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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 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 and slides 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 his paper 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 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 ," 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 Returns" and presented 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 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 paper she coauthored that offers a possible solution for the variation in ratings.
The panel discussion 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 a paper 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 . 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 , 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 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.
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 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 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 , "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 , 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 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 Policy. 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 ." 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 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 of monetary policy and normalizing—or shrinking—the Fed's balance sheet started with the panel's moderator, Vincent Reinhart from Dreyfus-Mellon, presenting 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.
December 2, 2021
Atlanta Fed Conference Investigates Inequalities in the Financial System
A commitment to an inclusive society also means a commitment to an inclusive economy. Such an economy would represent a rebuke of systemic racism and other exclusionary structures. It would represent a true embrace of the principles that all are created equal and should enjoy unburdened life, liberty, and the pursuit of happiness.
— Raphael Bostic, president and CEO of the Federal Reserve Bank of Atlanta, from the essay A Moral Imperative and Economic Imperative to End Racism
Despite the nation's progress toward a more inclusive economy over the last half century, vestiges of structural discrimination are still entrenched in US institutions, and often manifest themselves in the form of disparities in economic outcomes. To promote the topic of racial equality, the Atlanta Fed has partnered with other organizations, cohosting, hosting, or participating in several recent events, including the Atlanta Fed-Princeton University conference on Racial Justice and Finance in September 2020 and the Racism and the Economy webinar series, which began in 2020 and will conclude in early 2022.
On October 14–15, 2021, the Atlanta Fed kicked off the inaugural conference on Racial Inequality and Disparities in Financial Markets to further promote research on inequalities in the financial system. The conference, which was virtual, included presentations and discussions of six papers on racial or gender disparities in various financial markets, including credit markets for mortgages and automobiles, labor markets, and the academic finance profession.
Paula Tkac, associate director of the Atlanta Fed's Research Department, gave the opening remarks. She began by describing how researchers face a dearth of high-quality data in this area, but shared she is hopeful the increased interest in research on racial inequality will spur the effort needed to bring together better data sets. Tkac then called for "a deeper understanding of the 'whys', and insight into potential paths forward toward full economic inclusion" as research progresses. She stressed that this research is crucial in the context of the Fed's monetary policy mission, as a fuller understanding of the barriers stopping individuals from participating to their full potential in labor and financial markets is necessary for good policymaking. Tkac concluded her opening remarks with a quote from Atlanta Fed president Raphael Bostic from last year's Racial Justice and Finance conference:
The influence of race is multidimensional and persists over time. We must look "under the hood" at our institutions to see and truly understand their design and its implications...In your research, think about how you ask questions, particularly how you incorporate historical and institutional realities into your research designs. Examine the role played by institutions and structures and explore how the burdens they impart have contributed to inequities that are still with us...With such an understanding, we can then find more creative and accurate ways to incorporate race into our models, estimation approaches, and narratives. This, I hope, will yield better insights and result in a set of policy prescriptions that can truly create meaningful and lasting change.
Three papers in the conference examined racial disparities in mortgage lending. In "Racial Disparities in Mortgage Lending: New Evidence Based on Processing Time," authors Bin Wei (Atlanta Fed) and Feng Zhao (University of Texas–Dallas) looked at racial disparities in mortgage processing time, which is the time needed for a loan to be processed. Looking at the period prior to the 2008 global financial crisis, they found that Black borrowers experienced significantly longer processing times (about five days more) than did White borrowers for mortgages securitized by the government-sponsored enterprises. In contrast, processing times for the privately securitized mortgages were much shorter for Black borrowers, driven by the fact that Black borrowers were more likely to use nonstandard mortgage financing channels where fast-processing lenders and loan products proliferate.
In the second paper focusing on the mortgage market, "Mortgage Prepayment, Race and Monetary Policy," Kris Gerardi (Atlanta Fed), Paul Willen (Boston Fed), and David Zhang (Harvard) found that Black and Hispanic borrowers pay significantly higher mortgage interest rates than do White and Asian borrowers, and that the primary reason for the large gap in rates is due to differences in refinancing behavior. Minority borrowers are significantly less likely to have refinanced their loans in response to declines in mortgage interest rates, and as a result, they benefited less from lower interest rates.
In the third mortgage paper, "Mortgage Policies and Their Effects on Racial Segregation and Upward Mobility," Nirupama Kulkarni (Centre for Advanced Financial Research and Learning) and Ulrike Malmendier (University of California–Berkeley) noted that housing policies aimed at reducing racial disparities in home ownership can have unintended adverse consequences. Exploiting variation in the ease of mortgage financing created by the 1992 GSE Act, which explicitly targeted underserved neighborhoods, they showed that, while Black home ownership increased in targeted neighborhoods, white families moved out. As a result, segregation increased and the upward mobility of Black children deteriorated. They pointed to declining house prices, reduced education spending, and lower school quality in targeted areas as plausible channels for the decline in upward mobility.
The paper "Testing Models of Economic Discrimination Using the Discretionary Markup of Indirect Auto Loan" by Jonathan Lanning (Philadelphia Fed) examined racial discrimination in auto lending. Lanning presented some compelling empirical evidence for taste-based discrimination in the auto loan market. Auto loans are typically the largest consumer loans after mortgages. More than 80 percent of these loans are indirect, meaning they are arranged by a dealer on the borrower's behalf. The dealer has the discretion to mark up an indirect auto loan by as much as 250 basis points over the rate at which the lender is willing to extend credit. In exchange for the rate increase, the dealer receives additional compensation from the lender. Lanning found that the average markup for Black borrowers is about 14 basis points higher than for White borrowers. More importantly, the racial disparity in the markup is shown to be consistent with the taste-based discrimination theory developed by Becker (1957).
The final two papers in the conference examined the gender gap in the academic finance profession and in the labor market. In the paper "Diversity, Inclusion, and the Dissemination of Ideas: Evidence from the Academic Finance Profession," authors Renee Adams (University of Oxford) and Michelle Lowry (Drexel University) examined how diversity relates to variation in career outcomes within the academic finance profession. They conducted their research based on a survey they administered to current and recent past members of the American Finance Association (AFA) on the professional climate in the field of finance. The survey had 1,628 respondents, about 30 percent of them female. Survey results suggest that female finance faculty members in general have a lower satisfaction level than do their male counterparts. The authors found that gender discrimination is one of the most important causes for this discrepancy.
In the final paper, "Hidden Performance: Salary History Bans and Gender Pay Gap," Jesse Davis (University of North Carolina), Paige Ouimet (University of North Carolina) and Xinxin Wang (University of California–Los Angeles) looked at how salary history bans affected the wage gap between male and female workers. These bans prevent employers from requesting and using a job candidate's prior salary information. Many states have adopted these bans with the explicit intent of reducing the gender pay gap. The idea is that historical pay discrimination against women is propagated if employers are allowed to use past salary information to set pay for new female hires. Presumably, imposing bans should prevent the perpetuation of past discrimination. However, the bans have the additional, negative consequence of preventing potential employers from observing a signal of worker productivity. So the overall effect of salary history bans on the gender gap is unclear. Using a large-panel data set of disaggregated wages covering all public sector employees in 36 states, the authors do not find evidence that salary history bans significantly decrease the gender pay gap.
All in all, the conference proved to be a memorable event. Papers incorporated high-quality micro data and state-of-the-art empirical methods that uncovered evidence of racial and gender inequalities across a variety of financial markets. The paper presentations and thoughtful discussant presentations spurred a lot of dialogue and debate around the nature of the disparities and their implications for future policy. We hope to hold similar conferences in the future, perhaps on an annual or biennial frequency, to continue to promote and raise awareness of this topic.
October 18, 2021
Market Response to Taper Talk
As the Fed discusses reducing its $120 billion in monthly purchases of Treasury and mortgage-backed securities, market pundits have begun to form opinions on whether such talk about tapering will roil markets as it did in 2013. Some believe that, given the size of the Fed's monthly purchases, such discussion will lead to similar market reactions. Others believe that markets today better understand the Fed's decision-making process around its asset purchases and interest rate policy. This market knowledge and experience may help mitigate the negative effect taper talk could have this time. In this post, we provide evidence that both perspectives are at least partially correct.
To be specific, we analyze the past and present discussions on tapering, including the effects that the Federal Open Market Committee's (FOMC) September 2013 meeting, often referred to as the "untaper" meeting because plans for tapering were delayed, and the June 2021 "talking about talking about tapering" meeting had on the market's expectations for the future path of the fed funds rate. We show that a market response similar to 2013 has already occurred in the sense that an increase in the 10-year Treasury rate coincided with market participants expecting an earlier liftoff from a fed funds rate of zero. Subsequent taper talk only marginally affected how the market expects the pace of rate hikes to proceed. In other words, the market responds to increasing Treasury rates by first pricing in a strong opinion about how much time will pass before the first rate hike. Subsequent discussions about tapering have little to no effect on the market expectations for future interest rate policy.
For our analysis, we use the Federal Reserve Bank of Atlanta's, Market Probability Tracker (MPT), to measure the market's expectations for the future course of monetary policy. The MPT is computed and reported every day on the Federal Reserve Bank of Atlanta's website and is described in detail in an Atlanta Fed "Notes from the Vault" post. The MPT uses options contracts on Eurodollar futures to estimate the market's assessment of the target ranges of future effective fed funds rate. Using derivative contracts on Eurodollars has one main advantage over studying the effective fed fund futures directly. Unlike the futures market for fed funds, the options on Eurodollar futures market is one of the most liquid in the world, with a wide collection of traded options. Moreover, Eurodollar futures deliver three-month LIBOR (or London Interbank Offered Rate), which bears a stable relation and high correlation with the effective fed funds rate in global overnight money markets. Together, these features allow the MPT to extract more confidently measures of market expectations of future effective fed funds target ranges.
Turning our attention first to 2013, we look at how the market's expectations for the future path of rates changed as taper talk began to heat up. In figure 1, we plot several of the MPT's daily expected fed funds rate paths from before and after June 2013. Each unlabeled path in the figure is represented by a transparent blue line of the market expectations for the fed funds rate path as of Wednesday of that week. These weekly expected rate paths began on May 1, 2013, and ended on December 18, 2013, when the Fed announced it would begin paring down its asset purchases.
Note: Expectations computed daily with option data on Eurodollar futures contracts from May 1, 2013, to December 18, 2013. Each unlabeled line represents the market's expected path for monetary policy given the data as of Wednesday of the indicated week.
The orange line in figure 1 represents the market expectations as of May 1, 2013. At that time, no substantive discussion about the Fed shrinking its asset purchases had taken place. The FOMC had just released a statement that it would continue to purchase assets "until the outlook for the labor market has improved substantially in a context of price stability." Regarding its interest rate policy, the Committee stated that it "expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens." Given the Fed's policy, along with the state of the economy, the market expected the first rate hike to be in mid- to late 2015.
Between May 2013 and the next FOMC meeting on June 19, 2013 (the dashed blue line in figure 1), the market's expectation for future monetary policy began to price in an earlier rate hike sometime between late 2014 to early 2015 (see the sequence of transparent blue lines in figure 1 that move up and to the left from the orange to the dashed blue line). During this period between FOMC meetings, Ben Bernanke, then chairman of the Board of Governors, testified to Congress that the FOMC "could in the next few meetings...take a step down in our pace of purchases" (Bernanke Q&A congressional testimony, May 22, 2013).
Bernanke's May 2013 testimony may have contributed to pulling forward market expectations for when the Fed would end its highly accommodative monetary policy since many expected the Fed's asset purchases to end before the fed funds rate was increased from its zero lower bound. The chair's testimony is also credited with setting off what is commonly referred to as the "taper tantrum" in the Treasury market. In figure 2, the blue line shows how much the 10-year Treasury rate had changed since May 1, 2013. According to this figure, Bernanke's testimony was certainly followed by an increase in the 10-year Treasury rate, but this increase continued a trend that began back in May 2013. And market participants had been pricing in an earlier and earlier liftoff date while the 10-year rate was increasing in May, not when the chair testified to Congress.
Note: The blue line represents the change from May 1, 2013, to February 24, 2015. The orange line represents the change from November 5, 2020, to August 27, 2021.
The Committee's June 2013 statement on monetary policy changed little from its May statement, but the expected path for the fed funds rate had already steepened (compare the dashed blue line with the orange line in figure 1). Notably, it was over the six days that followed the June FOMC statement that the 10-year Treasury increased by 40 basis points (see the blue line in figure 2). Many believe this increase in the 10-year rate was due to Bernanke's comments during the post-FOMC press conference when, in responding to a question about asset purchases, he said it would be appropriate to moderate purchases "later this year" and to end purchases "around midyear" 2014. However, for our purposes, we point out the muted impact Bernanke's answer had on the expected rate paths plotted in figure 1.
Over the next couple of months, changes in the fed funds rate path continued to be minimal even in response to Bernanke's attempt to calm other markets by assuring market participants the Fed was committed to a highly accommodative monetary policy. By the September FOMC meeting—a meeting sometimes referred to as the "untapering" meeting because the Committee decided to "await more evidence that progress will be sustained before adjusting the pace of its purchases"—the expected funds rate path was statistically indistinguishable from the June rate path (see the dashed black line in figure 1). However, the September announcement to delay the tapering of its purchases appeared to have caught bond investors by surprise. In figure 2, we see that the 10-year Treasury rate (the blue line) dropped by approximately 20 basis points over the coming weeks—all while the market's expectation for the timing of liftoff remained relatively constant.
Over the rest of 2013, the pace of the expected rate hikes stayed relatively stable. Figure 1 shows this stability by the similar curvature of the expected path lines from September to December. Interestingly, the December FOMC formal announcement that the Fed would begin to reduce its monthly purchases of Treasuries and mortgage-backed securities (MBS) by $5 billion each did not change the market's expectations for how long it would be before liftoff (see the solid black line in figure 1). We interpret this as market participants having formed their expectations about the future pace of interest rate hikes when the Treasury rates had increased and as policymakers were beginning to talk about tapering and not when the Fed announced the actual date and pace of its shrinkage in asset purchases.
Now compare figure 1 to the sequence of expected rate paths plotted in figure 3 for the time interval of November 5, 2020, to August 11, 2021. Early in this time period, the orange line in figure 2 shows the 10-year Treasury rate increasing 95 basis points from November 2020 to the end of March 2021 (the high point of the orange line in figure 2). This increase in the 10-year rate was due in part to the improving economic conditions and optimism around the advent of COVID-19 vaccines. This time period also corresponds with a steepening in the market expectations for the fed funds rate path seen in figure 3. The "lower for longer" policy of the Fed can be seen in the flat November FOMC rate path (compare the orange rate paths in figures 1 and 3). But as in figure 1, the expected rate paths in figure 3 gradually steepen while the 10-year rate is increasing.
Note: The fed funds rate path was computed from daily option data on Eurodollar futures contracts from November 5, 2020, to August 27, 2021. Each unlabeled line represents the market's expected path for monetary policy given the data as of Wednesday of the week
The minutes from the April FOMC were released to the public on May 19, 2021 (see the pink rate path in figure 3). These minutes describe several participants suggesting that "it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases." Discussion about shrinking the monthly purchases of assets continued into the June 2021 FOMC meeting. Importantly, at the June FOMC press conference, Fed chair Jerome Powell responded to a question about the timeline for reducing asset purchases by saying that people can think of the June meeting as the "talking about talking about" meeting.
The market's expectation about the fed funds rate path to this taper chatter was muted. Market expectations for the first rate hike had already moved up from the middle of 2024 to the first half of 2023. Given the similarity in the paths at the FOMC meetings in June (see the dotted black line in figure 3) and July (the dashed black line in figure 3), and after Chair Powell's Jackson Hole speech (the solid black line), market participants did not alter their expectations about liftoff. Not even the June FOMC's hawkish Summary of Economic Projections affected the views of market participants on the future course of interest rates.
Comparing the sequence of 2013 and 2020–21 rate paths plotted in figures 1 and 3, we might believe that those who think tapering in 2021 will lead to a similar market reaction as in 2013 are right—but only in the sense that both events corresponded to a sizeable increase in the 10-year Treasury rate and not the actual taper.
That being said, after the rate paths in figures 1 and 3 steepened, the limited impact that taper talk had on the rate paths lends support to those who expect tapering to be a nonevent. The relatively constant pace of expected rate hikes found in 2013 and 2021 suggests that a formal announcement by the Fed on reducing its purchases of Treasuries and agency MBS will likely have a limited effect on the market expectations for the pace of future rate hikes. This is especially true for the 18- to 24-month time horizon of the rate paths.
Regardless of whether we believe that there will or will not be a "taper tantrum" similar to the one in 2013, the market expectations calculated from the Eurodollar futures market clearly show two common effects from the events of 2013 and 2020–21. The first is that as the 10-year Treasury rate begins to rise, market participants expect the Fed to start raising the fed funds rate earlier than before. The second effect is that after the first effect, the expected pace of future rate hikes does not appear to be very responsive to taper talk. Hopefully, knowledge of these tapering-related empirical regularities will help market participants form more accurate predictions about future interest rate policies.
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