Jeremy C Stein: Research on the monetary transmission mechanism
Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve
System, at the "Banking, Liquidity and Monetary Policy", a Symposium sponsored by the
Center for Financial Studies, Frankfurt am Main, 26 September 2013.
* * *
Let me start by thanking the organizers for including me in this event. It's a great pleasure to
be here with other old friends and colleagues to pay tribute to Raghu, and to congratulate
him not only on winning the Deutsche Bank prize for Financial Economics, but also on his
new job as governor of the Reserve Bank of India. It's an understatement to say that Raghu
has a few challenges on his hands in this new role, but having known him for more than
20 years, I can't imagine anybody being better equipped - in terms of intellect, judgment, and
strength of character - to handle these challenges.
I would like to talk briefly about some recent research of mine, done jointly with Sam Hanson
of Harvard Business School, on the monetary transmission mechanism.1 As will become
clear, our work is heavily influenced by some of Raghu's earlier writing, and in particular his
famous 2005 Jackson Hole paper.2 After describing what we find, I will try to draw some
connections to the current monetary policy environment as well as some lessons about the
interplay of monetary policy and financial stability. As always, I am speaking for myself, and
my views are not necessarily shared by other members of the Federal Open Market
Committee (FOMC).
In our paper, Sam and I begin by documenting the following fact about the working of
conventional monetary policy: Changes in the stance of policy have surprisingly strong
effects on very distant forward real interest rates. Concretely, over a sample period from
1999 to 2012, a 100 basis point increase in the 2-year nominal yield on FOMC
announcement day - which we take as a proxy for a change in the expected path of the
federal funds rate over the following several quarters - is associated with a 42 basis point
real
increase in the 10-year forward overnight rate, extracted from the yield curve for
Treasury inflation-protected securities (TIPS).3
On the one hand, this finding is at odds with standard New Keynesian macro models, in
which the central bank's ability to influence real variables stems from goods prices that are
sticky in nominal terms. In such models, a change in monetary policy should have no effect
on forward real rates at a horizon longer than that over which all prices can adjust, and it
seems implausible that this horizon could be on the order of 10 years. On the other hand, the
result suggests that monetary policy may have more kick than is implied by the standard
model, precisely because long-term real rates are the ones that are most likely to matter for a
variety of investment decisions.
1
See Samuel G. Hanson and Jeremy C. Stein (2012), "Monetary Policy and Long-Term Real Rates (PDF),"
Finance and Economics Discussion Series 2012-46 (Washington: Board of Governors of the Federal Reserve
System, July).
2
The
See Raghuram G. Rajan (2005), "Has Financial Development Made the World Riskier? (PDF)" in
Greenspan Era: Lessons for the Future, A Symposium Sponsored by the Federal Reserve Bank of Kansas
City, Jackson Hole, Wyoming, August 25-27, 2005 (Kansas City: Federal Reserve Bank of Kansas City),
pp. 313-69.
3
Our findings can be illustrated with the events of January 25, 2012. On that date the FOMC changed its
forward guidance, indicating that it expected to hold the federal funds rate near zero "through late 2014,"
whereas it had previously only stated that it expected to do so "through mid-2013." In response to this
announcement, the expected path of short-term nominal rates fell significantly from two to five years out, with
the 2-year nominal yield dropping 5 basis points and the 5-year nominal yield falling 14 basis points. More
strikingly, 10-year and 20-year real forward rates declined by 5 basis points and 9 basis points, respectively.
So what is going on? How, in a world of eventually flexible goods prices, is monetary policy
able to exert such a powerful influence on long-term real rates? A first clue is that the
movements in distant forward real rates that we document appear to reflect changes in term
premiums, as opposed to changes in expectations about short-term real rates far into the
future. Said differently, if the Fed eases policy today and yields on long-term TIPs go down,
this does not mean that the real short rate is expected to be lower 10 years from now - but
rather that TIPs have gotten more expensive relative to the expected future path of short
rates. These changes in term premiums then appear to reverse themselves over the
following 6 to 12 months.
This observation then raises the question of why monetary policy might be able to influence
real term premiums. Here is where we draw our inspiration from Raghu's work, in particular
his hypothesis that low nominal interest rates can create incentives for certain types of
investors to take added risk in an effort to "reach for yield." While an emerging body of
empirical research investigates this hypothesis in the context of credit risk - documenting
that banks tend to make riskier loans when rates are low - our focus is instead on the
implications of the reach-for-yield mechanism on the pricing of interest rate risk, also known
as duration risk.4
The theory we sketch involves a set of "yield-oriented" investors. We assume that these
investors allocate their portfolios between short- and long-term Treasury bonds and, in doing
so, put some weight not just on expected holding-period returns, but also on current income.
This preference for current yield could be due to agency or accounting considerations that
lead these investors to care about short-term measures of reported performance. A reduction
in short-term nominal rates leads them to rebalance their portfolios toward longer-term bonds
in an effort to keep their overall yield from declining too much. This, in turn, creates buying
pressure that raises the price of the long-term bonds and hence lowers long-term yields and
forward rates.
Thus, according to this theory, an easing of monetary policy affects long-term real rates not
via the usual expectations channel, but rather via what might be termed a "recruitment"
channel - by causing an outward shift in the demand curve of yield-oriented investors,
thereby inducing these investors to take on more interest rate risk and to push down term
premiums.
To provide some evidence that bears on the theory, we look at the maturity of securities held
by commercial banks. Banks fit with our conception of yield-oriented investors to the extent
that they care about their reported earnings - which, given bank accounting rules for
available-for-sale securities, are based on current income from securities holdings and not
mark-to-market changes in value. And, indeed, we find that when the yield curve steepens,
banks increase the maturity of their securities holdings. Moreover, the magnitudes of these
portfolio shifts are large in the aggregate, so that if they had to be absorbed by other, less
yield-oriented investors, the shifts could plausibly drive changes in marketwide term
premiums. We also find that primary dealers in the Treasury market - who, unlike banks,
must mark their securities holdings to market - take the other side of the trade, reducing the
maturity of their Treasury holdings when the yield curve steepens.5
Overall, I read this evidence as suggesting - albeit tentatively - that some mechanism
involving yield-oriented investors may eventually turn out to be central to our understanding
of how monetary policy works, both in ordinary and extraordinary times. When I say "central,"
I mean that this mechanism may play a role not only in determining how monetary policy
influences the pricing of credit risk, but also in how it shapes the real and nominal yield
curves for credit-risk-free Treasury securities. Of course, much work remains to be done
before statements like these can be made with any degree of confidence. But I think there is
a promising research agenda here, and one that owes much to Raghu's insights.
With these observations in mind, let me now turn to the events of the past few months in the
bond market. A brief summary goes as follows: Long-term real and nominal rates and term
premiums in the United States were very low as of early May, with the 10-year Treasury yield
bottoming out at 1.63 percent at the beginning of the month, with an associated term
premium estimated to be on the order of negative 0.80 percent.6 The 10-year TIPS yield
reached negative 0.72 percent around the same time.7
However, following Chairman
Bernanke's May 22 testimony to the Joint Economic Committee and after our June 18-19
FOMC meeting, yields rose sharply, with the nominal and real 10-year rates reaching
2.61 percent and 0.60 percent, respectively, as of June 25.8
In the absence of a significant shift in policy fundamentals, a number of observers have
highlighted the role of a variety of market dynamics in driving the observed changes in yields.
These factors include the unwinding of carry trades, tightening of risk limits in the face of
higher volatility, convexity hedging by holders of mortgage-backed securities, and large
outflows from bond funds. I believe these factors to have been important collectively,
although it is difficult to say how much of an effect is due to any one of them.
However, beyond trying to understand the market dynamics that drove changes in rates over
the period from May through June, it is also useful to ask a question about the starting levels:
What explains why real and nominal rates were as low as they were at the beginning of
May? Clearly, our accommodative policies - the combination of forward guidance and asset
purchases - played an important role. But I want to draw a key distinction between two views
of how our policies might have mattered. One view would be that the configuration of market
rates in early May was largely a direct hydraulic outcome of our policies. For example,
according to this view, a nominal 10-year yield of 1.63 percent in early May could be
explained to a first approximation based on the expected path of the federal funds rate, plus
a negative term premium that was itself primarily a function of the cumulative amount of
duration that we were expected to remove from the market via our asset purchase program.
Let's call this the "direct Fed control" view.
An alternative hypothesis is that our policies were indeed responsible for the very low level of
long-term rates, but in part through a more indirect channel. According to this view, real and
nominal term premiums were low not just because we were buying long-term bonds, but
because our policies induced an outward shift in the demand curve of other investors, which
led them to do more buying on our behalf - because we both gave them an incentive to
reach for yield, and at the same time provided a set of implicit assurances that tamped down
volatility and made it feel safer to lever aggressively in pursuit of that extra yield. In the spirit
of my earlier comments, let's call this the "Fed recruitment" view.
I take the events of the past few months to be evidence in favor of the recruitment view. And,
to be clear, I don't mean this as a criticism of the set of policies that we have in place. Quite
to the contrary - it can be useful to enlist help when you have a big job to do. Indeed, my
whole point in talking about the research I described earlier was to underscore my belief that
something like this investor-recruitment mechanism is central to how monetary policy
acquires much of its traction over the real economy even in ordinary times. Of course, the
magnitude of the effect - the extent of downward pressure that we may have been inducing
other investors to apply to the term premium--is likely to have been more noteworthy given
the unprecedented scope of our overall monetary accommodation. But in an important
sense, this effect is just a powered-up version of what makes garden-variety monetary policy
work.
Again, the existence of this recruitment channel is helpful; without it, I suspect that our
policies would have considerably less potency and, therefore, less ability to provide needed
support to the real economy. At the same time, an understanding of this channel highlights
the uncertainties that inevitably accompany it. If the Fed's control of long-term rates depends
in substantial part on the induced buying and selling behavior of other investors, our grip on
the steering wheel is not as tight as it otherwise might be. Even if we make only small
changes to the policy parameters that we control directly, long-term rates can be
substantially more volatile. And if we push the recruits very hard - as we arguably have over
the past year or so - it is probably more likely that we are going to see a change in their
behavior and hence a sharp movement in rates at some point. Thus, if it is a goal of policy to
push term premiums far down into negative territory, one should be prepared to accept that
this approach may bring with it an elevated conditional volatility of rates and spreads.
When we talk about the interplay of monetary policy and financial stability, I think that this
kind of tradeoff is an important part of what we should be bearing in mind. Indeed, maybe the
term "financial stability" is a bit misleading, because the risk scenario that I am describing -
and that may be among the most relevant when thinking about the costs and benefits of our
current highly accommodative policies - need not be one that is so dramatic as to call into
question the viability of any large financial firm or threaten an important part of the market's
infrastructure. Rather, one scenario to be worried about may simply be a sharp increase in
marketwide rates and spreads at an inopportune time, such that it becomes harder for us to
achieve our dual-mandate objectives.
Having said all of this, I believe we are currently in a pretty good place with respect to the
pricing of interest rate risk. The movement in Treasury rates that we have seen since early
May has led to somewhat tighter financial conditions in certain sectors - most notably the
mortgage market - but has also brought term premiums closer into line with historical norms,
and thereby has arguably reduced the risk of a more damaging upward spike at some future
date. On net, I believe the adjustment has been a healthy one.
Finally, let me say a few words about last week's FOMC meeting. I voted with the majority of
the Committee to continue our asset purchase program at its current flow rate of $85 billion
per month. It was a close call for me, but I did so because I continue to support our efforts to
create a highly accommodative monetary environment so as to help the recovery along by
using both asset purchases and our threshold-based approach to forward guidance.
How should the pace of purchases evolve going forward? The Chairman laid out a
framework for winding down purchases in his June press conference.9 Within that framework,
I would have been comfortable with the FOMC's beginning to taper its asset purchases at the
September meeting. But whether we start in September or a bit later is not in itself the key
issue - the difference in the overall amount of securities we buy will be modest. What is
much more important is doing everything we can to ensure that this difficult transition is
implemented in as transparent and predictable a manner as possible. On this front, I think it
is safe to say that there may be room for improvement.
Achieving the desired transparency and predictability doesn't require that the wind-down
happen in a way that is independent of incoming data. But I do think that, at this stage of the
asset purchase program, there would be a great deal of merit in trying to find a way to make
the link to observable data as mechanical as possible. For this reason, my personal
preference would be to make future step-downs a completely deterministic function of a labor
market indicator, such as the unemployment rate or cumulative payroll growth over some
period. For example, one could cut monthly purchases by a set amount for each further
10 basis point decline in the unemployment rate.10 Obviously the unemployment rate is not a
perfect summary statistic for our labor market objectives, but I believe that this approach
would help to reduce uncertainty about our reaction function and the attendant market
volatility. Moreover, we would still retain the flexibility to respond to other contingencies (such
as declines in labor force participation) via our other more conventional policy tool - namely,
the path of short-term rates.
Thank you very much. I look forward to your questions.