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Speech
GovernorJeremyC.Stein
Atthe"Banking,LiquidityandMonetaryPolicy,"aSymposiumSponsoredbytheCenterfor FinancialStudies,Frankfurt,Germany
September26,2013

Watchlive Letmestartbythankingtheorganizersforincludingmeinthisevent.It'sagreatpleasuretobehere withotheroldfriendsandcolleaguestopaytributetoRaghu,andtocongratulatehimnotonlyon winningtheDeutscheBankprizeforFinancialEconomics,butalsoonhisnewjobasgovernorofthe ReserveBankofIndia.It'sanunderstatementtosaythatRaghuhasafewchallengesonhishandsin thisnewrole,buthavingknownhimformorethan20years,Ican'timagineanybodybeingbetter equippedintermsofintellect,judgment,andstrengthofcharactertohandlethesechallenges. Iwouldliketotalkbrieflyaboutsomerecentresearchofmine,donejointlywithSamHansonof HarvardBusinessSchool,onthemonetarytransmissionmechanism.1 Aswillbecomeclear,ourwork isheavilyinfluencedbysomeofRaghu'searlierwriting,andinparticularhisfamous2005Jackson Holepaper.2 Afterdescribingwhatwefind,Iwilltrytodrawsomeconnectionstothecurrent monetarypolicyenvironmentaswellassomelessonsabouttheinterplayofmonetarypolicyand financialstability.Asalways,Iamspeakingformyself,andmyviewsarenotnecessarilysharedby othermembersoftheFederalOpenMarketCommittee(FOMC). Inourpaper,SamandIbeginbydocumentingthefollowingfactabouttheworkingofconventional monetarypolicy:Changesinthestanceofpolicyhavesurprisinglystrongeffectsonverydistant forwardrealinterestrates.Concretely,overasampleperiodfrom1999to2012,a100basispoint increaseinthe2yearnominalyieldonFOMCannouncementdaywhichwetakeasaproxyfora changeintheexpectedpathofthefederalfundsrateoverthefollowingseveralquartersisassociated witha42basispointincreaseinthe10yearforwardovernightrealrate,extractedfromtheyield curveforTreasuryinflationprotectedsecurities(TIPS).3 Ontheonehand,thisfindingisatoddswithstandardNewKeynesianmacromodels,inwhichthe centralbank'sabilitytoinfluencerealvariablesstemsfromgoodspricesthatarestickyinnominal terms.Insuchmodels,achangeinmonetarypolicyshouldhavenoeffectonforwardrealratesata horizonlongerthanthatoverwhichallpricescanadjust,anditseemsimplausiblethatthishorizon couldbeontheorderof10years.Ontheotherhand,theresultsuggeststhatmonetarypolicymay havemorekickthanisimpliedbythestandardmodel,preciselybecauselongtermrealratesarethe onesthataremostlikelytomatterforavarietyofinvestmentdecisions. Sowhatisgoingon?How,inaworldofeventuallyflexiblegoodsprices,ismonetarypolicyableto exertsuchapowerfulinfluenceonlongtermrealrates?Afirstclueisthatthemovementsindistant forwardrealratesthatwedocumentappeartoreflectchangesintermpremiums,asopposedto changesinexpectationsaboutshorttermrealratesfarintothefuture.Saiddifferently,iftheFedeases policytodayandyieldsonlongtermTIPsgodown,thisdoesnotmeanthattherealshortrateis expectedtobelower10yearsfromnowbutratherthatTIPshavegottenmoreexpensiverelativeto theexpectedfuturepathofshortrates.Thesechangesintermpremiumsthenappeartoreverse themselvesoverthefollowing6to12months. Thisobservationthenraisesthequestionofwhymonetarypolicymightbeabletoinfluencerealterm premiums.HereiswherewedrawourinspirationfromRaghu'swork,inparticularhishypothesisthat lownominalinterestratescancreateincentivesforcertaintypesofinvestorstotakeaddedriskinan effortto"reachforyield."Whileanemergingbodyofempiricalresearchinvestigatesthishypothesis inthecontextofcreditriskdocumentingthatbankstendtomakeriskierloanswhenratesarelow ourfocusisinsteadontheimplicationsofthereachforyieldmechanismonthepricingofinterestrate
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risk,alsoknownasdurationrisk.4 Thetheorywesketchinvolvesasetof"yieldoriented"investors.Weassumethattheseinvestors allocatetheirportfoliosbetweenshortandlongtermTreasurybondsand,indoingso,putsome weightnotjustonexpectedholdingperiodreturns,butalsooncurrentincome.Thispreferencefor currentyieldcouldbeduetoagencyoraccountingconsiderationsthatleadtheseinvestorstocare aboutshorttermmeasuresofreportedperformance.Areductioninshorttermnominalratesleads themtorebalancetheirportfoliostowardlongertermbondsinanefforttokeeptheiroverallyieldfrom decliningtoomuch.This,inturn,createsbuyingpressurethatraisesthepriceofthelongtermbonds andhencelowerslongtermyieldsandforwardrates. Thus,accordingtothistheory,aneasingofmonetarypolicyaffectslongtermrealratesnotviathe usualexpectationschannel,butratherviawhatmightbetermeda"recruitment"channelbycausing anoutwardshiftinthedemandcurveofyieldorientedinvestors,therebyinducingtheseinvestorsto takeonmoreinterestrateriskandtopushdowntermpremiums. Toprovidesomeevidencethatbearsonthetheory,welookatthematurityofsecuritiesheldby commercialbanks.Banksfitwithourconceptionofyieldorientedinvestorstotheextentthatthey careabouttheirreportedearningswhich,givenbankaccountingrulesforavailableforsalesecurities, arebasedoncurrentincomefromsecuritiesholdingsandnotmarktomarketchangesinvalue.And, indeed,wefindthatwhentheyieldcurvesteepens,banksincreasethematurityoftheirsecurities holdings.Moreover,themagnitudesoftheseportfolioshiftsarelargeintheaggregate,sothatifthey hadtobeabsorbedbyother,lessyieldorientedinvestors,theshiftscouldplausiblydrivechangesin marketwidetermpremiums.WealsofindthatprimarydealersintheTreasurymarketwho,unlike banks,mustmarktheirsecuritiesholdingstomarkettaketheothersideofthetrade,reducingthe maturityoftheirTreasuryholdingswhentheyieldcurvesteepens.5 Overall,Ireadthisevidenceassuggestingalbeittentativelythatsomemechanisminvolvingyield orientedinvestorsmayeventuallyturnouttobecentraltoourunderstandingofhowmonetarypolicy works,bothinordinaryandextraordinarytimes.WhenIsay"central,"Imeanthatthismechanism mayplayarolenotonlyindetermininghowmonetarypolicyinfluencesthepricingofcreditrisk,but alsoinhowitshapestherealandnominalyieldcurvesforcreditriskfreeTreasurysecurities.Of course,muchworkremainstobedonebeforestatementslikethesecanbemadewithanydegreeof confidence.ButIthinkthereisapromisingresearchagendahere,andonethatowesmuchtoRaghu's insights. Withtheseobservationsinmind,letmenowturntotheeventsofthepastfewmonthsinthebond market.Abriefsummarygoesasfollows:Longtermrealandnominalratesandtermpremiumsinthe UnitedStateswereverylowasofearlyMay,withthe10yearTreasuryyieldbottomingoutat1.63 percentatthebeginningofthemonth,withanassociatedtermpremiumestimatedtobeontheorderof negative0.80percent.6 The10yearTIPSyieldreachednegative0.72percentaroundthesametime.7 However,followingChairmanBernanke'sMay22testimonytotheJointEconomicCommitteeand afterourJune1819FOMCmeeting,yieldsrosesharply,withthenominalandreal10yearrates reaching2.61percentand0.60percent,respectively,asofJune25.8 Intheabsenceofasignificantshiftinpolicyfundamentals,anumberofobservershavehighlightedthe roleofavarietyofmarketdynamicsindrivingtheobservedchangesinyields.Thesefactorsinclude theunwindingofcarrytrades,tighteningofrisklimitsinthefaceofhighervolatility,convexity hedgingbyholdersofmortgagebackedsecurities,andlargeoutflowsfrombondfunds.Ibelievethese factorstohavebeenimportantcollectively,althoughitisdifficulttosayhowmuchofaneffectisdue toanyoneofthem. However,beyondtryingtounderstandthemarketdynamicsthatdrovechangesinratesoverthe periodfromMaythroughJune,itisalsousefultoaskaquestionaboutthestartinglevels:What explainswhyrealandnominalrateswereaslowastheywereatthebeginningofMay?Clearly,our accommodativepoliciesthecombinationofforwardguidanceandassetpurchasesplayedan importantrole.ButIwanttodrawakeydistinctionbetweentwoviewsofhowourpoliciesmight havemattered.OneviewwouldbethattheconfigurationofmarketratesinearlyMaywaslargelya directhydraulicoutcomeofourpolicies.Forexample,accordingtothisview,anominal10yearyield of1.63percentinearlyMaycouldbeexplainedtoafirstapproximationbasedontheexpectedpathof thefederalfundsrate,plusanegativetermpremiumthatwasitselfprimarilyafunctionofthe
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cumulativeamountofdurationthatwewereexpectedtoremovefromthemarketviaourasset purchaseprogram.Let'scallthisthe"directFedcontrol"view. Analternativehypothesisisthatourpolicieswereindeedresponsiblefortheverylowleveloflong termrates,butinpartthroughamoreindirectchannel.Accordingtothisview,realandnominalterm premiumswerelownotjustbecausewewerebuyinglongtermbonds,butbecauseourpolicies inducedanoutwardshiftinthedemandcurveofotherinvestors,whichledthemtodomorebuying onourbehalfbecausewebothgavethemanincentivetoreachforyield,andatthesametime providedasetofimplicitassurancesthattampeddownvolatilityandmadeitfeelsafertolever aggressivelyinpursuitofthatextrayield.Inthespiritofmyearliercomments,let'scallthisthe"Fed recruitment"view. Itaketheeventsofthepastfewmonthstobeevidenceinfavoroftherecruitmentview.And,tobe clear,Idon'tmeanthisasacriticismofthesetofpoliciesthatwehaveinplace.Quitetothecontrary itcanbeusefultoenlisthelpwhenyouhaveabigjobtodo.Indeed,mywholepointintalkingabout theresearchIdescribedearlierwastounderscoremybeliefthatsomethinglikethisinvestor recruitmentmechanismiscentraltohowmonetarypolicyacquiresmuchofitstractionoverthereal economyeveninordinarytimes.Ofcourse,themagnitudeoftheeffecttheextentofdownward pressurethatwemayhavebeeninducingotherinvestorstoapplytothetermpremiumislikelyto havebeenmorenoteworthygiventheunprecedentedscopeofouroverallmonetaryaccommodation. Butinanimportantsense,thiseffectisjustapoweredupversionofwhatmakesgardenvariety monetarypolicywork. Again,theexistenceofthisrecruitmentchannelishelpfulwithoutit,Isuspectthatourpolicieswould haveconsiderablylesspotencyand,therefore,lessabilitytoprovideneededsupporttothereal economy.Atthesametime,anunderstandingofthischannelhighlightstheuncertaintiesthat inevitablyaccompanyit.IftheFed'scontroloflongtermratesdependsinsubstantialpartonthe inducedbuyingandsellingbehaviorofotherinvestors,ourgriponthesteeringwheelisnotastightas itotherwisemightbe.Evenifwemakeonlysmallchangestothepolicyparametersthatwecontrol directly,longtermratescanbesubstantiallymorevolatile.Andifwepushtherecruitsveryhardas wearguablyhaveoverthepastyearorsoitisprobablymorelikelythatwearegoingtoseeachange intheirbehaviorandhenceasharpmovementinratesatsomepoint.Thus,ifitisagoalofpolicyto pushtermpremiumsfardownintonegativeterritory,oneshouldbepreparedtoacceptthatthis approachmaybringwithitanelevatedconditionalvolatilityofratesandspreads. Whenwetalkabouttheinterplayofmonetarypolicyandfinancialstability,Ithinkthatthiskindof tradeoffisanimportantpartofwhatweshouldbebearinginmind.Indeed,maybetheterm"financial stability"isabitmisleading,becausetheriskscenariothatIamdescribingandthatmaybeamongthe mostrelevantwhenthinkingaboutthecostsandbenefitsofourcurrenthighlyaccommodative policiesneednotbeonethatissodramaticastocallintoquestiontheviabilityofanylargefinancial firmorthreatenanimportantpartofthemarket'sinfrastructure.Rather,onescenariotobeworried aboutmaysimplybeasharpincreaseinmarketwideratesandspreadsataninopportunetime,such thatitbecomesharderforustoachieveourdualmandateobjectives. Havingsaidallofthis,Ibelievewearecurrentlyinaprettygoodplacewithrespecttothepricingof interestraterisk.ThemovementinTreasuryratesthatwehaveseensinceearlyMayhasledto somewhattighterfinancialconditionsincertainsectorsmostnotablythemortgagemarketbuthas alsobroughttermpremiumscloserintolinewithhistoricalnorms,andtherebyhasarguablyreduced theriskofamoredamagingupwardspikeatsomefuturedate.Onnet,Ibelievetheadjustmenthas beenahealthyone. Finally,letmesayafewwordsaboutlastweek'sFOMCmeeting.Ivotedwiththemajorityofthe Committeetocontinueourassetpurchaseprogramatitscurrentflowrateof$85billionpermonth.It wasaclosecallforme,butIdidsobecauseIcontinuetosupportoureffortstocreateahighly accommodativemonetaryenvironmentsoastohelptherecoveryalongbyusingbothassetpurchases andourthresholdbasedapproachtoforwardguidance. Howshouldthepaceofpurchasesevolvegoingforward?TheChairmanlaidoutaframeworkfor windingdownpurchasesinhisJunepressconference.9 Withinthatframework,Iwouldhavebeen comfortablewiththeFOMC'sbeginningtotaperitsassetpurchasesattheSeptembermeeting.But whetherwestartinSeptemberorabitlaterisnotinitselfthekeyissuethedifferenceintheoverall amountofsecuritieswebuywillbemodest.Whatismuchmoreimportantisdoingeverythingwecan
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toensurethatthisdifficulttransitionisimplementedinastransparentandpredictableamanneras possible.Onthisfront,Ithinkitissafetosaythattheremayberoomforimprovement. Achievingthedesiredtransparencyandpredictabilitydoesn'trequirethatthewinddownhappenina waythatisindependentofincomingdata.ButIdothinkthat,atthisstageoftheassetpurchase program,therewouldbeagreatdealofmeritintryingtofindawaytomakethelinktoobservable dataasmechanicalaspossible.Forthisreason,mypersonalpreferencewouldbetomakefuturestep downsacompletelydeterministicfunctionofalabormarketindicator,suchastheunemploymentrate orcumulativepayrollgrowthoversomeperiod.Forexample,onecouldcutmonthlypurchasesbya setamountforeachfurther10basispointdeclineintheunemploymentrate.10 Obviouslythe unemploymentrateisnotaperfectsummarystatisticforourlabormarketobjectives,butIbelievethat thisapproachwouldhelptoreduceuncertaintyaboutourreactionfunctionandtheattendantmarket volatility.Moreover,wewouldstillretaintheflexibilitytorespondtoothercontingencies(suchas declinesinlaborforceparticipation)viaourothermoreconventionalpolicytoolnamely,thepathof shorttermrates. Thankyouverymuch.Ilookforwardtoyourquestions. 1.SeeSamuelG.HansonandJeremyC.Stein(2012),"MonetaryPolicyandLongTermRealRates (PDF),"FinanceandEconomicsDiscussionSeries201246(Washington:BoardofGovernorsofthe FederalReserveSystem,July).Returntotext 2.SeeRaghuramG.Rajan(2005),"HasFinancialDevelopmentMadetheWorldRiskier?(PDF) " inTheGreenspanEra:LessonsfortheFuture,ASymposiumSponsoredbytheFederalReserve BankofKansasCity,JacksonHole,Wyoming,August2527,2005(KansasCity:FederalReserve BankofKansasCity),pp.31369.Returntotext 3.OurfindingscanbeillustratedwiththeeventsofJanuary25,2012.OnthatdatetheFOMC changeditsforwardguidance,indicatingthatitexpectedtoholdthefederalfundsratenearzero "throughlate2014,"whereasithadpreviouslyonlystatedthatitexpectedtodoso"throughmid 2013."Inresponsetothisannouncement,theexpectedpathofshorttermnominalratesfell significantlyfromtwotofiveyearsout,withthe2yearnominalyielddropping5basispointsandthe 5yearnominalyieldfalling14basispoints.Morestrikingly,10yearand20yearrealforwardrates declinedby5basispointsand9basispoints,respectively.Returntotext 4.Theideathatbankstakeonmorecreditriskwhenratesarelowisexploredin,forexample,Gabriel Jimnez,StevenOngena,JosLuisPeydr,andJessSaurina(forthcoming),"HazardousTimesfor MonetaryPolicy:WhatDo23MillionBankLoansSayabouttheEffectsofMonetaryPolicyon CreditRiskTaking?(PDF) "Econometrica.Returntotext 5.PrimarydealersarebrokerdealerfirmsthatserveastradingcounterpartiesoftheFederalReserve BankofNewYorkinitsimplementationofmonetarypolicy.Returntotext 6.The10yearnominalratehit1.63percentonMay2,2013.TheKimWrighttermpremiumwas estimatedtobenegative0.78percentonthisday.(Formoreinformationonthetermpremium,see DonH.KimandJonathanH.Wright(2005),"AnArbitrageFreeThreeFactorTermStructureModel andtheRecentBehaviorofLongTermYieldsandDistantHorizonForwardRates(PDF),"Finance andEconomicsDiscussionSeries200533(Washington:BoardofGovernorsoftheFederalReserve System,August).Returntotext 7.The10yearrealratehitnegative0.72percentonApril26,2013.Returntotext 8.SeeBenS.Bernanke(2013),"TheEconomicOutlook,"statementbeforetheJointEconomic Committee,U.S.Congress,May22andBoardofGovernorsoftheFederalReserveSystem(2013), "FederalReserveIssuesFOMCStatement,"pressrelease,June19.Returntotext 9.InformationontheChairman'sJune19,2013,pressconferenceisavailableontheBoard'swebsite. Returntotext 10.Tobeclear,Iamsketchingoutabroadconcept,andmanydetailswouldneedtobefilledinto
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makeitoperationalsuchas,whattodoiftheunemploymentratefallsinonemonthandthenlater rises.Returntotext Returntotop

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