The Federal Reserve’s balance sheet and overnight interest rates: Empirical modeling of exit strategies

This paper provides a comprehensive study of the interplay between the Federal Reserve’s balance sheet and overnight interest rates. We model both the supply of and the demand for excess reserves. Treating outright securities holdings of the Federal Reserve as a policy tool, we estimate the effects of unconventional monetary policy on overnight funding rates. Further, we offer the first empirical assessment of the FOMC’s principles of the exit strategy. Assuming a path for removing monetary policy accommodation that is consistent with the FOMC’s exit principles, we project that the federal funds rate increases to 70 basis points by 2016, settling in a corridor bracketed by the discount rate and the interest rate on excess reserves, as excess reserves of depository institutions decline to near zero.     

Should the Federal Reserve Pay Competitive Interest on Reserves?

In 2008, the Federal Reserve began paying interest on reserves. How should the Fed use this new policy instrument? As the Fed reduces its balance sheet, should it continue to satiate reserve demand and pay competitive interest on reserves? Here, we argue that this may be an inefficient use of the new policy instrument. Using a standard Dynamic Stochastic General Equilibrium model (DSGE), augmented to include a banking sector and an interbank market, our benchmark calibration implies an optimal tax on reserves of about 20 to 40 basis points in the steady state, and a fluctuating tax rate in response to shocks.     

Voluntary Reserve Targets

We study monetary policy implementation through an operating regime involving voluntary reserve targets (VRTs). Operating regimes based on reserve requirements may lead to a collapse in interbank trade, as they have since the financial crisis. We show that, no matter the abundance of reserves, VRTs encourage market activity and support the central bank's control over interest rates. We consider (i) the impact of anticipated and unanticipated liquidity injections by the central bank on market outcomes and (ii) a comparison with the implementation framework currently adopted by the Federal Reserve. Overall, a VRT framework may provide several advantages over other frameworks.     

Nominal Interest Rates and the News

This paper provides new estimates of the impact of monetary policy actions and macroeconomic news on the term structure of nominal interest rates. The key novelty is to parsimoniously capture the impact of news on all interest rates using a simple no‐arbitrage model. The different types of news are analyzed in a common framework by recognizing their heterogeneity, which allows for a systematic comparison of their effects. This approach leads to novel empirical findings. First, monetary policy causes a substantial amount of volatility in both short‐term and long‐term interest rates. Second, macroeconomic data surprises have small and mostly insignificant effects on the long end of the term structure. Third, the term‐structure response to macroeconomic news is consistent with considerable interest‐rate smoothing by the Federal Reserve. Fourth, monetary policy surprises are multidimensional while macroeconomic surprises are one‐dimensional.     

Interest on bank reserves and optimal sweeping

A key rationale offered by the Federal Reserve for the payment of interest on reserves was to remove the incentive for banks to operate sweep accounts. Sweeping shifts funds from transactions deposits subject to reserve requirements to non-reservable deposits. This paper extends a conventional banking model to analyze sweeping behavior. Sweeping responds positively to increases in bank loan rates and reserve ratios and negatively to increases in the interest rate on reserves or exogenous increases in bank equity. Sweeping generates greater responsiveness in lending to changes in loan rates or the interest rate on reserves and lower responsiveness to changes in reserve ratios or equity than in its absence. Empirical analysis of an explicit condition that we derive suggests that, with an unchanged reserve requirement, the Fed could eliminate sweeping by setting the interest rate on reserves to no less than approximately 4% points below the market loan rate.     

Reserves Announcements and Interest Rates: Does Monetary Policy Matter?

The author provides evidence on the perceived existence of strong liquidity effect. The analysis is based on the response of the term structure of interest rates to the weekly Federal Reserve announcements of bank reserves during the post-October 1979 period. It is shown that unanticipated changes in the mix between borrowed and nonborrowed reserves cause expected real interest rates to change after the announcement because they provide information about a future change in the supply of money. A precise model is developed and tested during subperiods of nonborrowed and borrowed reserves targeting by the Fed.     

Payment system disruptions and the federal reserve following September 11, 2001

The monetary and payment system consequences of the September 11, 2001, terrorist attacks and the Federal Reserve's response are reviewed. Interbank payment disruptions appear to be a central feature of many US banking crises, and interbank payment disruptions seem likely to recur. Federal Reserve credit extension following September 11 succeeded in massively increasing the supply of banks’ balances to satisfy the disruption-induced increase in demand and thereby ameliorate the effects of the shock. Relatively benign banking conditions helped make Fed credit policy manageable. An interbank payment disruption that coincided with less-favorable banking conditions could be more difficult to manage, given current daylight credit policies. Paying interest on reserves would facilitate improvements in daylight credit policy.     

Interest rate corridors and reserves

This paper evaluates reserves regimes versus interest rate corridors, which have become competing frameworks for monetary policy implementation. Rate corridors, relying on lending and deposit facilities to create ceilings and floors for overnight interest rates, evince mixed results on controlling volatility. Reserve requirements allow period-average smoothing of interest rates but, even if remunerated, are subject to reserve avoidance activities. A system of voluntary, period-average reserve commitments could offer equivalent rate-smoothing advantages. If central banks created symmetric opportunity costs of meeting or falling short of period-average reserve requirements (or commitments), they could achieve flat reserve demand on settlement day.     

Purdah—On the Rationale for Central Bank Silence around Policy Meetings

Many central banks share the practice of purdah , a guideline of abstaining from communication around policy meetings. Although seemingly contradicting the virtue of transparency by withholding information precisely when it is sought after intensely, it has been justified on grounds that such communication may create excessive market volatility. This paper assesses the purdah for the Federal Reserve and confirms that financial markets are substantially more sensitive to central bank communication around policy meetings. Short-term interest rates react three to four times more strongly in the purdah before Federal Open Market Committee meetings than otherwise, and volatility increases (compared to a reduction otherwise).     

Federal reserve policy viewed through a money supply lens

Federal Reserve nonborrowed reserve supply systematically responded to changes in inflation and in the output gap over the period 1969-2000. While the feedback from output gap is always negative, the response of money supply to changes in inflation varies considerably across time. Nonborrowed reserves decreased with inflation in the post-1979 period and increased in the pre-1979 period. Applying a standard macro-model, the estimated reaction functions are shown to ensure equilibrium determinacy. Viewed through the money supply lens, Federal Reserve policy substantially changed over time, but has never allowed for endogenous fluctuations, which contrasts conclusions drawn from federal funds rate analyses.     

Identifying VARS based on high frequency futures data

Using the prices of federal funds futures contracts, we measure the impact of the surprise component of Federal Reserve policy decisions on the expected future trajectory of interest rates. We show how this information can be used to identify the effects of a monetary policy shock in a standard VAR. This alternative approach to identification is quite different, and, we argue, more plausible, than the conventional identifying restrictions. We find that a usual recursive identification of the model is rejected, as is any identification that insists on a monetary policy shock having an exactly zero effect on prices contemporaneously. We nevertheless agree with the conclusion of much of the VAR literature that only a small fraction of the variance of output can be attributed to monetary policy shocks.     

The Liquidity Effect in the Federal Funds Market: Evidence at the Monthly Frequency

In this paper, we argue that much of the research into the link between money and interest rates suffers from misspecification. The measure of money and the measure of interest rates are not always well matched. In examining the transmission of monetary policy, we show that using an appropriate measure of money, Federal Reserve balances, and the appropriate interest rate, the federal funds rate, a clear liquidity effect exists. Furthermore, we explain how a lack of a clear institutional understanding may have contributed to the finding of a "liquidity puzzle" in the past.     

The Effects of Liquidity Regulation on Bank Demand in Monetary Policy Operations

We estimate the effects of the liquidity coverage ratio (LCR), a liquidity requirement for banks, on the tenders that banks submit in Term Deposit Facility operations, a Federal Reserve tool created to manage the quantity of central bank reserves. We identify these effects using variation in LCR requirements across banks and a change over time that allowed term deposits to count toward the LCR. Banks subject to the LCR submit tenders more often and submit larger tenders than exempt banks when term deposits qualify for the LCR. These results suggest that liquidity regulation affects bank demand in monetary policy operations.     

Using private forecasts to estimate the effects of monetary policy

I develop a methodology that uses the forecasts of market participants and of policy makers to estimate the effects of monetary policy on output and inflation. My approach has advantages over the standard practice of fitting a vector autoregression to the data. I apply my methodology to data on output, interest rates and prices. I find that, even using the Federal Reserve Board's Greenbook forecasts to control for the policy maker's information set, prices rise initially in response to a monetary contraction. This finding undermines the standard justification for including an index of commodity prices in VARs.     

Real-Time Model Uncertainty in the United States: The Fed, 1996–2003

We study 30 vintages of FRB/US, the principal macro-model used by the Federal Reserve Board staff for forecasting and policy analysis. We document the surprisingly large and consequential changes in model properties that occurred during the period from July 1996 to November 2003 and compute optimal Taylor-type rules for each vintage. Model uncertainty is shown to be a substantial problem; the efficacy of purportedly optimal policy rules should not be taken on faith. We also find that previous findings that simple rules are robust to model uncertainty may be an overly sanguine conclusion.     

International linkages and macroeconomic news effects on interest rate volatility — Australia and the US

We examine international linkages between daily time series of US and Australian 3-month treasury bills and 10-year government bonds from 1987–1995, paying particular attention to the effects of macroeconomic announcements in both countries. The two countries' interest rate data are modeled by a bivariate exponential generalized autoregressive conditional heteroscedasticity (EGARCH) formulation. The results suggest that market participants believed the Reserve Bank of Australia targeted the consumer price index (CPI), while the Federal Reserve targeted economic activity. Monetary policy announcements had significant effects on interest rates, as well as on their volatility in the short term. US macroeconomic activity announcements significantly moved Australian interest rates, particularly at the short end. Australian interest rates moved significantly in response to the previous day's US interest rate shocks. The conditional volatility of the Australian interest rate changes was also significantly influenced by lagged US interest rate shocks, as well as by surprises in US macroeconomic announcements. Some macroeconomic news announcements raised conditional volatilities, while others reduced them. Overall, there was a remarkable and complex array of linkages between the two countries.     

Fluctuation dynamics in US interest rates and the role of monetary policy

This paper presents empirical evidence suggesting that the degree of long-range dependence in interest rates depends on the conduct of monetary policy. We study the term structure of interest rates for the US and find evidence that global Hurst exponents change dramatically according to Chairman Tenure in the Federal Reserve Board and also with changes in the conduct of monetary policy. In the period from 1960s until the monetarist experiment in the beginning of the 1980s interest rates had a significant long-range dependence behavior. However, in the recent period, in the second part of the Volcker tenure and in the Greenspan tenure, interest rates do not present long-range dependence behavior. These empirical findings cast some light on the origins of long-range dependence behavior in financial assets.     

Monetary policy regimes: Implications for the yield curve and bond pricing

We develop a multivariate dynamic term structure model, which takes into account the nonlinear (time-varying) relation between interest rates and the state of the economy. In contrast to the classical term structure literature, in which nonlinearities are captured by increasing the number of latent state variables or by latent regime shifts, in our no-arbitrage framework the regimes are governed by thresholds and are directly linked to economic fundamentals. Specifically, starting from a simple monetary policy model for the short rate, we introduce a parsimonious and tractable model for the yield curve, which takes into account the possibility of regime shifts in the behavior of the Federal Reserve. In our empirical analysis, we show the merit of our approach three dimensions: interpretable bond dynamics, accurate short end yield curve pricing, and yield curve implications.