Jeremy C Stein: Large-scale asset purchases
Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve
System, at the Third Boston University/Boston Fed Conference on Macro-Finance Linkages,
Boston, Massachusetts, 30 November 2012.
* * *
Given that the conference theme is macro-finance linkages, I thought I would try to lay out a
corporate finance perspective on large-scale asset purchases (LSAPs). I have found this
perspective helpful in thinking both about the general efficacy of LSAPs going forward, and
about the differential effects of buying Treasury securities as opposed to mortgage-backed
securities (MBS). But before I get started, please note the usual disclaimer: The thoughts
that follow are my own and do not necessarily reflect the views of other members of the
Federal Open Market Committee (FOMC). I should also mention that these comments echo
some that I made in a speech at Brookings last month.1
As I noted in that speech, I support
the Committee's decision to purchase mortgage-backed securities (MBS) at a rate of
$40 billion per month, in tandem with the ongoing maturity extension program in Treasury
securities, and its plan to continue with asset purchases if the Committee does not observe a
substantial improvement in the outlook for the labor market.
I will start with the case of Treasury LSAPs, and then go on to discuss the differences that
arise when the Fed purchases MBS instead. One thing that seems clear in the data is that if
you buy a lot of long-term Treasury securities, this exerts significant downward pressure on
their yields and term premiums. Indeed, the Fed's past actions are likely one important
reason why Treasury term premiums are now near historic lows, on the order of minus
80 basis points, according to a model used by the Board staff.2 Moreover, while this is not
entirely uncontroversial, my own reading of the evidence is that there has also been
substantial pass-through to corporate bond rates. Based on this evidence, a reasonable
estimate is that, if the Fed were to undertake an additional $500 billion Treasury LSAP, both
long-term Treasury and corporate bond rates might be expected to decline by something on
the order of 15 to 20 basis points.
This observation leads to an important conceptual question: How should one expect a firm to
respond when its long-term borrowing costs fall not because of a change in the expected
future path of short-term rates - as would be the case with a conventional monetary easing -
but rather because of a change in the term premium? By way of a benchmark, it should be
emphasized that many macro models - including the Fed staff's FRB/US model - implicitly
treat the two sorts of shocks as having similar effects on corporate investment. But is there
any reason to believe that, in reality, the response to the two might differ?
A basic corporate finance analysis suggests the answer may be yes - and, in particular, that
a shock to the term premium is more likely to elicit a financing response on the part of firms,
as opposed to a change in their capital spending plans. To see why, consider the following
example. A firm faces a rate on its 10-year bonds of 2 percent. At the same time, it expects
that the sequence of rolled-over short-term rates over the next 10 years will average
3 percent. Hence, there is a term premium of minus 1 percent. What should the firm do?
Clearly, it should take advantage of the cheap long-term debt by issuing bonds. But if the firm
is not facing a binding financing constraint, it is less obvious that the bargain 2 percent rate
on these bonds should exert any influence on its capital spending plans. After all, it can use
the proceeds of the bond issue to pay down short-term debt, repurchase stock, or buy
short-term securities. These capital-structure adjustments all yield an effective return of
3 percent. As a result, the hurdle rate for new investment should remain pinned at 3 percent.
In other words, the negative term premium matters a lot for financing behavior, but in this
stylized world, investment spending is decoupled from the term premium and is determined
instead by the expected future path of short rates.
This reasoning suggests why one might expect future rounds of Treasury-based LSAPs to
have diminishing returns, at least for corporate investment. As noted earlier, the data make
clear that past rounds of LSAPs have pushed down interest rates and term premiums. But
the further the term premium is driven into negative territory, and the more financing
constraints are thereby relaxed, the more the previous logic comes into play, and hence the
weaker is likely to be the response of aggregate spending to further downward pressure on
long-term rates.
The corporate finance example is also consistent with what we have observed in markets in
recent months. Issuance of both investment-grade and high-yield bonds has been robust.
Indeed, domestic nonfinancial corporate bond issuance is on pace to set a record in 2012,
and the speculative-grade segment appears on track to register a new high for the year. At
the same time, a large fraction of issuance has been devoted to refinancing - either to
retiring existing debt or to payouts to equity holders via dividends and share buybacks.
These uses of proceeds have accounted for about two-thirds of all issuance by
speculative-grade firms so far this year. Such patterns are what one would expect based on
the logic I have just discussed.
Another way to make a similar point is to note that as borrowing costs have fallen, Federal
Reserve staff estimates of the expected return on the stock market (using a model based on
analysts' earnings expectations) remain high by historic standards. This unusually large
divergence in the costs of debt and equity - due in part to the cumulative effects of our LSAP
policies - is likely to be one factor that makes debt-financed repurchases of equity attractive.
Let me turn now from Treasury-based LSAPs to those involving MBS. If there is to be any
difference between the two, one necessary condition is that there is some form of market
segmentation, so that buying MBS has a different effect on the constellation of credit-market
rates than buying Treasury securities - in other words, it's not all about just removing a
certain amount of undifferentiated duration from the market. Judging by what happened in
the wake of the Committee's policy announcement on September 13, this segmentation
condition seems to be clearly satisfied - indeed, I would say surprisingly so.3
In particular,
while nominal long-term Treasury yields were roughly unchanged on the day of the
announcement, yields on MBS fell dramatically. Moreover, although the pass-through to
primary mortgage rates has been more gradual, it too has been significant to
date. According to Freddie Mac's primary mortgage market survey, the rate on 30-year
fixed-rate mortgages has come down by more than 20 basis points since the September
announcement, and is now near historic lows.
One way to say it is that, given the nature of market segmentation, MBS purchases appear to
trade off of some amount of breadth of effect across markets for a more pronounced effect in
a single market - namely, the mortgage market. What, then, are the implications for the
transmission mechanism? Clearly, it depends on the sensitivity of different forms of spending
to changes in rates. If, per my previous example, corporate investment reacts only weakly to
further changes in term premiums, there may be more "kick" to be had by focusing efforts on
a sector that is more responsive.
Moreover, it seems plausible that households' spending behavior will in fact be more strongly
affected by changes in the mortgage rate. As compared with many of the large firms that are
active in the corporate bond market, one might expect a greater proportion of households to
behave as if they are financially constrained. Hence, a reduction in the cost of mortgage
borrowing might be expected to allow households to spend more, either on a new home or
by using the proceeds from a mortgage refinancing for non-housing consumption.
The bottom line is that I suspect that mortgage purchases may confer more macroeconomic
stimulus dollar-for-dollar than Treasury purchases. This is of course, not to say that Treasury
purchases have no effect on the real economy; research has found that in addition to moving
bond prices, they are associated with increases in stock prices, which in turn can have
wealth effects on consumption and investment.
Interestingly, however, to the extent that Treasury purchases trigger a financing response on
the part of firms, as opposed to an investment response, they may have something of an
unintended benefit for financial stability. A major source of problems during the recent crisis
was the excessive maturity transformation undertaken by financial firms. Put simply, these
firms were relying too much on short-term debt. One of the thrusts of regulatory reform has
been to attack this problem - for example, via the constructs of the Liquidity Coverage Ratio
and the Net Stable Funding Ratio that are a part of Basel III. However, a complementary way
to deal with the problem is to influence the underlying incentives for short-term debt
issuance. And these incentives are in turn shaped by the structure of rates and term
premiums in the market.
As I noted earlier, a natural response for any firm facing an unusually low term premium is to
adjust its capital structure by issuing cheap long-term debt to replace its shorter-term debt. It
is therefore not surprising that the average debt maturity of large nonfinancial firms has
increased notably over the past few years. Moreover, the same pattern shows up among
large financial firms - they too have been significantly lengthening their average debt
maturity.
The current cheapness of long-term debt contrasts with the pre-crisis configuration, where
frequently a pronounced premium favored issuers not at the long end of the yield curve, but
at the very short end. In other words, the fact that the yield curve often tended to be steeply
upward sloping at the front end gave financial firms a strong incentive to issue overnight
paper. Thus I suspect that LSAPs have, by changing the structure of term premiums in the
market, helped encourage an extension of debt maturity by both financial and nonfinancial
firms. All else being equal, this development is a good thing from a financial stability
perspective.
To conclude: A corporate finance perspective on LSAPs suggests that when monetary policy
works by moving term premiums, as opposed to moving expectations about the future path
of short rates, the transmission to the real economy may be altered in important ways. These
differences can have implications for how we think about the benefits of a policy action, its
costs, and even its consequences for financial stability.
Thanks very much, and I look forward to your questions.