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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.

Authors for Policy Hub: Macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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June 24, 2021

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.

Day two began with a paper presentation by Chris Cotter of Oberlin College and discussion by Hugh Rockoff of Rutgers University. Cotter's paperOff-site link ("Off the Rails: The Real Effects of Railroad Bond Defaults Following the Panic of 1873") analyzes the knock-on effects of railroads' bond defaults stemming from the 1873 financial panic. About one-quarter of all U.S. railroads defaulted on their bonds then. The paper's data set combines data on bond defaults with geographic data on national banks operating in areas served by the defaulting railroads. The main result of the paper is that even though banks did not (and legally could not) hold railroad bonds, the presence of a defaulting railroad in the area served by a bank tended to contract the loans and deposits at that bank. The railroad bond defaults thus exerted systemic, negative effects on the U.S. banking system despite lack of direct exposure of banks' portfolios to the bond defaults.

In the discussion, Rockoff agreed with the paper's conclusion but proposed that the paper could be strengthened by including case studies to check for their consistency against historical narrative. Rockoff also suggested a robustness check of comparing the effects of the 1873 panic to those of an 1877 nationwide railway strike. The post-1873 economic contraction was also one of the longest in U.S. economic history, Rockoff noted, so it would be interesting to know how much the railroad bond defaults contributed to the postpanic slowdown in economic growth.

The next paper presentationOff-site link was by Lee Ohanian of the University of California, Los Angeles, with a discussion by Angela Redish of the University of British Columbia. The paper ("The International Consequences of Bretton Woods Capital Controls and the Value of Geopolitical Stability," coauthored with Diana Van Patten of Princeton University), Paulina Restrepo-Echavarria of the Federal Reserve Bank of St. Louis, and Mark L.J. Wright of the Federal Reserve Bank of Minneapolis) models the world economy using a three-sector general equilibrium model (the United States, Western Europe, and the rest of the world) and uses this model to measure the impact of the Bretton Woods system of exchange controls. These controls were present from the end of the second World War until 1973, and in the model, these controls show up as taxes ("wedges") on the intersector movement of capital. The main result of the paper is that these wedges redirected very large amounts of capital away from the United States as compared to a first-best allocation, reducing growth and consumption in the United States but increasing them elsewhere. Aggregate global welfare was also reduced. Ohanian argued that despite its large domestic cost, the United States was willing to tolerate such a system for geopolitical reasons.

Redish noted in her discussion that while Bretton Woods is commonly thought of as an exchange-rate regime, in practice capital controls were necessary to afford countries some degree of monetary autonomy under fixed exchange rates. Redish also noted that the capital controls took many different forms and a closer examination of which types of capital controls were actually implemented could amplify the paper's message. She suggested that the high level of aggregation in the model obscures some potentially important cross flows of capital (for example, inflows into Germany are netted against outflows from the United Kingdom). The paper's counterfactual simulations are striking, but additional narrative could improve them. While supportive of the paper's overall conclusions, Redish noted that one unmodeled benefit of fixed exchange rates was reduced exchange rate volatility, which could have promoted capital formation. Another unmodeled benefit of Bretton Woods could have been a reduced incidence of financial crises stemming from "hot money" flows, which ideally could be weighed against the costs of inefficiently allocated capital.

The second invited lecture of the conference was presented by Catherine Schenk of the University of Oxford. Schenk's presentation described a multiyear research project that will collect and analyze data on global correspondent banking, especially as it developed in the post-WWII era ("Constructing and Deconstructing the Global Payments System 1870–2000"). The presentation focused on events during the 1960s and 1970s. The expansion of foreign exchange trading during this era led U.S. banks to found a technologically advanced, privately owned, large-value payment system (CHIPS) in 1970. Schenk explained how CHIPS enabled banks to settle the rapidly growing volumes of U.S. dollar payments from foreign exchange trading and facilitated the expansion of the global correspondent banking system. She also described how problems with CHIPS and certain other features of the correspondent banking system came to light in 1974 with the failure of a German bank, Bankhaus Herstatt. The Herstatt failure revealed the extent of the expanded correspondent system and also highlighted potential risks arising from unsettled foreign exchange trades, creating new challenges for banking regulators.

The audience discussion focused on changes in the regulatory environment coinciding with or following the Herstatt failure. William Roberds pointed out that a longer-term consequence of Herstatt was the founding of CLS in 2001 as a mechanism for coordinating foreign exchange settlements. Schenk noted that the Basel Committee on Bank Supervision was formed shortly after 1974, leading to global coordination in bank capital requirements and other supervisory standards. Robert Hetzel pointed out that 1974 witnessed another watershed bank failure, that of Franklin National, which like Herstatt was also heavily exposed in foreign exchange transactions. Responding to a question by Alain Naef (Banque de France), Schenk argued that many of the problems banks faced with foreign exchange operations in the 1970s simply resulted from a technical inability to handle an increased transaction volume. Michael Bordo noted that the technical changes in transaction technologies during this period interacted with economic forces to create profound changes in global banking.

Alain Naef of the Banque de France presented the final paperOff-site link of the second day ("Blowing against the Wind? A Narrative Approach to Central Bank Foreign Exchange Intervention"). Owen Humpage of the Federal Reserve Bank of Cleveland discussed it. The paper considers the effectiveness of Bank of England foreign exchange interventions over a sample running from 1952 until 1992, using daily data the Bank has recently made available. The Bank intervened on almost 80 percent of trading days during the sample, and most interventions were not publicized. The Bank intervened to influence the exchange rates of the pound against the dollar and deutschmark. Interventions were offset (sterilized) through domestic open market operations. Naef's presentation highlighted the main result of the paper, which is that interventions were usually ineffective when they attempted to go against market trends, in which case they were estimated to succeed only 8 percent of the time.

In the discussion, Humpage placed Naef's results in the context of the extensive literature on sterilized foreign exchange intervention. He noted that many traditional theories of sterilized intervention are oriented around the idea that such interventions could serve as a signal of a central bank's private information or intent. These theories would not seem to apply to the sample Naef analyzed, however, in which interventions were rarely publicized. He also noted that endogeneity concerns are common to this type of study. He recommended an alternative empirical approach focusing on the probability of certain market movements following an intervention, which could allow for a broader range of explanatory variables (for example, whether an intervention was coordinated with other central banks). Humpage also suggested additional clarification as to whether interventions in the data set were undertaken on the initiative of the Bank of England or the UK Treasury. Lastly, he noted that despite the apparent ineffectiveness of sterilized intervention, there are long stretches in the data where pound exchange rates appear to be pegged, indicating that there may be some unmodeled interactions between Bank policy and the foreign exchange markets that should be taken into account in the analysis.

The workshop concluded with a panel discussion video fileOff-site link of the potential impact of central bank digital currencies (CBDCs). The first panelist, Michael Bordo, proposed that the introduction of CBDCs could be as transformative as the introduction of circulating, central-bank-issued currency in the 17th and 18th centuries. Bordo said that while there was a role for private digital currencies, CBDCs could play a stabilizing role in the digital monetary landscape. He also suggested that CBDCs could also expand the options available for monetary policy, facilitating (for example) negative policy interest rates or tiered interest rates on central bank liabilities.

The second panelist, Warren Weber, began with the observation that 80 percent of the world's central banks are now at least considering issuing central bank digital currencies, most to be eligible for use in retail (consumer) transactions. Motivating factors for this development include the declining use of physical currency in some countries and Facebook's proposal to create a private digital currency (originally named Libra and now named Diem). A related motivating factor is the concern central banks have about financial stability risks that private digital currencies pose. Weber discussed this last issue in the context of two historical episodes when privately issued paper currency was commonplace and currency issued by central banks was not (in the United States between 1786 and 1863 and in Canada between 1817 and 1890). Weber argued that many private currencies in circulation during these periods failed to meet the definition of "safe asset" since their value tended to fluctuate, and sudden losses of value could occur when an issuing bank failed or suspended payments. However, private currencies became more reliable after more stringent regulation was introduced (1863 in the United States and 1890 in Canada), and in both cases this heightened reliability was accomplished without the introduction of central bank currency. On the basis of these experiences, Weber argued that CBDCs were not necessary for reliable digital currencies to exist, although CBDCs could be desirable on other policy grounds.

The third panelist in this session was François Velde of the Federal Reserve Bank of Chicago. Velde discussed CBDCs in the context of the general history of central bank money. He argued that central bank money historically arose to fill gaps in existing monetary systems (resolving ambiguity about units of account, facilitating payments, or boosting governments' fiscal capacity), and that historically, most central banks have shied away from involvement with retail payments other than the provision of paper currency. If CBDCs become prevalent, then they will still need to be oriented around provision of a stable unit of account, Velde noted, but an unanswered question is whether a widely accessible CBDC would fundamentally alter the relationship between private and central bank money. History suggests that governments and central banks will have some degree of involvement with digital currency, as with other forms of money, but the extent and form of this involvement are yet to be determined. Velde concluded with the observation that monetary innovations often have not resulted from conscious policy decisions but from a combination of underlying societal trends and chance occurrences.

In the subsequent panel discussion, Gorton argued that the more interesting types of available digital currencies are stablecoins, which purport to maintain a constant value against a central bank currency such as the U.S. dollar. Gorton argued that to be fully credible, stablecoins will need to operate under some degree of regulation, and, as the use of stablecoins expands, lawmakers may face the issue of whether stablecoin issuance falls under the purview of bank regulation. He noted that in to promote its state-issued digital currency, China has effectively shut down private digital currency issuance. Gorton and other panelists predicted that much of the future success of digital currencies would derive from more convenient cross-border payments—for example, along international supply chains. Bordo argued that even within domestic markets, digital currencies including CBDCs could offer efficiency gains over existing payment channels. If private digital currencies become sufficiently widespread, however, Bordo argued that they could interfere with central banks' ability to conduct monetary policy.

Velde then noted that the challenges facing digital currency adoption remain daunting, with mainstream acceptance probably requiring some degree of regulation to establish sufficient scale and credibility. Gorton agreed, but said that the example of money market mutual funds showed that such regulation could be challenging to get right. A question was posed as to whether governments' fiscal demands might also promote interest in CBDC issue, to which Velde said current low rates of interest on government debt do not provide strong incentives for governments to seek seigniorage through CBDC issue. Weber and Gorton suggested that what we might see instead of CBDCs are traditional banks moving into the issue of digital currencies as these become more widely accepted.

In the audience discussion, Peter Rousseau (Vanderbilt University) proposed that early U.S. monetary history showed that government regulation was not necessary to establish functional currencies, and that problems such as those that arose with pre–Civil War state banknotes could be minimized with modern technologies such as the blockchain. Chris Meissner (University of California, Davis) questioned whether, from a political economy point of view, private digital currencies would be allowed to become widespread enough to compete with CBDCs. Gorton responded by saying that in countries such as the United States, it will not be politically feasible to outlaw private digital currencies. Hugh Rockoff then remarked that CBDCs could facilitate fiscal transfers and Bordo said that in general, financial inclusion could be bolstered through CBDCs. Maylis Avaro (University of Oxford) noted that there did exist an historical example of such "retail outreach" by the Banque de France, which offered consumer accounts. Mark Carlson (Board of Governors) questioned whether the technological feasibility of fiscal transfers through CBDCs might affect central bank independence.

Larry Wall (Federal Reserve Bank of Atlanta) observed that the increased cross-border efficiency of CBDCs could lead to increased competition between central bank currencies. Bordo stated that the historical pattern of dollarization supported Wall's hypothesis, and Gorton suggested that one major reason that China has been accelerating development of its digital currency is to promote cross-border usage and international acceptance of the yuan.

June 23, 2021

Workshop on Monetary and Financial History: Day One

On May 21 and May 22, the Atlanta Fed hosted a virtual workshop on monetary and financial history. The workshop was organized by Michael Bordo (Rutgers University), William Roberds (the Federal Reserve Bank of Atlanta), and Warren Weber (formerly of the Federal Reserve Bank of Minneapolis and currently a visiting scholar at the Federal Reserve Bank of Atlanta). The workshop featured presentations on the history of money, banking, finance, and central banking. Six papers were presented along with two invited lectures. Both days of the workshop concluded with a panel discussion of contemporary policy issues from a historical perspective.

In this post, I'll discuss events from the workshop's first day, and in another post tomorrow I'll discuss day two of the workshop.

The workshop opened with a paper presentation by Ryland Thomas of the Bank of England and discussion by Clemens Jobst of the University of Vienna. The paper was titled "What You Owe or Who You Know? The Recipients of Central Bank Liquidity during the English Crisis of 1847," and its authors were Mike Anson (Bank of England), David Bholat (Bank of England), and Kilian Rieder (the Austrian National Bank). It focused on the Bank of England's responses to an 1847 financial panic. This episode is of interest to central bank historians because it was the first panic in which the Bank of England was subject to legislation (the Bank Charter Act of 1844, also known as Peel's Act) that limited its ability to extend credit in crisis situations. The paper analyzes the actions of the Bank during the panic, using a data set of credit actions (discounts and advances) hand-collected from the Bank's archives. The presentation emphasized that the constrained bank was able to provide emergency liquidity by rationing credit along several dimensions. In particular, the bank's credit actions discriminated against parties such as bill brokers, firms dealing in agricultural commodities, and firms located outside London, while favoring banks, London firms, and firms associated with bank directors. Ultimately these actions proved insufficient to stem the panic, however, and constraints on the Bank had to be eased by a government decree ("Chancellor's letter").

In his discussion, Jobst noted that the paper's results go against a traditional view of the 19th-century Bank of England as an arms-length ("frosted glass") lender. He also suggested that the paper's data set could uncover to what extent the structure of the London bill market shifted during the 1847 panic, with traditional dealers in bills ("bill brokers") apparently becoming disintermediated during the panic. Finally, Jobst noted that the 19th-century Bank used its interactions with the bill market in a quasi-macroprudential fashion, to maintain a sense of risk preference in the market as well as to exert control over the market. The paper's data set could thus be used to reveal the information available to the bank in its policy decisions as well as its resulting policy actions.

The second paper of the workshop was presented video fileOff-site link by Marc Flandreau of the University of Pennsylvania and discussed by William Goetzmann of Yale University. The paper ("How Vulture Investors Draft Constitutions: North and Weingast 30 Years Later") focuses on sovereign debt negotiations following a default by Portugal in 1828. The paper describes how a contender for the Portuguese throne was then able to obtain new loans from Portugal's London creditors during 1830–33, despite Portugal's recent default. In his presentation, Flandreau showed that a key aspect of the loan renegotiation was an 1827 British law that allowed a creditors' committee to control a defaulter's access to the London market, strengthening the creditors' bargaining position. The presentation also described how such control then allowed "vulture" investors in Portugal's defaulted debt to later earn large returns on their investment, and how the repayment of the renegotiated debt imposed high costs on Portuguese taxpayers.

In the discussion, Goetzmann observed that the 1827 law effectively inserted collective action clauses into the original Portuguese debt issue, even though the debt did not contain such clauses. Goetzmann also displayed a copy of a later (1855) lending agreement between the Portuguese crown and London creditors, which contained similar clauses to the contracts described in the paper, indicating that patterns documented by Flandreau persisted. Goetzmann then noted that cooperation between sovereign creditors was not unique to London, and he described how early (1790s) loans from Amsterdam creditors to the United States were subject to similar types of collective agreements. He further noted that many sovereign debt issues previously negotiated in Amsterdam were defaulted on during the Napoleonic period, creating a debt overhang problem and increasing the attractiveness of London as an alternative market for sovereign loans. International competition between sovereign lenders must therefore be considered as a constraining factor in the structure of sovereign loans.

Gary Gorton of Yale University delivered the workshop's first invited lecture, in which he described his research project with Ping He of Tsinghua University ("Economic Growth and the Invention of the Term Loan"). The focus of this research is the advent of term bank loans in the United States during the 1930s. Before that time, most business loans tended to be very short term—three months maturity or less—but could be rolled over at the discretion of the lending bank. Gorton noted that the 1930s witnessed rapid productivity growth in manufacturing concomitant with the expansion of term lending. He then presented a general equilibrium model that incorporates the growth effects of these two developments. In the model, an increase in bank term loans can result from an increase in financial efficiency (an improvement in banks' ability to predict borrowers' performance). Fitting this model to U.S. banking and macro data suggests that as much as one-third of economic growth during the 1930s resulted from an increase in financial efficiency experienced early in the decade.

Audience discussion of this result focused on regulatory changes as possibly contributing to the strength of the estimated financial efficiency effect. Among the changes mentioned were the debut of the Securities and Exchange Commission (which imposed new regulatory requirements on bond issues, raising the attractiveness of bank financing) and the Federal Deposit Insurance Corporation (which lowered the chances of an insured bank being caught in a run, making term lending less risky for banks).

The final paper of the first day of the workshop was presented by Marco Del Angel of California State University, Los Angeles, and was discussed by Kim Oosterlinck of the Université Libre de Bruxelles. The paper ("Do Global Pandemics Matter for Stock Prices? Lessons from the 1918 Spanish Flu," coauthored with Caroline Fohlin (Emory University) and Marc Weidenmier (Chapman University), focuses on the effects of the 1918 influenza pandemic on U.S. stock prices. The paper uses a new weekly stock price data set compiled by the authors, as well as data on death rates during the influenza pandemic period (1918–20). Del Angel presented results from vector autoregressions that show a persistent negative response of stock prices to upticks in pandemic deaths, even when the autoregressions incorporate series on war news obtained by filtering contemporary press reports. This same pattern holds when stock prices are disaggregated to the sectoral level. Negative pandemic developments thus exerted a strong negative effect on stock prices.

Several people in the audience argued that the paper's results might be affected by changes in Federal Reserve policies during this period. In the discussion, Oosterlinck suggested Fed policy could be incorporated through the inclusion of an interest rate series in the autoregressions. Oosterlinck also noted that the persistent effects of pandemic shocks on stock prices indicate an apparent inefficiency in markets' ability to process the economic impact of pandemic developments, a surprising pattern that merits some further discussion in the paper. He also recommended an event-study approach to analyzing stock price movements, which could exploit regional variation in influenza outbreaks, as a complement to the paper's existing econometric methodology.

The first day concluded with a panel discussion of the COVID-19 pandemic and ensuing policy responses. The first panelist was Alan M. Taylor of the University of California, Davis. Taylor's remarks drew on his recent paperOff-site link on historical pandemics ("Longer-Run Economic Consequences of Pandemics," coauthored with Sanjay Singh of the University of California, Davis, and Òscar Jordà of the Federal Reserve Bank of San Francisco). Taylor and his coauthors survey a number of pandemics starting with the Black Death (1331–50) and conclude that their effects are different from the other major category of demographic shock: wars. Pandemics tend to make labor scarce relative to capital (wars can do the opposite), exerting downward pressure on returns to capital and interest rates. Moreover, these effects tend to persist. Taylor argued that these patterns are consistent over centuries of data and that we should expect similarly persistent effects from the COVID-19 pandemic.

The second participant in the panel was Ellis Tallman of the Federal Reserve Bank of Cleveland. Tallman noted that the pandemic has resulted in a historic U.S. debt expansion comparable to that seen during World War II. Tallman also noted that following the WWII expansion, U.S. fiscal and monetary policy turned more conservative, with the Korean War largely financed through tax increases. He observed that prospects for renormalization of policy were more uncertain under current circumstances and that the extraordinary magnitude of recent policy responses raised the issue of capacity to respond to possible future crises. Commenting on Taylor's work, Tallman observed that the rapid deployment of vaccines meant that fundamentals for a strong recovery were more favorable now than in many historical pandemic events.

The last panelist in the session was Gary Richardson of the University of California, Irvine. Richardson agreed with Tallman's comment that the availability of modern medical technology suggests that a stronger recovery might be expected now than what followed past pandemics. Another unusual feature of the COVID-19 pandemic has been that its death toll has been concentrated in older individuals, many of whom had left the labor force, again suggesting less impact from labor scarcity than experienced in earlier pandemics. Richardson also contrasted U.S. policy paths following the two world wars, arguing that policy after World War I was more "hands off," whereas policy following World War II was more consciously aimed toward a transition to the restructured peacetime economy. In his view, the current situation is more reminiscent of the post-WWI scenario.

In the subsequent audience discussion, Michael Bordo suggested that the post-WWII scenario is more like current circumstances, particularly with respect to the inflation outlook. Owen Humpage (Federal Reserve Bank of Cleveland) pointed out that post-WWII Fed policy was more accommodative than is commonly recognized due to the presence of the "even keel" policy of stabilizing prices on newly auctioned Treasury debt, initiated after the 1951 Fed-Treasury accord. Taylor agreed with the other panelists that modern medical technology has improved the fundamentals for recovery as compared to past pandemics, but he suggested that the traumatic experience of the COVID pandemic could have persistent behavioral effects—on, for example, patterns of consumption. Responding to Bordo, Richardson argued that while the Fed has the tools to control inflation, its independence is likely to come under pressure from both political parties, complicating the inflation outlook. Robert Hetzel (Federal Reserve Bank of Richmond) suggested that recent increases in the money stock also point to an increase in underlying inflation, as occurred immediately after both world wars, but Richardson argued that this would depend on the extent of earlier patterns of consumption behavior returning after the pandemic. Taylor mentioned that forecasts of inflation based on money growth have not done well in recent decades. Another issue discussed was whether the COVID-19 pandemic was more comparable to the 1957–58 influenza pandemic, which had relatively mild economic effects, than earlier pandemics, when modern medical technology was not available. Taylor suggested that because there have been relatively few modern pandemics, it is not possible to answer this question with high statistical confidence.

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

May 27, 2021

The Role of Central Banks in Fostering Economic and Financial Resiliency

The Atlanta Fed recently hosted its 25th annual Financial Markets Conference, with the theme of Fostering a Resilient Economy and Financial System: The Role of Central Banks. The conference addressed both the adequacy of the monetary policy toolkit and the role of the U.S. dollar (USD) in international financial markets. The conference included two keynote talks. The first day featured a keynote speech by Federal Reserve Board vice chair Richard Clarida, followed by a discussion with Atlanta Fed president Raphael Bostic. The second day began with an armchair discussion featuring Harvard professor Larry Summers and Atlanta Fed research director David Altig. A video of the conference is available here video fileOff-site link. This post reviews some of the highlights from the conference.

Keynote talks
Vice chair Clarida's keynote speechOff-site link focused on global factors that help determine the yield curve for sovereign bonds. Clarida observed that studies of domestic and major foreign government markets have found that most of the movements in the term structure of interest rates can be explained by the overall level of the curve and the slope of the curve. He then reviewed work suggesting that a global factor—one that is highly correlated with estimates of the neutral real interest rate—has a great influence on the level of the curve. Given this information, central banks may not have much ability to influence the yield curve's level unless they are willing to unanchor inflation expectations in their domestic market. Clarida then presented evidence that the slope of the U.S. yield curve is highly correlated with its monetary policy, specifically the deviation of the U.S. neutral nominal policy rate from the actual federal funds rate. He acknowledged that correlation does not equal causation but provided some evidence that central bank decisions (by the Fed and major foreign central banks) have a causal relationship with the slope of the yield curve. These observations led Clarida to conclude that "major central banks can be thought of as calibrating and conducting the transmission of policy...primarily through the slopes of their yield curves and much less so via their levels."

Professor Summers raised a variety of concerns about current policy and the risks to the financial system in his chat on the conference's second day. One of these concerns relates to the monetary policy projections, which suggest that inflation will remain sufficiently low so that the Fed's policy rate may not increase for several years. This expectation of low rates may create a "dangerous complacency," according to Summers, that will make it more difficult to raise rates. The result may be that nominal policy rates remain too low, producing higher inflation that leads to even lower real rates and even higher inflation. The result could be not only a "substantial pro-cyclical bias in financial conditions" but also a threat to financial stability if the low nominal rates result in excessive financial leverage.

Monetary policy panel session
The monetary policy toolkit received some scrutiny in a panel titled "Is the Monetary Policy Toolkit Adequate to Meet Future Challenges?" It was moderated by Julia Coronado, president of MacroPolicy Perspectives. Coronado promised a session with some provocative comments, and each of her panelists delivered. Among the problems addressed by the panelists was central banks' limited ability to counteract economic downturns. Historically, central banks have lowered their nominal interest rate target by several percentage points in response to the onset of a recession, or even the elevated risk of one. The continuing decline in nominal rates, however, has reduced central banks' ability to use rate reductions to fight recessions, instead forcing them to rely more on quantitative easing (or more accurately, large-scale asset purchases). Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics, and Willem Buiter, a visiting professor at Columbia University, provided two alternative ways of restoring the central bank's ability to lower nominal rates by more than 1 or 2 percentage points.

Gagnon's analysis was based on the Fisher equation, in which the nominal interest rate is approximately equal to the real rate of interest plus the rate of inflation. Gagnon observed that central banks, including the Fed, had set a target inflation rate of 2 percent back when the equilibrium real rate was higher (likely around 2 to 3 percent). Establishing this target rate resulted in equilibrium nominal interest rates around 4 to 5 percent, which gave central banks considerable room to respond to a recession. However, in the period since the inflation targets were set, equilibrium real rates have fallen by 1 to 2 percentage points. This decline greatly reduced central banks' ability to lower rates without taking them negative. Thus, to restore the ability of central banks to respond to higher inflation, Gagnon argued that central banks' inflation target should be increased to 3 to 4 percent.

Buiter implicitly started from the same point: that the decline in the equilibrium real rate had left central banks with too little room to cut interest rates. However, rather than raising the inflation target, Buiter argued that a better solution would be to accept deeply negative nominal interest rates. Several central banks in Europe, as well as the Bank of Japan, have lowered their rates below zero but never as much as 1 percent below zero. Buiter recommended that central banks take the steps necessary to be able to have deeply negative interest rates if that is appropriate for conditions.

Simon Potter, vice chairman at Millennium Management, noted an international dimension to the Fed's policy setting. Potter observed that many emerging markets had taken on considerably more debt to respond to the ongoing pandemic. He argued that these countries would need fast U.S. growth, and the accompanying increase in exports to the United States to be able to service their debt. Absent such increased debt service capacity, he pointed out that changes in the structure of these countries' debt markets would make rescheduling their debts even more difficult than it had been previously.

These provocative comments did not go unchallenged, however, as the other panelists raised concerns about the feasibility and/or desirability about each of these policy recommendations in the subsequent discussion that Coronado moderated.

Global dollar policy session
A panel on the conference's second day had the provocative title "Is the Financial System's Backbone, the U.S. Dollar, Also a Transmitter of Stress?" The panel's moderator was Federal Reserve Bank of Dallas president Robert Kaplan, who began the discussion by highlighting the importance of the USD in both international trade and international financial markets.

Stanford University Professor Arvind Krishnamurthy's presentation Adobe PDF file format supplied further evidence on the importance of the USD in trade and financial markets. He suggested that the USD's important role resulted in it providing a convenience yield to its users, which resulted in lower USD interest rates for those borrowing USD—both domestic and foreign borrowers. These lower rates, however, came with some financial risks, according to Krishnamurthy. For one, lower rates may induce greater financial leverage in U.S. borrowers. Additionally, foreigners who borrow USD to take advantage of the lower rates may be creating a mismatch between the currency they receive as revenue (especially from sales in their domestic markets) and the USD they need to repay their debt.

Thomas Jordan, chairman of the governing board of the Swiss National Bank, also noted the dominance of the USD in international markets and discussed its implications from the Swiss point of view. He noted two ways in which Switzerland is especially vulnerable to developments regarding USD. First, Swiss banks hold substantial amounts of USD assets and liabilities. Second, the Swiss franc is a safe haven currency that experiences increased demand in times of international financial stress. These result in Switzerland having a strong interest in global financial stability and especially in the stability of USD-funding markets. In this respect, Jordan observed that the Federal Reserve's swap lines with other central banks, including the Swiss National Bank, has been "very crucial." The swap lines provide an important liquidity backstop that recently proved valuable during the COVID-19 crisis.

Michael Howell, the managing director at CrossBorder Capital, focused on the potential for another currency to displace the USD in international markets. In his presentation Adobe PDF file format, he argued we should not be "shortsighted" in dismissing other currencies. In particular, he pointed to China, saying that China sees the USD as a rival and wants to displace it, particularly in Asia. He then went on to discuss some of the steps that China would need to take—and is taking—to displace the USD.

After these remarks by the panelists, Kaplan moderated a question-and-answer session that took a closer look at these and other issues.

May 3, 2021

Is There a Global Factor in U.S. Bond Yields?

The answer to this question seems obvious simply from observing the secular comovement of global nominal yields across some advanced economies plotted in chart 1.

Chart 1: 10-Year Bond Yields, 1992-2021

This observation raises the possibility that domestic bond yields, including those in the large U.S. Treasury market, may be anchored by global economic developments (see, for example, hereOff-site link and hereOff-site link), provision of global liquidity, and international markets arbitrage. The synchronized dynamics in global yields during the last few months serve as a stark reminder of the powerful role that global bond markets play in the transmission of country-specific shocks as well as of monetary and fiscal impulses.

Yet the standard term structure models (see, for example, hereOff-site link), that policymakers and market participants use to form their expectations about the future path of the policy rate, are typically estimated only with information embedded in domestic yields. Global influences enter only via the term premia—that is, the extra returns that investors demand to hold long-term bonds—and are influenced by the flight to safety and arbitrage across international markets. But because the term premia are obtained as a residual component in the model, any misspecification of the factor structure that drives equilibrium interest rates—by omitting a common global factor, for example—may result in erroneously attributing some fundamental movements to the term premia.

Chart 2 illustrates this point, presenting a less-noticed and even overlooked empirical regularity between the term premiaOff-site link on the spread between the 10-year U.S. bond and the 10-year/2-year German bond, which is the benchmark bond for the Eurozone government bond market. This comovement has proved remarkably strong since 2014.1

Chart 2: German Bond Spread and U.S. Term Premia, 2010–21

Take, for example, the pronounced decline in the term premia and the accompanying slide in the German bond spread between 2014 and 2019. Although technical factors might be behind the downward trend in the German bond spread—for example, large Eurozone bond outflows triggered by the euro-area crisis and the introduction of negative interest rates—the slope of the yield curve could also convey important information about the fundamentals of the economy. If the term premia on the 10-year U.S. bond reflect an exogenous "distortion" in the U.S. yield curve due to a flight to safety or an elevated demand for global safe assets, yields are likely to return to normal levels when the uncertainty shock dissipates. In contrast, if investors interpret the yield curve's decline as an endogenous "risk-off" response—that is, a switch to less risky assets—to a deteriorated global environment that can spill over to the U.S. economy, the term structure model would require a "global" factor whose omission may otherwise contaminate an estimate of the term premia.

So how sensitive is the estimate of the future path of policy rate to model specification? I next illustrate this sensitivity by augmenting the factor space in a standard (five-factor) term structure model with incremental information from an additional global factor, not contained in the other factors. Given the reasonably tight correlation between the term premia for the 10-year U.S. bond and the 10-year/2-year German bond spread, it seems natural to use the latter as an observed proxy for a global factor, although other statistical approaches for extracting one or more common global factors are certainly possible.

To quantify the potential effect of the global factor, I focus on yield curve dynamics seen in 2019, a period characterized by elevated economic, trade, and geopolitical uncertainty that led to a material decline in observed yields. But did a fundamental shift in the expected path of policy rate, or lower term premia, drive this decline? In the left panel of chart 3, I plot the expected policy rate paths for the second quarter (or midpoint) of 2019, obtained from models with and without a global factor. (Recall that in the second quarter of 2019, the target range for the federal funds rate was 2.25 percent to 2.50 percent.)

Chart 3: Model-Implied Paths of Policy Rate

The difference in the shape of the expected policy rate paths implied by the two models is striking. (The models' estimates use unsmoothed yield data at quarterly frequency, with continuous bond maturities from one to 80 quarters.) Although the expected policy rate path for the standard model is fairly flat, the rate path for the model with a global factor is deeply inverted up to five-year maturities, suggesting that over this horizon one could have expected rate cuts of almost 100 basis points. These expectations occurred against the backdrop of stable growth and inflation outlook in the United States but deteriorating global economic and trade conditions. The right panel of chart 3 displays the evolution of the expected rate path, estimated from the global factor model, for the two quarters before and the two quarters after the second quarter of 2019, as the Federal Reserve started to adjust its policy rate lower. It is worth noting that the strong effect of the German 10-year/2-year spread in the term structure model with global factor is a relatively recent phenomenon. (Additional results suggest that this factor has only a muted impact on the model estimates prior to 2014.)

The policy implications of these findings warrant several remarks. One direct implication is that the common global determinants of the neutral rate of interest, as well as inflationary dynamics, could constrain the potency of domestic monetary policy. A prime example of these constraints was the policy rate normalization phase undertaken by the Fed during the 2016–18 period, which was characterized by global disinflationary pressures, underwhelming economic performance in Europe and Japan, slowing economic growth in China, and escalating trade tensions. These forces were potentially counteracting the Fed's policy efforts and exerting downward pressure on the global neutral rate of interest. The recent economic and financial developments resulting from the COVID-19 pandemic (such as the global nature of the shock, synchronized monetary and fiscal response across countries, and international financial market comovements) and the ongoing recovery appear to only strengthen the case for the importance of incorporating global information in bond-pricing models.




1 [go back] I should note that the correlation between the two series increased from 52.9 percent before 2014 to 76.2 percent after 2014. Interestingly, the beginning of 2014 marks another important shift in financial markets: a sharp and persistent compression in the breakeven inflation forward curve, as a Liberty Street Economics blog postOff-site link recently discussed. A similar flattening is present in the forward term premia of nominal bonds. This is consistent with the interpretation that such flattening—starting in 2014—is likely the result of a new regime, characterized by the compression of inflation risk across maturities.