Saturday, August 28, 2010

Bernanke at Jackson Hole

Bernanke's Jackson hole speech is quite interesting, though the poor guy doesn't seem to be relaxing in the mountains. There is a photo of him in the New York Times with Kohn, who looks a little dressed-down, but Bernanke is in the regular suit-and-tie mode.

Here are the interesting parts of the speech (at least for me). On why Fed purchases of long-term debt matter:
The channels through which the Fed's purchases affect longer-term interest rates and financial conditions more generally have been subject to debate. I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve's purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed's strategy relies on the presumption that different financial assets are not perfect substitutes in investors' portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.
"Porfolio balance channel" is reminiscent of Tobin's "A General Equilibrium Approach to Monetary Theory," (JMCB 1969), and the rest is basically a market segmentation story. This is not much to go on, but of course serious modern dynamic financial economics has not delivered much that is usable here for a central banker. I think any effects we might get from changes in the maturity structure of the Fed's Treasury holdings have more to do with the effects on liquidity premia at different maturities, due to the fact that Treasuries of different maturities play different roles in financial market exchange and as collateral. Actually, later in his speech, Bernanke says something consistent with that, which is
...such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high.
Now I think we are getting somewhere.

A second issue has to do with what happens if the Fed reduces the interest rate on reserves, say to zero. Bernanke says:
A third option for further monetary policy easing is to lower the rate of interest that the Fed pays banks on the reserves they hold with the Federal Reserve System. Inside the Fed this rate is known as the IOER rate, the "interest on excess reserves" rate. The IOER rate, currently set at 25 basis points, could be reduced to, say, 10 basis points or even to zero. On the margin, a reduction in the IOER rate would provide banks with an incentive to increase their lending to nonfinancial borrowers or to participants in short-term money markets, reducing short-term interest rates further and possibly leading to some expansion in money and credit aggregates. However, under current circumstances, the effect of reducing the IOER rate on financial conditions in isolation would likely be relatively small. The federal funds rate is currently averaging between 15 and 20 basis points and would almost certainly remain positive after the reduction in the IOER rate. Cutting the IOER rate even to zero would be unlikely therefore to reduce the federal funds rate by more than 10 to 15 basis points. The effect on longer-term rates would probably be even less, although that effect would depend in part on the signal that market participants took from the action about the likely future course of policy. Moreover, such an action could disrupt some key financial markets and institutions. Importantly for the Fed's purposes, a further reduction in very short-term interest rates could lead short-term money markets such as the federal funds market to become much less liquid, as near-zero returns might induce many participants and market-makers to exit. In normal times the Fed relies heavily on a well-functioning federal funds market to implement monetary policy, so we would want to be careful not to do permanent damage to that market.
What is weird here is the focus on the fed funds rate, as if that is what matters. Suppose the Fed reduces the IOER rate to zero. I think what he is saying is that the fed funds rate will still be positive, since there is some risk premium associated with lending on the fed funds market (all unsecured). But so what? The important thing is that a lower IOER reduces the incentive of banks to hold reserves (not by much of course by going from 0.25 to 0). We don't really care what the fed funds rate is when there is a positive quantity of excess reserves in the system. The Fed also should not care whether or not the fed funds market is active. Presumably most of the current activity in the fed funds market is just Fannie Mae and Freddie Mac lending overnight (because they do not receive interest on their reserve accounts) to other market participants (who do). Maintaining that activity is somehow important to monetary policy? Baloney.


  1. I think you're misinterpreting Bernanke's statement

    "..such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high."

    I don't think he is thinking about the roles of different instruments in exchange or as collateral.

    I read it as saying (i) yes, market segmentation is real, but (ii) in normal times, there is some arbitrage capital that keeps the links between the fed funds rate and more distant points along the maturity and risk spectrum from uncoupling, and (iii) during times of market distress, arbitrage capital dries up and there's a role for the Fed to step in and replace it; but if capital markets are well functioning there's not much the Fed can do to change the yields on long-maturity or higher risk debt without making VERY large changes to its balance sheet (an unattractive option).

  2. Yes, that could be it. Do you know anything about market segmentation in the asset pricing literature? What I am familiar with is the monetary policy segmentation models, where you just differentiate between financial market participants and non-participants, not among participants in, for example, different segments of the Treasury market.

  3. This paper by Dmitri Vayanos and Jean-Luc Vila builds a term structure model that features risk-averse arbitrageurs and investor clienteles with preferences for specific maturities.