Tuesday, March 19, 2013

Ben Bernanke and the Term Structure of Interest Rates

The FOMC meets today and tomorrow, and will likely vote to continue with its current program of purchases of $85 billion per month in mortgage-backed securities and long-maturity Treasury bonds - "quantitative easing." A few weeks ago, Ben Bernanke publicly articulated some of the economics behind quantitative easing. It's useful reading, but for me it was far from reassuring.

The core of Beranke's talk uses empirical work from a paper coauthored by D'Amico, English, Lopez-Salido, and Nelson at the Board of Governors. We can take this as honest empirical work, I think, but we can infer - as usual - that the work was done in part as reverse engineering. Quantitative easing (QE) came before the empirical and theoretical work that was done at the Fed to justify the policy.

But leaving aside our suspicions for now, what does D'Amico/English/Lopez-Salido/Nelson (henceforth DELN) have to say? The authors think that there are three avenues through which QE might work:

1. Expectations/signaling: QE may move asset prices because it signals something about future Fed policy actions that actually matter - through this channel the QE asset purchases don't matter directly.
2. Preferred habitat/scarcity: QE might matter because markets for assets of different maturities are at least partially segmented. Then, central bank actions that change the relative supplies of assets of different maturities will cause the term structure of interest rates to change.
3. Duration risk: The yield curve may typically be upward-sloping because long-maturity bonds are riskier assets - their prices are more volatile. If the Fed removes long-maturity bonds from public circulation, this could remove some duration risk, and therefore make asset holders more willing to bear duration risk at the margin, thus making the yield curve less steep.

If you've read this previous post, you'll understand that I don't think that either of (2) or (3) hold water. Certainly (1) does, and I wrote about that in my previous post. Basically, for political reasons QE may constrain future Fed actions in particular ways.

To address preferred habitat, we have to think about the asset transformation activities of private financial intermediaries, vs. what the Fed is capable of doing when engaging in the same types of activities. Particular individuals may have well-defined preferences over future payoffs (a preferred habitat, if you like), but private financial intermediaries are in the business of taking assets with particular future payoff streams and transforming them into liabilities with different payoff streams. Banks intermediate across maturities; and derivatives and asset-backed securities are designed to reallocate risk in particular ways, for example. Like private banks, the Fed can also transform long-maturity assets into short-maturity liabilities. If you want to construct a model of "preferred habitat," you need to model intermediation - by the Fed and private financial intermediaries. If QE is to matter in this context - for the better - it must be because the Fed is somehow better at intermediating across maturities than are private sector financial intermediaries. No one has to date carried out such a theoretical exercise. Certainly Vayanos/Vila, cited by DELN, do not do that. In the Vayanos/Vila model, preferred habitat is represented by defining preferences over assets - a poor place to start.

On duration risk: This is dubious, for two reasons. First, suppose the Treasury is considering financing its deficit with short-maturity debt vs. long-maturity debt. Why would a choice to issue long-maturity debt imply that the private sector faces more aggregate risk? Second, if the Fed purchases long-maturity bonds by issuing reserves, this does not relieve the private sector of risk, as the Fed's future payments to the Treasury (which have implications for future debt issue and taxes) are more risky. It is hard to see how the private sector can unload risk to the Fed's balance sheet.

(1)-(3) is the "theory" in the DELN paper, but most of the authors' effort went into the empirical work. Basically, they construct measures from the data that allow them to decompose nominal bond yields in ways that they think will give us a handle on the effects of QE. That part of the paper is summarized in Bernanke's speech. Here's a chart of Bernanke's that helps to explain it. In the chart, the 10-year nominal bond yield has been broken down into three components: (i) expected average inflation (inflation premium); (ii)expected average real short rate; (iii) term premium. With risk neutrality, the first two components should explain everything. That's basically the expectations theory of the term structure, which implies that the real yield is the average of the real future short rates, plus average anticipated inflation (that's Irving Fisher). The "term premium" is then just a residual. It's not at all clear what it means, but Bernanke wants to think of it this way:
In general, the term premium is the extra return investors expect to obtain from holding long-term bonds as opposed to holding and rolling over a sequence of short-term securities over the same period.

In any case, what you see in Bernanke's chart is: (i) a slow decrease in the measured expected average inflation rate, beginning in 2007; (ii) a decrease in the expected average real short rate from about 1.5% in 2007 to about 0% today; (ii) a volatile term premium that declines into negative territory beginning in the latter half of 2011. Bernanke wants to claim credit for that term premium decline - he thinks that's driven by QE. But do we trust the measurement?

I'm finding it hard to square what DELN and Bernanke are seeing with what I can eyeball in the 10 year nominal bond and TIPS yields, and in the inflation data. Here's a plot of the breakeven inflation rates from the 10-year bond yield data, and the twelve-month pce inflation rate (I know that TIPS is contingent on the CPI - I used PCE here for a specific reason). Before the recent recession, the breakeven rate seemed roughly consistent with the average rate of inflation we were actually observing. And the breakeven rate has roughly returned to pre-recession levels, which might lead us to believe that the expected average inflation rate is about at what the average was for 2003-2007, which my eyeball tells me is 2.6-2.8%. But Bernanke is telling me that anticipated inflation has fallen, to about 2.2% currently.

Next, let's look at the raw 10-year nominal and TIPS yields. Note in particular that Bernanke is telling us that the TIPS yield has dropped by about 2.3 percentage points from the end of the recession, but he wants us to believe that the expected average real short rate has dropped by only 1.5 percentage points. We are supposed to believe that 10-year TIPS prices are so high because TIPS have become really scarce and/or because market participants think there is less duration risk. Well, to the best of my knowledge, the Treasury has been working away to extend the average duration of the government debt, and that effect outweighs the effects of Fed asset purchases, on net. Thus government/Fed actions have made long bonds less scarce. Further, the contortions the Fed is going through would surely make most market participants more uncertain about real future rates, which would tend to increase any duration risk that might exist out there.

Some other problems:

1. DELN estimate their model for the period 2002-2011. Obviously the monetary policy regime changed dramatically after the financial crisis. How can we think of the pre-2008 data as useful for thinking about the problem?
2. The current scarcity of safe assets (for use as collateral and in financial exchange) implies that Fisher relations don't hold, so inflation premia aren't going to work as in the crude theory outlined in DELN.
3. The key problem is that the Fed is lacking a structural model. They need a model that can successfully explain the term structure of interest rates, and capture the key details of how monetary policy works - both pre-crisis and post-crisis. Without that QE, and attempts like Bernanke's to rationalize it, are just mumbo-jumbo.


  1. Well, I am tempted to paraphrase an old joke about French thinkers: They ask, "Sure, Market Monetarism might work in practice, but more importantly, does it work in theory?"

    I have a question. Yes, the Fed is an intermediary. But does not the Fed also create money? And when a central bank creates money, does not that count for something?

    Let me ask another question: Would it work (to stimulate the national economy) to furtively at night place grocery bags full of cash on street corners in moderate-income neighborhoods for the next five years? Say $100 billion a year, fresh new money.

    How about a national lottery, that pays out $100 in cash for every $50 wagered? Biggest prize is $1000, and you have to buy tickets at 7-11s, no more than $200 per day.
    Winners are given fresh new money.

    How about we entice drug lords to repatriate that $600 billion in Benjamin Franklins or so offshore. Would that help?

    I am just trying to understand why QE does not help.

    In QE, the Fed gives (digitized) cash in exchange for securities. The sellers have cash. If they spend it great. If they invest it, great. This is fresh new money. Are you saying they only put it into banks and the already swollen reserves?

    Still, I cannot imagine a situation in which a central bank cannot print enough money to cause demand to go up, and then inflation.

    On Fed independence: I am not sure anymore that is a good idea. I would prefer to see a powerful Fed chief appointed by the President, to serve co-terminously. Forget the FOMC. Without looking at Wikipedia, I cannot tell you how FOMC members are appointed and who they are. Somebody in NY has a permanent seat. Ask Rube Goldberg to explain it.

    The voters have a right to accountable government. Clarity, transparency.

    Imagine living in Europe. You hate monetary policy there. You are a citizen. And how do you vote?

    I am entitled to vote on macroeconomic policy, if that is what our federal government does.

    1. "This is fresh new money."

      Yes, fresh money is the best.

  2. It is asserted, "They need a model," which assumes that a model is possible.

    What if, based on our lack of knowledge, psychology, bias, etc., any set of facts has 10 or 20 outcomes or 100s of billions?

    It seems to me that all you have shown is that economics is like quantum mechanics---sometimes it works---but we don't know whether the cat is alive or dead and well never know.

    Benjamin was right and deserved a better response.

    1. "Benjamin was right and deserved a better response."

      This is an amendment to the Constitution maybe?

  3. Benjamin, I'll start with

    "I have a question. Yes, the Fed is an intermediary. But does not the Fed also create money? And when a central bank creates money, does not that count for something?"

    NO the fed doesn't create money, they create reserves which they swap for interest bearing treasuries, they effectively take interest income out of the economy to hopefully lower borrowing costs and spur the fiscal channel to work.. that's how it's supposed to work at least but for the moment the fiscal channel is officially broken.. i digress, Stephen, another excellent post thx.. and while i agree with many points about the effectiveness of monetary policy and for me this is especially true as time progresses with the same policy. I will say in the chart of deconstructed 10yr yields, that the significant drop at the end of 2011 was absolutely fed driven and can be shown in forward yield curves across the term structure that all dropped roughly 100+bps. This was largely driven by the date driven commitment from the fed to the end of 2014? i believe? It was in that one instance;where the commitment appeared a very effective tool for driving down term interest rates.

  4. "...that the significant drop at the end of 2011 was absolutely fed driven..."

    How do you know?

  5. for example 3y5y rates stood in a range between roughly 3.5 to 4.5% for several years including post financial crisis. but suddenly in august 2011 which is when the 'mid 2013' surprise statement came out, that rate has yet to peak above 3% since that time. it rallied 100+ bps in the 10 days after that statement and settled in a range much lower than 3%. I would call that a direct result of an unexpected flattening of future rate expectations, that was primarily fed driven.

  6. Sure. The Fed said something, and asset prices changed. So, it's Fed driven, but that's consistent with QE having no direct effect, and just acting as a signal of a change in future Fed actions.

  7. I can't tell if you're skeptical about the idea of a term premium or skeptical about the measurement of the term premium.

    1. To say what the data means, I have to have an explicit theory. So, in this instance I would like to have a theory that prices bonds of different maturities, and the theory should allow me to say how different factors matter - inflation, monetary policy, for example. It should also tell me about the link between real and nominal rates at different maturities. The problem here is that the theory is not formalized. There is something that is being estimated here, but we have no idea what it is - I need the theory to tell me how to interpret those estimates.

      But, one thing I know is that, on average, the nominal yield curve is upward-sloping, so it appears that long-maturity nominal government debt sells at a lower price - adjusting for duration - than does short maturity government debt. Thus there is a regularity in the data - short maturity government debt commands a premium in financial markets. Why? No one has successfully explained that. It could be a liquidity premium of some sort, or you could call it a term premium if you want. But without a theory we can't make any sense of it, or measure it.

  8. Agency issues abound in the bond market. These can result in homogeneity of duration bet strategies that in turn lead to price distortions. For instance, since '09 the term real yield has declined into negative territory while stock prices have more than doubled. This divergence is difficult to explain under conditions that allow arbitrage. The question is not whether QE "works" as its proponents advertise. Instead, its whether such an outcome can emerge out of a few simple market inefficiencies. A representative agent model would likely capture this dynamic.

    1. I agree with you that there are frictions out there that we want to model, and that we want to understand the implications of those frictions for asset prices and for how financial markets function. I think, however, that representative agent models are not the way to go on this. We need to be thinking about financial intermediation and credit market frictions, and heterogeneity is necessary to capture those things.

    2. Not sure if you realize I meant representative agent modelling in the complexity theory sense. The intention of these models is to capture heterogeneity.

  9. Cidiel, and Stephen Williamson:

    I like the idea of a Constitutional amendment bearing my name.

    But let me ask this: Okay, the Fed's QE program does nothing. So the Fed can buy all outstanding US Treasuries, and wipe out the national debt (presuming they hold to maturity)?

    What would happen if they did this? You are saying, "nothing. only that bank reserves would swell." Can this be right?

    Sounds like the opportunity of a lifetime to me.Or several lifetimes.

    BTW, I am asking these questions earnestly.

    When I say "fresh new money" I mean newly created currency. I am sorry if i do not know the proper terminology. If we increase the amount of currency floating around, that will have no effect? Or a positive effect? Seems like it has to be positive.

    These seem like reasonable questions to me.

    1. Sorry, but the reason I'm not replying to your comments in detail, and just making jokes, is that you are very confused. I would need to teach you a whole course to get you up to speed. But let's start with a small thing:

      "So the Fed can buy all outstanding US Treasuries, and wipe out the national debt..."

      No, the Fed cannot "wipe out" debt. A central bank can only change the composition of the outstanding government debt. For example, if the Fed buys T-bills with reserves, what changes, in terms of the outstanding nominal debt? Nothing. Of course, in normal circumstances, we might expect that to increase prices, so the real quantity of outstanding debt would fall. Of course, it's not normal circumstances now - if the Fed swaps reserves for T-bills, absolutely nothing happens, as the T-bills and reserves are identical, to a first approximation.

  10. Stephen,

    Basically I agree with you on all points, though I am skeptical that even the signalling channel is very productive. The question is whether the Fed is sufficiently worried about losses to err on excessively stimulative policy for too long. Personally, I think their credibility hinges more on inflation than remittances to the treasury.

    Here's what bothers me though. Lets assume their portfolio balance theory is correct, and also that their assessment of the risk premium is correct. If the 10-year risk premium is negative that means that the market assesses that it is risk *reducing* to the market portfolio. If that is the case, then removing more of it will increase variance in the market portfolio which will cause it to decline given a constant level of risk aversion.

    My personal suspicion is that Wallace irrelevance fails, probably due to inconsistent expectations, and central bank purchases can have a significant impact on prices (see e.g. exchange rate targets). I'm pretty sure that if, for example, the Fed announced a $Tn stock purchase we'd get a decent rally. But if buying treasuries is equivalent to *selling* stocks then it's a really bad idea. Maybe that's why stocks fell on both Operation Twist announcements.

  11. Clarification:

    "then removing more of it will increase variance in the market portfolio which will cause it [*the market*] to decline given a constant level of risk aversion."

  12. Benjamin,

    "What would happen if they did this? You are saying, "nothing. only that bank reserves would swell." Can this be right?"

    Yes. They'd have to pay IOR at the policy rate in order to raise the rate above zero. Which they'll have to do when we start to get some inflation. Reserves are then the same as t-bills. So they've swapped bonds for t-bills. That's all. Whatever.

  13. Benjamin, to be sure, what the fed is doing right now is a tax on savings, part of the theory is to drive investment into riskier parts of the economy by making safe yields less attractive or negative on a real yield basis. right now 10yr real yields are -60bps, given a fairly benign 10yr inflation rate of 2.5%.. as for the fed wiping out the national debt, the answer is no, the fed could wipe out the interest we pay on the debt, it doesn't wipe out the debt unilaterally. if they bot every tsy out there in existence then yes bank reserves just swell and more interest income gets drained from the economy and real yields go even more negative, again tax on savers. banks don't lend reserves they lend TCE ratios etc etc.. the true 'money creators' are the banks from actual loan creation, which again is a function of their overall health not how many reserves they have. hope that clarifies some things, or maybe it makes it muddier!

  14. stephen on the front end treasury curve, the reason say 1yr and in is consistently inside 25 bps is because you have a bank that has put a ceiling on that level via it's ballooned reserve balances. (they would always buy above that) while you also have a whole host of people that can't participate in IOER b/c they aren't banks but they have large cash balances, GSE's for one are monster participants in front end cash management they alone can move the front rates 5-10bps just based on their daily coupon inflows/outflows. add in all the other front end cash management out there that can't participate in IOR and you have the reason the front end trades below 25bps. i'm skeptical of any model in all this, it's impossible to capture all the actors involved and their rationale.

    1. I agree with most of what you're saying. Under a floor system (excess reserves outstanding overnight) the IOER determines the overnight rate. But there's some slippage in terms of the effect of the IOER on all other short rates, due to: (i) GSEs; (ii)limitiations on the who can participate in the exchange of reserve account balances. But, (a) I'm not as skeptical as you about our ability to model these things. (b) In some cases these interest rate margins aren't a big deal in terms of how monetary policy works. For example, I think that as IOER rises, that the interest rate differentials - e.g. between IOER and T-bills - should stay roughly constant.

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  16. Yes, but bank reserves are not federal debt. So when the Fed buys Treasuries with digitized cash, the federal debt is reduced.

    Also, I have a question. Okay, say I own a $10k T-note. I sell it, and get cash, and the outfit i sell it to sells it to the Fed.

    How is this not putting cash into the economy? I may put all the money in the bank, but what if I spend some or invest in stocks or property?

  17. "...but bank reserves are not federal debt."

    No. What matters is the consolidated debt of the Fed+Treasury.

  18. How does Zimbabwe create inflation? Can we copy them, except at 10 percent a year rather than 10 percent a day?

    1. Fiscal policy can do it. This is an old paper, but it gives you some insight into this. It's the working paper version:


      By the way, why do you think 10% inflation would solve our problems?