``The Liquidity Premium of Near-Money Asset’’ by Stefan Nagel

Discussant: Annette Vissing-Jorgensen, University of California Berkeley

Conclusions:

• Despite the fact Treasuries have a liquidity yield discount, the supply of Treasuries

does not matter for this liquidity yield discount.

• The negative empirical relation between the liquidity yield discount on Treasuries

and Treasury supply is not causal.

Why not?

• The level of short (illiquid) interest rates is set exogenously by the Fed and is what

really drives all liquidity yield discounts (with a positive sign).

• Treasury supply happens to be negatively correlated with the level of interest rates.

Furthermore:

``There is no contradiction, however, between the quantity correlations reported in

Krishnamurthy and Vissing-Jorgensen (2012) and Greenwood, Hanson and Stein (2014)

and my evidence that supply-related variables are unrelated to the liquidity premium

once short-term interest rates are controlled for. In fact, the elastic money supply

response of the CB may be precisely what gives rise to the negative correlation

between T-bill supply and private sector near-money supply that these papers

document. In my model, an expansion in money supply facilitates demand deposit

creation.’’

Comment 1: Whether you think the relation between the fed funds rate and Debt/GDP

is coincidental or not, the conclusion about Treasuries being special is the same:

Short Treasury yields are low due (at least in part) to high Treasury liquidity

KVJ (2012):

• We wanted to understand whether Treasuries are special in terms of safety or

liquidity to understand why they have low yields

• Our test: Do changes in Treasury supply changes the equilibrium price of

safety/liquidity

• We found a role for both safety and liquidity

Current paper:

• The Fed controls the equilibrium price of liquidity because it controls the level of

the short interest rate.

- This is the cost of liquidity for the most liquid assets (checking+cash)

- But other liquid assets must have yield discounts that are closely related to this

cost.

• Within Stefan’s framework (i.e. with the Fed controlling the short interest rate):

- Yields on short-term Treasuries are low because Treasuries are very liquid.

- Increased Treasury supply by itself would lower the equilibrium price of

liquidity.

- However, you cannot observe this effect in the data because the Fed changes

its supply of liquid assets to hit the interest rate target.

So, there’s no disagreement about whether Treasuries are special or not. The question

is how to test for it.

• Stefan’s point is that our supply test for liquidity effects was not useful.

• Instead you should test whether the yield discount on Treasuries relate closely to

the level of interest rates.

• It is. So, the conclusion is – fortunately – the same! High liquidity helps explain low

Treasury yields (relative to 3-month repo rate or banker’s acceptance rate).

Comment 2. The comment about quantities is not right – variations in reserve supply

in response to Treasury supply is not driving the crowding-out effect of Treasury

supply

0.2

.4.6

.81

1.2

1870 1890 1910 1930 1950 1970 1990 2010Year

(Treasury supply-Foreign Treasury holdings)/GDP

Treasury supply/GDP

Net long-term investments/GDP

Net short-term debt/GDP

Net equity/GDP

Stefan: ``the elastic money supply response of the CB may be precisely what gives rise

to the negative correlation between T-bill supply and private sector near-money

supply’’

This cannot be right, for several reasons:

1) The relation between Treasury supply and Net short-term debt (=Lending to the

non-financial sector financed by short-term debt) is unaffected by controlling for

Reserves/GDP and/or the level of the Fed funds rate, or the level of long rates (I

checked).

2) In the data, the relation between Reserves/GDP and Treasury supply/GDP is

positive, not negative (graph below).

3) The components of the financial sector balance sheet that drive the crowding out

result is not checking deposits. In the data:

- Checking deposits/GDP are positively related to Treasury supply/GDP

- The crowding out is driven by:

a) Treasury supply crowding out non-checkable short-term debt (this is mainly

time/savings deposits)

b) Treasury supply leading to substitution on the asset side away from lending

and towards Treasuries.

0.2

.4.6

.81

1900 1920 1940 1960 1980 2000 2020Year

Debt/GDP

Reserves/GDP

But we still learn something about quantities from Stefan’s way of thinking:

• Since the crowding out relation is unaffected by controls for the market price of

liquidity (Fed funds rate, or GC(BA)-Treas spread), it’s likely driven by an effect of

Treasury supply on the market price of safety (i.e. investor willingness to take

``abnormally’’ low yields, relative to a CCAPM, for assets with ultra-low default risk).

• Qualifier: It’s hard to control well for the expected future price of liquidity.

Comment 3. Consistent with safety effects of Treasury supply driving crowd-out, our

results about the impact of Treasury supply on the equilibrium price of safety are

robust to controlling for the level of short rates

• This is consistent with these spreads capturing safety effects and Treasury supply

affecting the equilibrium price of safety.

• Thus, part of the low yields on Treasuries (which are even safer than Aaa and P1) is

likely due to safety effects.

• And Treasury supply does have a causal impact on the equilibrium price of safety.

The impact of Debt/GDP on Aaa-Treas (which we had interpreted as a mix of safety

and liquidity discounts on treasuries) is only a bit smaller with yield controls.

Bottom line:

• Treasury supply has causal effects on quantities and safety spreads, even

controlling for the interest rate target.

• If Treasury supply is to have a causal effect on liquidity spreads, then either:

a) You need to look at a frequency at which the Fed does not adjust its reserve

supply to hit its target, or

b) Treasury supply must drive the interest rate target.

Comment 4: Regarding a): In settings where the Fed does not fully offset changes in

Treasury supply our test works: Treasury supply drives the market price of liquidity

• Greenwood, Hanson and Stein (2014) instead exploit weekly variations in the supply

of T-bills due to Federal tax deadlines.

: Yield discount on n-week T-bills

: Bills supply impact on yield discount

IVs: Week of the year dummies.

b(n) is significantly positive for n=2, 4, 10 week bills.

Since there (presumably) is no tax-deadline related variation in the Fed’s interest

rate target, these results should be robust to controlling for the target and thus

should be caused by Treasury supply changes.

Comment 5. Regarding b), is it plausible that Treasury supply could impact the interest

rate target

Here is the main graph we need to think about (1934 onward to the right, due to Reg Q

and gold standard).

191519161917

1918 1919

1920

1921

1922

1923

192419251926

1927

19281929

1930

1931

1932 1933

1934193519361937

19381939194019411942 1943 1944 1945194619471948

1949195019511952

1953

1954

1955

19561957

1958

19591960

1961

19621963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

19821983

1984

1985

1986

1987

1988

1989

1990

1991

19921993

1994

1995

19961997

19981999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009 2010201120122013201405

10

15

Fed f

unds r

ate

0 .2 .4 .6 .8 1Debt/GDP, end of fiscal year

1915-2014

1934193519361937

19381939194019411942 1943 1944 1945194619471948

1949195019511952

1953

1954

1955

19561957

1958

19591960

1961

19621963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

19821983

1984

1985

1986

1987

1988

1989

1990

1991

19921993

1994

1995

19961997

19981999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009 2010201120122013201405

10

15

Fed f

unds r

ate

.2 .4 .6 .8 1 1.2Debt/GDP, end of fiscal year

1934-2014

One more graph to guide our thinking: The relation between Treasury supply and the

target is mainly coming from a relation between Treasury supply and expected inflation.

(Using the Livingston data for expected inflation, 1947-2014)

1947

1948

1949

1950

1951

1952

1953

19541955

1956

1957

1958

19591960196119621963

19641965

19661967

19681969

197019711972

1973

1974

197519761977

1978

1979

1980

1981

1982

1983

1984

1985

1986

198719881989

19901991

1992199319941995

19961997

19981999200020012002

20032004200520062007

2008

2009 201020112012

2013

2014

-10

-50

510

12-m

onth

expecte

d inflation

0 .2 .4 .6 .8 1Debt/GDP

1947

1948

1949

1950

1951

1952

1953

1954

1955

1956

1957

1958

19591960

1961

1962

1963

1964

19651966

1967

1968

1969

1970

19711972

1973

1974

1975

1976

1977

1978

1979

1980

1981

19821983

1984

1985

1986

1987

1988

19891990

1991

19921993

1994

199519961997

1998

1999

2000

2001

200220032004

2005

2006

2007

2008

2009 2010

20112012

2013

2014

-20

24

68

Fed funds -

12-m

onth

expecte

d inflation

0 .2 .4 .6 .8 1Debt/GDP

(The vertical line is the 1973 oil crisis)

-10

-50

51

01

2-m

on

th e

xp

ecte

d in

fla

tio

n

0.2

.4.6

.81

De

bt/G

DP

1850 1900 1950 2000 2050Year

Debt/GDP

12-month expected inflation

Can Debt/GDP have an impact on the interest rate target and expected inflation

within a Taylor rule framework?

• The Taylor rule:

• Add the usual New Keynesian elements:

A Phillips curve

The Euler equation for consumption (output growth)

Money market clearing.

• A possible argument for a causal impact of WW2 Debt/GDP reduction:

A reduction in Treasury supply (relative to GDP and thus relative to the price level)

put upward pressure on inflation and nominal rates via the money market:

M/P (which includes some weight on Treasuries/P)=L(y,i)

The Fed could have clamped down on this, but that would be costly in terms of

output in the short run. Suppose the Fed let’s things slide until Volcker finally said

enough is enough!

As Treasury supply/GDP fell this caused inflation and nominal rates to increase until

the Volcker recession.

Of course, an alert Fed could have prevented this all from happening by gradually

increasing the money supply as Treasury supply/GDP fell. But it didn’t, perhaps not

fully appreciating the above argument…

• Does it matter if this argument is complete bogus??? Yes!

Could it be that the massive amounts of (safe haven) government debt currently

outstanding is putting downward pressure on inflation?

Is it a coincidence that Japan has had both the highest Debt/GDP and the lowest

inflation?

Perhaps a good topic to discuss over drinks…