An Exit Strategy from Quantitative Easing and the Demand for Monetary Base in the United States
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Transcript of An Exit Strategy from Quantitative Easing and the Demand for Monetary Base in the United States
An Exit Strategy from Quantitative Easing and the Demand for Monetary Base in the United
States
Richard G. AndersonRobert H. Rasche
Professors Meeting, November 5th 2009
Demand for the Monetary Base 2
Disclaimer
Opinions expressed are my own and are not necessarily those of the Federal Reserve Bank of St. Louis or the Federal Reserve System.
Audio and /or video recording is expressly prohibited without written prior consent from the Federal Reserve Bank of St. Louis.
This presentation contains no confidential information.
Demand for the Monetary Base 3
Introduction• Discuss Quantitative easing• Discuss Fed’s implementation of Quantitative easing• Discuss “exit strategy” – Exit to where?• Examine the long-run demand for the adjusted monetary base in
the United States, 1919 – 2008.– 4 variable SVAR – The “price” of the monetary base is measured by the inverse
of the yield on long-term high-quality corporate bonds– Unitary Income elasticity– Inflation is approximately a random walk=> “excess” base
does not forecast inflation• a stable function “… of a small number of variables.”
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Unconventional Policy
• The Federal Reserve has pursued “unconventional” monetary policy since August 2007– Reduction in policy target rate– Direct lending and discounting
• On balance sheet (TAF, TALF, central bank currency swaps)• Off balance sheet
– “Credit easing”• Focus on composition of assets, not quantity
• “Quantitative Easing” since early 2009– large scale asset purchase program
• “Agency” (housing GSEs) debt, MBS• Longer-dated Treasuries
• Monetary base will be $2.4T 2010 Q1, with reserves balances > $1.4T (vs $10B in 2007 Q1)
QE and Demand for the Monetary Base 5
Quantitative Easing: How Does It Work? (1)
• New Keynesian models (sticky prices/wages, imperfect competition in product and labor markets, all financial assets perfect substitutes, inflation forecast-targeting monetary policy)
• Policy rate at zero bound• Policy effect due to promise to maintain policy rate at zero for an
“extended period”• What is an extended period?
– When aggregate demand strengthens and forecasts suggest higher inflation, delay increasing policy rate => future higher actual inflation (above policy goal)
– Sustaining the nominal rate and increasing future expected inflation => lowering future real rates => shifting spending forward
• Balance sheet increases are a commitment mechanism to increase the cost of policymakers reneging on the “extended period” promise
Demand for the Monetary Base 6
Quantitative Easing: How Does It Work? (2)
• But central bankers pledge no future higher inflation• What channel remains?
• Credit channel (Bernanke and others)• In Bernanke’s writing, an amplifier to the interest rate channel, not a substitute
or alternative• Bank lending channel
• Loans readily available for good credit• Strong bank lending 2008 Q4• Contraction in 2009 likely a good thing
• Balance sheet channel• Massively alter the balance sheet of the private sector (because the
elasticities of substitution among high-quality financial assets are small)
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5200
5600
6000
6400
6800
7200
7600
Bill
ions
of D
ol-
lars
Bear Stearns' res-cue
Fannie Mae & Freddie Mac sup-port
Lehman’s collapse, Paulson plan
2006 2007 2008 2009
Total Loans and Leases at Commercial Banks
Credit crunch starts
Bill
ions
of D
ol-
lars
Strong bank lending in 2008 Q4
Bank Lending Channel
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1050
1100
1150
1200
1250
1300
1350
1400
US Government Securities at All Commercial Banks
2006 2007 2008 2009
Lehman’s collapse, Paulson plan
Fannie Mae & Freddie Mac support
Bear Stearns' rescue
Credit crunch starts
Billi
ons o
f Dol
lars
Balance Sheet Channel
Demand for the Monetary Base 9
2007 Fourth Quarter Real Estate 20477.39 Home Mortgage 10485.21Deposits 7381.34 Consumer Credit 2551.95Treasury 252.31 Bank Loan 126.99MBS 689.82 Other Loan 126.99Corporate Equities 9453.03 Security Credit 325.53Mutual Fund 4575.24 Other 728.71Pension 13375.89Other 21767
Assests 78228.75 Liabilities 14318.12Net Worth 63910.63
2009 Second QuarterReal Estate 18272.03 Home Mortgage 10401.67Deposits 7760.17 Consumer Credit 2475.51Treasury 605.86 Bank Loan 118.53MBS 129.53 Other Loan 134.01Corporate Equities 6266.29 Security Credit 147.59Mutual Fund 3740.53 Other 790.67Pension 10656.29Other 19777.2
Assests 67207.9 Liabilities 14067.98Net Worth 53139.92
Household Balance Sheet (Billions of Dollars)
Perfect Substitutes !
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• Many countries have done QE before (forthcoming FRBSTL Review article)
• Best way (?): Cold turkey
• How?– Sell assets to the public [potential losses]– RP assets to the public [losses]– Sequester in central bank “time deposits”– Sell central bank securities
• Raise remuneration rate (Goodfriend, Woodford, FRBNY Review, 2002)
How to End Quantitative Easing?
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-140
-70
0
70
140
210
280
350
2007 2008 2009
Adjusted Monetary BasePe
rcen
t cha
nge
at a
n an
nual
ra
te
2006
Targeted Interest Rate and Monetary Base Growth
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00Effective Federal Fund Rate Intended Federal Fund Rate Primary Credit Rate
Perc
ent
Reserve Market Rates
20072006 2008 2009
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Composition of Federal Reserve Assets and Liabilities
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• The challenge: Does a Stable Demand Relationship Exist?
• What does “demand” mean when the quantity demanded always equals the quantity supplied? – Corollary: The private sector cannot change the size of the monetary base.
• Short-run demand curves for base money are useless. – John Taylor’s initial exploration of interest rate-based monetary policy rules grew from a
frustration with the apparent instability of US money demand. – Friedman and Kuttner asserted that all extant stable money-demand relationships from 1970s are
sample specific and disintegrate when the sample extends into the 1980s.
• Subsequent research has suggested the existence of stable relationships. Friedman and Kuttner’s criticism is not robust to the use of reasonable, alternative functional forms.
• Remuneration rate might be able to control credit expansion by banks => the size of the base is not relevant to monetary policymaking or aggregate demand (Goodfriend, 2002; Woodford, 2002)
=> We search for an alternative functional form that might be a stable long-run “demand curve”.
What Size Should the Monetary Base Be?
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Data Selection 1919-present
• Monetary Base: The Federal Reserve Bank of St. Louis’ adjusted monetary Base.
• GDP: BEA’S annual GDP series (1929 -2008) is spliced with Balke and Gordon’s GDP series (1919 - 1946) via an index number method (splice using average of the period-by-period growth rates of the two series)
• Interest Rates: Moody’s Aaa-rated corporate bond yields
• Default rate: Moody’s series on defaults on investment grade corporate bonds.
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0 2 4 6 8 10 12 14 16-5.25
-5.00
-4.75
-4.50
-4.25
-4.00
-3.75
-3.50
Log Monetary Base Velocity and Aaa Bond RateAnnual 1919-2009
Aaa Rate
log(
Mon
etar
y B
ase
Velo
city
)
2009
1941
1931
1937
2007
2008
Level of Bond Rate (Lucas, 1988) – poor model
• Nonlinear• Interest elasticity is an increasing function of the level of the interest rate
Demand for the Monetary Base 16
0.8 1 1.2 1.4 1.6 1.8 2 2.2 2.4 2.6 2.8-5.25
-5.00
-4.75
-4.50
-4.25
-4.00
-3.75
-3.50
Log Base Velocity and Log Aaa Bond RateAnnual 1919-2009
Log(Inverse Aaa Rate)
log(
Mon
etar
y B
ase
Velo
city
)
2009
1941
1931
1937
2007
2008
Log Constant Elasticity Model (Cagan, 1956)
• Less Nonlinear• Interest elasticity is constant
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5 10 15 20 25 30 35 40 45-5.25
-5.00
-4.75
-4.50
-4.25
-4.00
-3.75
-3.50
Log Base Velocity and Inverse Aaa Bond RateAnnual 1919-2008
100*(Inverse Aaa Rate)
log(
Mon
etar
y B
ase
Velo
city
)
1941
19211931
1937
2007
2008
Log price model (inverse interest rate)
• Almost linear• Interest elasticity is decreasing function of level of interest rate
Demand for the Monetary Base 18
5 10 15 20 25 30 35 40 45-5.25
-5.00
-4.75
-4.50
-4.25
-4.00
-3.75
-3.50
Log Base Velocity and Inverse Aaa Bond RateAnnual 1919-2009
100*(Inverse Aaa Rate)
log(
Mon
etar
y B
ase
Velo
city
)
2009 1941
19211931
1937
2007
2008
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Default on Investment-Grade Corporate Bonds
0%
1%
2%
3%
4%
5%
6%
7%
8%Default Rate
New
def
ault
as p
erce
ntag
e of
bon
ds
outs
tand
ing
0200400600800
100012001400160018002000
New DefaultsM
illio
ns o
f Dol
lars
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A Forecast of Monetary Base Velocity
5 10 15 20 25 30 35 40 45-5.25
-5.00
-4.75
-4.50
-4.25
-4.00
-3.75
-3.50
Log Base Velocity and Inverse Aaa Bond RateAnnual 1919-2008 (Adjusted for New Defaults)
100*(Inverse Aaa Rate)
log(
Nom
inal
GD
P/B
ase)
1921
1931
1937
1941
2007
2008
2009
2010
Quantitative Easing!
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A Forecast of Quarterly Monetary Base Velocity
5 10 15 20 25 30 35 40 45-5.25
-5.00
-4.75
-4.50
-4.25
-4.00
-3.75
-3.50
Log Base Velocity and Inverse Aaa Bond RateQuarterly 1947Q1-2010Q2
100*(Inverse Aaa Rate)
log(
Mon
etar
y B
ase
Velo
city
)
2008Q4
2009Q1
2009Q2 2009Q3
2009Q4
2010Q12010Q2
Quantitative Easing!
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Functional Form and Velocity Restriction
• We applied Box-Cox transformation to the base money demand function, and the general functional form is:
• We also imposed a restriction on monetary base velocity (γ = 1), and set λ0 = λ2 = 0; then the general functional form becomes:
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Box – Cox Transformation on Aaa Rate Variable
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Interest Rate Elasticity Estimates
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Recursive estimations prefer the velocity restriction:
• The recursively estimated parameters from the models with velocity restriction are more consistent across different sample sizes.
Forward and Backward Recursive Estimations
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Forward and Backward Recursive Estimations
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Recursive estimations prefer the velocity restriction:
• The recursively estimated parameters from the models with velocity restriction are consistent across different sample sizes.
• The recursively estimated parameters from the models without velocity restriction have bad performance for small sample size.
• The β parameters from the models without velocity restriction have significantly different results between forward recursive estimations and backward recursive estimations.
Forward and Backward Recursive Estimations
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Forward and Backward Recursive Estimations
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• The fitted values are very close to the actual values
• Most of the standardized residuals and recursive residuals are inside the S.E. bands
• Reasonable correlations between residuals
• The standardized residuals look normally distributed
Residual Diagnostics for Log-Inverse Model with Velocity Restriction
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Residual Diagnostics for Log-Inverse Model with Velocity Restriction
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VECM Model
• We used a structural VAR to interpret the long-run monetary-base velocity equation as a demand curve.
The Reduced-form VECM is:
After Imposing the restrictions, the VECM becomes:
where defines the contemporaneous (simultaneous) relationships.
Tt
Pt
ttp uu
LXXLIHH
)}({2
1
ttp LXXLI )]([
12
1
221
1121
111
2
1
)()1(0
WCW
TTBT
HH
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The Estimation Strategy
• First, we re-order the equations such that the single equation for the base, which contains the transitory shock, is at the bottom; and the other equations, which contain permanent shocks, are above.
• After that, we estimated the set of equations with permanent shocks via Sims-like Wold/Cholesky variance decomposition, since this is essentially a VAR system.
• Finally, we estimate the coefficients of the final equation via instrument variables, using the residuals from the prior equations as instruments.
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Parameter Estimates of the Identified VECMModel w/o velocity restriction Model with velocity restriction
Constant -2.697 (0.745) 1.947 (0.835)
CIV –1 -0.650 (0.179) 0.565 (0.245)
rAMB -1 0.156 (0.209) 0.326 (0.405)
rGDP 1.564 (0.398) -1.739 (0.841)
rGDP -1 -0.512 (0.297) 1.132 (0.581)
InverseRate 6.170 (1.279) -10.281 (4.601)
InverseRate -1 -1.588 (0.876) 2.440 (1.584)
DefaultRate 6.347 (1.717) 0.699 (3.150)
DefaultRate -1 0.405 (1.795) 1.184 (2.681)
Standard error of regression 0.09357 0.17002
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Implicit Distributed Lag Coefficients in Identified VECM
Without velocity restriction With velocity restriction
Real GDP Inverse Rate Real GDP Inverse Rate
Period t 1.564 6.17 -1.739 -10.281
Period t-1 -1.367 -5.403 2.306 10.590
Period t-2 0.512 1.588 -1.132 -2.44
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Impulse response functions, Inverse Interest Rate ShockModel with Velocity Restriction
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Impulse Response Functions, Real Output ShockModel with Velocity Restriction
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Impulse Response Functions, Real Monetary-Base ShockModel with Velocity Restriction
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Concluding Remarks
• We find a well-defined stable demand function.
• Our analysis suggests that demand for monetary base may be modeled as demand for a zero coupon, default risk – free consol.
• The statistically significant cointegrating vector suggests that there is a strong pull from any short-run disequilibrium toward the long-run equilibrium.
• Our Results suggests that growth of the monetary base, at least at the relatively low frequency of annual data, can provide guidance for monetary policymakers, particularly when inflation or the level of nominal interest rates is high.
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Any Questions?