kahn, professor emeritus at the University of Illinois, presented Adobe PDF file format his paper Adobe PDF file format on CBDC. The paper makes the important point that a wide variety of choices need be made in the design of a CBDC and that these decisions should be based the intended benefits from adopting a CBDC. Kahn noted that although a CBDC may have many benefits over the existing system, in many cases it is not clear whether a CBDC is the right tool for obtaining the benefits. He then discussed CBDC developments in four of the CBDC leaders: Sweden, Canada, the Bahamas, and the People's Republic of China. These four countries have different priorities and have taken different paths. The two closest to the United States in terms of economic conditions, Sweden and Canada, have both done extensive work but neither has yet implemented a CBDC.

Following Kahn, David Mills from the Federal Reserve Board presented Adobe PDF file format the Federal Reserve's current thinking about CBDC. He noted that the Federal Reserve had recently published a discussion paper, "Money and Payments: The U.S. Dollar in the Age of Digital Transformation Adobe PDF file formatOff-site link," as a first step in fostering a broad and transparent public dialogue about CBDCs as well as a call for comments on a variety of CBDC-related issues. Mills indicated that the discussion paper raised a wide variety of issues that would need to be considered before adoption of a CBDC. Mills cited support for the US dollar's international role and promotion of financial inclusion as some potential benefits. On the other hand, he noted the potential risks it raises, including consumer privacy and financial system stability.

Paul Kupiec, from the American Enterprise Institute, provided a discussion and an article addressing several issues raised by a CBDC. He concluded that the United States should not adopt a CBDC. Kupiec argued that the issuance of such a currency would likely result in political pressures affecting the type of CBDC issued and, arguably more importantly, could create political pressure on the Fed to manage the rates paid on a CBDC for the benefit of holders rather than for monetary policy purposes. He also noted the risk that a CBDC could lead to a run on banks, with depositors shifting their funds to a CBDC. He offered as an alternative the development of private stablecoins and tokenized bank deposits that could be used for payments.

ESG and Money Management
There can be little doubt that interest in the topic of investing based on environmental, social, and corporate governance—commonly known as ESG—has exploded during the last decade. Participants at FMC considered some issues that ESG investing raises for money managers. The discussions highlighted that this seemingly simple concept in fact raises a variety of complex issues whose answers may legitimately vary among different money managers.

Dissecting Green Returns
Do ESG investors pay a financial penalty when accounting for nonfinancial considerations, or are they being rewarded through "doing well by doing good"? In a session moderated by Paula Tkac of the Atlanta Fed, a paper titled "Dissecting Green ReturnsOff-site link" and presented Adobe PDF file format by University of Chicago professor Lubos Pastor addressed these questions. Specifically, Pastor and his coauthors Rob Stambaugh and Luke Taylor looked at the returns associated with environmentally sustainable investments. They note a conflict between theorists and practitioners. Investors, money managers, and some studies suggest that green stocks tend to produce higher returns. However, theory suggests that ex ante expected green returns should be lower than investments that are not environmentally sustainable. Thus, Lubos and his coauthors study the performance of green investments. They find that the past performance was superior, but that this performance reflects the unanticipated increases in the climate concerns of investors and consumers. The superior returns disappear after controlling for changes in investors' level of environmental interest. Their findings imply that the strong historical performance of green assets does not suggest that we should expect higher returns for green assets in the future.

Anna Pavlova, of the London Business School, began her discussion Adobe PDF file format by highlighting the theoretical reason that ESG investing should bring lower returns. She notes that one of the goals of ESG investing is to reduce the cost of capital to green firms, which requires that equilibrium returns on green stocks be below that of the returns on brown stocks (that is, stocks of companies with a large carbon footprint). That said, she also observed that there are a variety of ratings of overall ESG performance and for the environmental component. However, the correlations of these ratings are rather low and sometimes negative for a variety of reasons. Pavlova pointed to a paperOff-site link she coauthored that offers a possible solution for the variation in ratings.

The panel discussion video fileOff-site link on ESG investing, moderated by S.P. Kothari from the Massachusetts Institute of Technology, delved more deeply into the issues associated with this type of investing. Laura Starks from the University of Texas presented Adobe PDF file format a paper Adobe PDF file format that raised a number of points on ESG investing. For example, she noted that the number of institutional investors, and the amount of institutionally managed funds devoted to ESG, have grown substantially.

However, Starks devoted a large portion of her presentation to the difference between ESG values (or values-based) investing versus ESG value investing. Some ESG investors avoid supporting (or investing in) companies that engage in activities that violate the ESG principles. Alternatively, some ESG values investors focus on affecting firms' ESG performance, which can mean limiting their supply of capital to firms that are not strong on ESG or through engagement with the management of firms that are not strong on ESG.

In contrast, Starks said that an ESG value investor approaches ESG from the perspective of the value of the firm as an investment. Thus, an ESG value investor is concerned that firms' poor ESG records are likely to have lower earnings or higher risk in the future, or even both. However, similar to ESG values investors, a value investor can implement the ESG value by avoiding firms with poor records, or by engaging with firms' managers in an attempt to improve the firm's ESG performance.

Lukasz Pomorski, head of ESG research at AQR Capital Management, built on Starks's discussion of ESG value versus values investing. He notes that up to a point, ESG can be valuable for risk management, but at a certain point it becomes a constraint that can have an adverse impact on a portfolio's financial performance. In response to a question from Kothari, Pomorski explained that binding restrictions not only affect portfolio diversification but also the ability of active money managers to exploit their skill. A money manager may have above-average ability to evaluate firms in some disfavored industries, but an excluded industry precludes that money manager from using that skill to benefit investors.

Pomorski also addressed a point that Starks's presentation touched on. Firms can be influenced in two ways: the cost of capital and voting stock ownership. Pomorski emphasized that these mechanisms sit in opposition to each other. The only way to raise the cost of capital is to sell the stock, but only shareholders own votes.

The final panelist, Mikhaelle Schiappacasse from Dechert LLP, reviewed the evolving ESG rules in Europe, especially those related to green finance. She observed that the European Commission has set a goal of net zero carbon emissions by 2050 and is intent on using regulations on investment to support that goal. Thus, the European rules are pushing firms and investors to divest activities with big carbon footprints and invest in those with smaller carbon footprints. However, Schiappacasse also discussed some complications in implementing these goals. One major issue is often called "greenwashing"—firms and investment managers creating only the appearance, but not the reality, of being green. Another complication she discussed is that ESG money managers can get a good rating only by investing in green assets, so they can't work with brown firms in an attempt to shrink their carbon footprint.

Cyber Risk in the Financial Sector
Finance and cyber risk management often have a hard time understanding each other, according to Patricia Mosser of Columbia University, the moderator of the FMC's cyber risk panel video fileOff-site link. In part, the lack of understanding arises from having different goals. Cyber risk is about avoiding adverse shocks, but adverse shocks are unavoidable in finance, so finance's goal is resiliency to those shocks. Another important difference is the nature of the shocks. Cyber risks, and their resulting theft or disruption, are the intention of whoever created them. Moreover, cyber shocks are not random but happen at moments of increased vulnerability. The occurrence and timing of financial shocks, on the other hand, are not intentional.

The presentation Adobe PDF file format , by Jason Healey from Columbia University, noted that the nature of the cybersecurity problem has increased considerably from the early years. Then, it was simply a matter of controlling access to the computer room, but more recently anyone connected to the internet is conceivably a threat. In some respects, however, the problem has not changed much since the mid-1990s, and many of the risks remain the same. What has changed is our capacity to respond. For example, in response to an audience question, Healey noted the development of cloud computing, which allows individual firms to reduce their individual exposure to cyber risk but at the expense of increased systemic risk by concentrating risk in relatively few vendors. Healy also listed the ways that cyber risks could become a financial issue, and then he listed some ways a cyber-driven financial issue could become a financial stability issue.

Stacey Schreft, of the US Department of Treasury's Office of Financial Research and currently on assignment at the Federal Reserve Board, discussed some issues and responses to cyber risk. Schreft's presentation Adobe PDF file format included figures showing some of the parties in the financial sector who are vulnerable to cyber risk and linking these to concerns about traditional financial sector risk. Among the responses she mentioned is the mitigation of vulnerabilities through the supervision of financial firms from the grassroots level. Another response has been increased collaboration across the financial sector, both within the United States and globally. These responses are attempts to strengthen vulnerabilities in the financial system's stability and improve the way we measure cyber risk.

June 3, 2022

Financial Markets Conference 2022: Normalizing the Fed's Balance Sheet

The Atlanta Fed's 2022 Financial Markets Conference (FMC), A New Era of Financial Innovation and Disruption: Challenges and Opportunities, featured policy panels, academic paper presentations, and keynote speakers who explored various developments having a significant impact on the financial system. This Policy Hub: Macroblog post offers some highlights from the conference keynote speakers as well as an academic paper and policy panel on normalizing the Fed's balance sheet. More information on all of the sessions is available on the conference agenda page, which has links to the various sessions' videos, papers, and presentation materials.

Keynotes
The four conference keynotes touched on a variety of issues. However, because of concern about inflation running well above the Fed's 2 percent target and about how the Fed will respond, a large part of the keynotes addressed monetary policy–related issues. The conference kicked off with a fireside chat video fileOff-site link featuring Roger W. Ferguson Jr. from the Council on Foreign Relations and Atlanta Fed president Raphael Bostic. President Bostic asked questions touching on all four of the policy themes, taking advantage of Ferguson's diverse background as a former Federal Reserve vice chair and chief executive officer of the Teachers Insurance and Annuity Association–College Retirement Equities Fund. In talking about current Fed policy, Ferguson referred to a survey he led of corporate CEOs that included a question effectively asking if the CEOs think the Fed will successfully bring inflation down. The answer that many CEOs gave is that so many factors and forces are at work they cannot be 100 percent certain the Fed can do this.

Harvard economics professor Kenneth Rogoff gave the Monday night keynote speech video fileOff-site link on the importance of the political economy. Most of Rogoff's speech recounted the economic and political conditions that led to the current relatively high inflation rates. He concluded by noting that if secular stagnation returns, the Fed could find inflation and market interest rates once again near zero. Should this happen, Rogoff argued, the Fed should be given the tools to drive nominal interest rates well below zero, if necessary, to counteract an economic downturn.

The Tuesday morning keynote video fileOff-site link , "Inflation and the Policy Response to Supply Shocks," was given by Charles Goodhart of the London School of Economics and Manoj Pradhan, founder of Talking Heads Macroeconomics. In their presentation Adobe PDF file format, they contended that the low inflation rate observed in recent decades was largely the result of a large increase in the labor supply, mainly due to China's integration into global markets. They noted, however, that this growing labor supply is in the process of reversing almost everywhere except in African countries. They contend that this reversal is likely to lead to slower growth, and potentially stagflation, in the medium run.

The final keynote was a fireside chat video fileOff-site link featuring Bostic taking questions from Julia Coronado of MacroPolicy Perspectives. Their chat devoted considerable attention to the current state of the economy, including both the recent negative shocks to supply and the potential for positive shocks to supply. One potential positive shock that Bostic discussed is the adoption of new productivity-enhancing technologies. Coronado pointed to a 2019 conference jointly held by the Federal Reserve Banks of Atlanta, Dallas, and Richmond titled Technology-Enabled Disruption: Implications for Business, Labor Markets, and Monetary PolicyOff-site link. Bostic indicated that at the time of this 2019 conference, monetary policymakers were concerned that technology was disrupting markets in a way that would be adverse to workers' human capital but the current problem is a shortage of workers.

Discussing the Federal Reserve's balance sheet
During and after the financial crisis, the Federal Reserve increased the size of its balance sheet from under $1 trillion to more than $4 trillion. These purchases, part of a process often called quantitative easing (QE), were initially intended to support financial market functioning and later intended to provide additional monetary policy accommodation because the Federal Reserve decided to keep its federal funds target rate above zero. As the economy strengthened in the late 2010s, the Fed reduced its balance sheet to just under $3 trillion in what was often referred to as quantitative tightening (QT). However, with the onset of the pandemic, the Federal Reserve once again expanded its balance sheet to more than $8 trillion in assets. As with the first rounds of QE in the wake of the financial crisis, the initial goal was to support financial market functioning but later focused more on providing monetary policy accommodation.

With a relatively low unemployment rate and inflation rates far above the Fed's 2 percent target, the current focus on policy has shifted to reducing monetary accommodation, which includes shrinking the Fed's balance sheet. Along with several keynote speeches touching on this issue, one of the academic papers presented at the 2022 FMC addressed one aspect of the reduction—the effect of QT on financial conditions—and one of the policy panels examined a variety of issues associated with shrinking the Fed's balance sheet.

Addressing the Unexpected Supply Effects of QE and QT
One challenge with analyzing the effect of monetary policy on the financial system is that market participants often partially anticipate policy moves, and market prices might at least partially incorporate the moves before a policy move is even announced. Stefania D'Amico of the Chicago Fed and her coauthor Tim Seida sought to get around this problem in the cases of QE and QT by looking at unexpected changes in the supply of Treasury securities at specific maturities in their paper "Unexpected Supply Effects of Quantitative Easing and Tightening Adobe PDF file format." D'Amico explained that their methodology sought to identify the effect of QE and of QT by looking for kinks in the yield curve arising from the unexpected changes in supply. They found that Treasury yields are more sensitive to QT surprises than to QE surprises. These effects do not diminish during periods of market calm amid economic expansion but are increased by interest rate uncertainty.

The discussion Adobe PDF file format by Morten Bech from the Bank for International Settlements highlighted the implications of the paper for both US domestic markets and the markets of other developed countries. In domestic terms, D'Amico's paper estimates the average supply effect of about 21 basis points (bp) per $1 trillion in balance sheet reduction, which increases to more than 70 bp when uncertainty about the 10-year Treasury rate is especially elevated. He noted that these estimates are consistent with Fed chair Jerome Powell's estimate of 25 bp per $1 trillion (which Powell says has "very wide error bands") and one market participant's range of 7 bp to 42 bp per $1 trillion. On the international front, Bech noted that the Bank of Japan and the European Central Bank have balance sheets that are significantly larger, as a proportion of their economies, than the Fed's. Thus, QE and potentially QT are not only a US issue but one relevant to other major central banks.

Examining Challenges during Balance Sheet Normalization
The panel discussion video fileOff-site link of monetary policy and normalizing—or shrinking—the Fed's balance sheet started with the panel's moderator, Vincent Reinhart from Dreyfus-Mellon, presenting Adobe PDF file format a review of the current situation. Reinhart noted that the unemployment rate had dropped to near prepandemic lows and that inflation rates were at 40-year highs, prompting the Federal Open Market Committee (FOMC) to announce plans to raise its federal funds target rate and reduce its securities holdings.

Cleveland Fed president Loretta Mester provided additional perspective on balance sheet normalization. She observed that the FOMC's planned reduction will reduce securities holdings faster than what occurred after the financial crisis, but that this faster reduction reflects the current strength of the economy and the high levels of inflation. She also observed that the FOMC's statement didn't address two items. First, the announced plan talks only about reduced reinvestment of maturing securities and does not address the issue of balance sheet sales. In the panel's question-and-answer period, Mester observed that such sales of agency securities may be necessary if the FOMC is to meet its goal of having its portfolio consist predominantly of Treasury securities. Second, the FOMC had not set a target for the size of its balance sheet, only that it intends to operate in an environment of ample reserves.

The next panelist, Seth Carpenter from Morgan Stanley, forecast that the peak of the fed funds rate would be about 3.25 percent and that it would take the Fed about two-and-a-half to three years to reach its balance sheet target. He added his belief that financial market prices (except for some credit markets) already reflect most of the effects of the announced changes. Carpenter also suggested that it was unlikely the Fed would engage in the sale of mortgage-backed securities, observing that housing is among the most cyclical of sectors and that tighter monetary policy would likely slow it down enough.

Brian Sack from D.E. Shaw noted that it is not often that a market participant announces a planned reduction in the size of its balance sheet by $2 billion to $3 billion, as the Fed has done. He said he anticipates that QT will likely have a moderate effect on market rates, perhaps raising the 10-year Treasury yield by somewhere in the range of 25 bp to 30 bp. However, Sack observed, the reduction in reserves could lead to a strain in funding markets, like that experienced in September 2019. Sack suggested that although pricing is a clearer signal than balance sheet size per se, the Fed should watch behavior in money markets closely to judge when reductions could lead to strain in the markets.

The last panelist was former Federal Reserve Board governor and current Harvard professor Jeremy Stein, who focused on QT's potential to cause strains in money markets and threaten financial stability. In his view, the villain is the minimum leverage ratio requirement (the minimum ratio of capital to total assets a given bank must hold) imposed on banks by their regulators and especially its effects on the largest banks, which are also critical participants in money markets. Stein noted that the problem with the leverage ratio is that it does not account for the risks different types of assets pose. In Stein's telling, the ratio effectively penalizes banks' holdings of low-risk assets, especially the holding of reserves. Ideally, he said, the risk-based capital ratio that does not impose a similar penalty on low-risk assets would be binding, but he thinks that regulatory policy is unlikely to be changed in such a way that the risk-based ratio would become binding. Thus, Stein suggested that the Fed narrow the gap between the interest paid on bank reserves and the rate with which the Fed engages in reverse repurchase agreements with some money funds and other money managers, which would result in banks holding lower reserves and thereby relaxing the constraint imposed by the leverage ratio.

Please check Policy Hub: Macroblog soon to read my post summarizing the rest of the 2022 FMC. I will highlight three other important issues discussed there: central bank digital currency; environmental, social, and corporate governance (commonly known as ESG) investing; and cybersecurity.