An Exit Strategy from Quantitative Easing and the Demand for Monetary Base in the United States...

An Exit Strategy from Quantitative Easing and the Demand for Monetary Base in the United

States

Richard G. AndersonRobert H. Rasche

Professors Meeting, November 5th 2009

Demand for the Monetary Base 2

Disclaimer

Opinions expressed are my own and are not necessarily those of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

Audio and /or video recording is expressly prohibited without written prior consent from the Federal Reserve Bank of St. Louis.

This presentation contains no confidential information.


Introduction

• Discuss Quantitative easing• Discuss Fed’s implementation of Quantitative easing• Discuss “exit strategy” – Exit to where?• Examine the long-run demand for the adjusted monetary base

in the United States, 1919 – 2008.– 4 variable SVAR

– The “price” of the monetary base is measured by the inverse of the yield on long-term high-quality corporate bonds

– Unitary Income elasticity– Inflation is approximately a random walk=> “excess” base

does not forecast inflation• a stable function “… of a small number of variables.”


Unconventional Policy

• The Federal Reserve has pursued “unconventional” monetary policy since August 2007– Reduction in policy target rate– Direct lending and discounting

• On balance sheet (TAF, TALF, central bank currency swaps)• Off balance sheet

– “Credit easing”• Focus on composition of assets, not quantity

• “Quantitative Easing” since early 2009– large scale asset purchase program

• “Agency” (housing GSEs) debt, MBS• Longer-dated Treasuries

• Monetary base will be $2.4T 2010 Q1, with reserves balances > $1.4T (vs $10B in 2007 Q1)

QE and Demand for the Monetary Base 5

Quantitative Easing: How Does It Work? (1)

• New Keynesian models (sticky prices/wages, imperfect competition in product and labor markets, all financial assets perfect substitutes, inflation forecast-targeting monetary policy)

• Policy rate at zero bound• Policy effect due to promise to maintain policy rate at zero for an

“extended period”• What is an extended period?

– When aggregate demand strengthens and forecasts suggest higher inflation, delay increasing policy rate => future higher actual inflation (above policy goal)

– Sustaining the nominal rate and increasing future expected inflation => lowering future real rates => shifting spending forward

• Balance sheet increases are a commitment mechanism to increase the cost of policymakers reneging on the “extended period” promise


Quantitative Easing: How Does It Work? (2)

• But central bankers pledge no future higher inflation• What channel remains?

• Credit channel (Bernanke and others)• In Bernanke’s writing, an amplifier to the interest rate channel, not a substitute

or alternative• Bank lending channel

• Loans readily available for good credit• Strong bank lending 2008 Q4• Contraction in 2009 likely a good thing

• Balance sheet channel• Massively alter the balance sheet of the private sector (because the

elasticities of substitution among high-quality financial assets are small)


5200

5600

6000

6400

6800

7200

7600

Bill

ions

of

Dol

-la

rs

Bear Stearns' res-cue

Fannie Mae & Freddie Mac sup-port

Lehman’s collapse, Paulson plan

2006 2007 2008 2009

Total Loans and Leases at Commercial Banks

Credit crunch starts

Bill

ions

of

Dol

-la

rs

Strong bank lending in 2008 Q4

Bank Lending Channel


1050

1100

1150

1200

1250

1300

1350

1400

US Government Securities at All Commercial Banks

2006 2007 2008 2009

Lehman’s collapse, Paulson plan

Fannie Mae & Freddie Mac support

Bear Stearns' rescue

Credit crunch starts

Billi

ons

of D

olla

rsBalance Sheet Channel


2007 Fourth Quarter Real Estate 20477.39 Home Mortgage 10485.21Deposits 7381.34 Consumer Credit 2551.95Treasury 252.31 Bank Loan 126.99MBS 689.82 Other Loan 126.99Corporate Equities 9453.03 Security Credit 325.53Mutual Fund 4575.24 Other 728.71Pension 13375.89Other 21767

Assests 78228.75 Liabilities 14318.12Net Worth 63910.63

2009 Second QuarterReal Estate 18272.03 Home Mortgage 10401.67Deposits 7760.17 Consumer Credit 2475.51Treasury 605.86 Bank Loan 118.53MBS 129.53 Other Loan 134.01Corporate Equities 6266.29 Security Credit 147.59Mutual Fund 3740.53 Other 790.67Pension 10656.29Other 19777.2

Assests 67207.9 Liabilities 14067.98Net Worth 53139.92

Household Balance Sheet (Billions of Dollars)

Perfect Substitutes !


• Many countries have done QE before (forthcoming FRBSTL Review article)

• Best way (?): Cold turkey

• How?– Sell assets to the public [potential losses]– RP assets to the public [losses]– Sequester in central bank “time deposits”– Sell central bank securities

• Raise remuneration rate (Goodfriend, Woodford, FRBNY Review, 2002)

How to End Quantitative Easing?


-140

-70

0

70

140

210

280

350

2007 2008 2009

Adjusted Monetary BaseP

erce

nt c

hang

e at

an

annu

al

rate

2006

Targeted Interest Rate and Monetary Base Growth

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00Effective Federal Fund Rate Intended Federal Fund Rate Primary Credit Rate

Perc

ent

Reserve Market Rates

20072006 2008 2009


Composition of Federal Reserve Assets and Liabilities


• The challenge: Does a Stable Demand Relationship Exist?

• What does “demand” mean when the quantity demanded always equals the quantity supplied? – Corollary: The private sector cannot change the size of the monetary base.

• Short-run demand curves for base money are useless. – John Taylor’s initial exploration of interest rate-based monetary policy rules grew from a

frustration with the apparent instability of US money demand. – Friedman and Kuttner asserted that all extant stable money-demand relationships from 1970s

are sample specific and disintegrate when the sample extends into the 1980s.

• Subsequent research has suggested the existence of stable relationships. Friedman and Kuttner’s criticism is not robust to the use of reasonable, alternative functional forms.

• Remuneration rate might be able to control credit expansion by banks => the size of the base is not relevant to monetary policymaking or aggregate demand (Goodfriend, 2002; Woodford, 2002)

=> We search for an alternative functional form that might be a stable long-run “demand curve”.

What Size Should the Monetary Base Be?


Data Selection 1919-present

• Monetary Base: The Federal Reserve Bank of St. Louis’ adjusted monetary Base.

• GDP: BEA’S annual GDP series (1929 -2008) is spliced with Balke and Gordon’s GDP series (1919 - 1946) via an index number method (splice using average of the period-by-period growth rates of the two series)

• Interest Rates: Moody’s Aaa-rated corporate bond yields

• Default rate: Moody’s series on defaults on investment grade corporate bonds.


0 2 4 6 8 10 12 14 16-5.25

-5.00

-4.75

-4.50

-4.25

-4.00

-3.75

-3.50

Log Monetary Base Velocity and Aaa Bond RateAnnual 1919-2009

Aaa Rate

log

(Mo

net

ary

Bas

e V

elo

city

)

2009

1941

1931

1937

2007

2008

Level of Bond Rate (Lucas, 1988) – poor model

• Nonlinear• Interest elasticity is an increasing function of the level of the interest rate


0.8 1 1.2 1.4 1.6 1.8 2 2.2 2.4 2.6 2.8-5.25

-5.00

-4.75

-4.50

-4.25

-4.00

-3.75

-3.50

Log Base Velocity and Log Aaa Bond RateAnnual 1919-2009

Log(Inverse Aaa Rate)

log

(Mo

net

ary

Bas

e V

elo

city

)

2009

1941

1931

1937

2007

2008

Log Constant Elasticity Model (Cagan, 1956)

• Less Nonlinear• Interest elasticity is constant


5 10 15 20 25 30 35 40 45-5.25

-5.00

-4.75

-4.50

-4.25

-4.00

-3.75

-3.50

Log Base Velocity and Inverse Aaa Bond RateAnnual 1919-2008

100*(Inverse Aaa Rate)

log

(Mo

net

ary

Bas

e V

elo

city

)

1941

19211931

1937

2007

2008

Log price model (inverse interest rate)

• Almost linear• Interest elasticity is decreasing function of level of interest rate


5 10 15 20 25 30 35 40 45-5.25

-5.00

-4.75

-4.50

-4.25

-4.00

-3.75

-3.50

Log Base Velocity and Inverse Aaa Bond RateAnnual 1919-2009


log

(Mo

net

ary

Bas

e V

elo

city

)

2009 1941

1921

1931

1937

2007

2008


Default on Investment-Grade Corporate Bonds

0%

1%

2%

3%

4%

5%

6%

7%

8%Default Rate

New

def

ault

as p

erce

ntag

e of

bon

ds

outs

tand

ing

0200400600800

100012001400160018002000

New DefaultsM

illio

ns o

f D

olla

rs


A Forecast of Monetary Base Velocity

5 10 15 20 25 30 35 40 45-5.25

-5.00

-4.75

-4.50

-4.25

-4.00

-3.75

-3.50

Log Base Velocity and Inverse Aaa Bond RateAnnual 1919-2008 (Adjusted for New Defaults)


log

(No

min

al G

DP

/Bas

e)

1921

1931

1937

1941

2007

2008

2009

2010

Quantitative Easing!


A Forecast of Quarterly Monetary Base Velocity

5 10 15 20 25 30 35 40 45-5.25

-5.00

-4.75

-4.50

-4.25

-4.00

-3.75

-3.50

Log Base Velocity and Inverse Aaa Bond RateQuarterly 1947Q1-2010Q2


log

(Mo

net

ary

Bas

e V

elo

city

)

2008Q4

2009Q1

2009Q2 2009Q3

2009Q4

2010Q12010Q2

Quantitative Easing!


Functional Form and Velocity Restriction

• We applied Box-Cox transformation to the base money demand function, and the general functional form is:

• We also imposed a restriction on monetary base velocity (γ = 1), and set λ0 = λ2 = 0; then the general functional form becomes:


Box – Cox Transformation on Aaa Rate Variable


Interest Rate Elasticity Estimates


Recursive estimations prefer the velocity restriction:

• The recursively estimated parameters from the models with velocity restriction are more consistent across different sample sizes.

Forward and Backward Recursive Estimations


Recursive estimations prefer the velocity restriction:

• The recursively estimated parameters from the models with velocity restriction are consistent across different sample sizes.

• The recursively estimated parameters from the models without velocity restriction have bad performance for small sample size.

• The β parameters from the models without velocity restriction have significantly different results between forward recursive estimations and backward recursive estimations.



• The fitted values are very close to the actual values

• Most of the standardized residuals and recursive residuals are inside the S.E. bands

• Reasonable correlations between residuals

• The standardized residuals look normally distributed

Residual Diagnostics for Log-Inverse Model with Velocity Restriction


Residual Diagnostics for Log-Inverse Model with Velocity Restriction


VECM Model

• We used a structural VAR to interpret the long-run monetary-base velocity equation as a demand curve.

The Reduced-form VECM is:

After Imposing the restrictions, the VECM becomes:

where defines the contemporaneous (simultaneous) relationships.

Tt

Pt

ttpu

uLXXLI

H

H)}({

2

1

ttp LXXLI )]([

12

1

221

1121

111

2

1

)(

)1(0

W

CW

TTB

T

H

H


The Estimation Strategy

• First, we re-order the equations such that the single equation for the base, which contains the transitory shock, is at the bottom; and the other equations, which contain permanent shocks, are above.

• After that, we estimated the set of equations with permanent shocks via Sims-like Wold/Cholesky variance decomposition, since this is essentially a VAR system.

• Finally, we estimate the coefficients of the final equation via instrument variables, using the residuals from the prior equations as instruments.


Parameter Estimates of the Identified VECMModel w/o velocity restriction Model with velocity restriction

Constant -2.697 (0.745) 1.947 (0.835)

CIV –1 -0.650 (0.179) 0.565 (0.245)

rAMB -1 0.156 (0.209) 0.326 (0.405)

rGDP 1.564 (0.398) -1.739 (0.841)

rGDP -1 -0.512 (0.297) 1.132 (0.581)

InverseRate 6.170 (1.279) -10.281 (4.601)

InverseRate -1 -1.588 (0.876) 2.440 (1.584)

DefaultRate 6.347 (1.717) 0.699 (3.150)

DefaultRate -1 0.405 (1.795) 1.184 (2.681)

Standard error of regression 0.09357 0.17002


Implicit Distributed Lag Coefficients in Identified VECM

Without velocity restriction With velocity restriction

Real GDP Inverse Rate Real GDP Inverse Rate

Period t 1.564 6.17 -1.739 -10.281

Period t-1 -1.367 -5.403 2.306 10.590

Period t-2 0.512 1.588 -1.132 -2.44


Impulse response functions, Inverse Interest Rate ShockModel with Velocity Restriction


Impulse Response Functions, Real Output ShockModel with Velocity Restriction


Impulse Response Functions, Real Monetary-Base ShockModel with Velocity Restriction


Concluding Remarks

• We find a well-defined stable demand function.

• Our analysis suggests that demand for monetary base may be modeled as demand for a zero coupon, default risk – free consol.

• The statistically significant cointegrating vector suggests that there is a strong pull from any short-run disequilibrium toward the long-run equilibrium.

• Our Results suggests that growth of the monetary base, at least at the relatively low frequency of annual data, can provide guidance for monetary policymakers, particularly when inflation or the level of nominal interest rates is high.


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314 444 8574

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An Exit Strategy from Quantitative Easing and the Demand for Monetary Base in the United States...

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