FEDS 2016-104
Forecast combination for euro area inflation - A cure in times of crisis? (PDF)

Kirstin Hubrich and Frauke Skudelny

Abstract: The period of extraordinary volatility in euro area headline inflation starting in 2007 raised the question whether forecast combination methods can be used to hedge against bad forecast performance of single models during such periods and provide more robust forecasts. We investigate this issue for forecasts from a range of short-term forecasting models. Our analysis shows that there is considerable variation of the relative performance of the different models over time. To take that into account we suggest employing performance-based forecast combination methods, in particular one with more weight on the recent forecast performance. We compare such an approach with equal forecast combination that has been found to outperform more sophisticated forecast combination methods in the past, and investigate whether it can improve forecast accuracy over the single best model. The time-varying weights assign weights to the economic interpretations of the forecast stemming from different models. The combination methods are evaluated for HICP headline inflation and HICP excluding food and energy. We investigate how forecast accuracy of the combination methods differs between pre-crisis times, the period after the global financial crisis and the full evaluation period including the global financial crisis with its extraordinary volatility in inflation. Overall, we find that, first, forecast combination helps hedge against bad forecast performance and, second, that performance-based weighting tends to outperform simple averaging.

Keywords: Forecasting, euro area inflation, forecast combinations, forecast evaluation

DOI: https://doi.org/10.17016/FEDS.2016.104

Accessible materials (.zip)

FEDS 2016-103
Identity, Identification and Identifiers: The Global Legal Entity Identifier System (PDF)

Arthur B. Kennickell

Abstract: Identity is a critical concept in the rational interactions of any set of objects involving subject-object relationships. The objects must be distinguished according to some framework in order for such relationships to have meaning. In the world of economic systems, relationships such as ownership and responsibility require specific parties to be fixed with a high degree of certainty. This need is particularly strong in financial markets, where transactions can take place in nanoseconds. This paper discusses a particular framework for defining economic actors, the Global Legal Entity Identifier System (GLEIS), which was initiated for the purpose of creating greater transparency about participants in financial markets and transactions.

Keywords: Data mapping, Market participants, Organizational structure

DOI: https://doi.org/10.17016/FEDS.2016.103

Accessible materials (.zip)

FEDS 2016-102
The Volcker Rule and Market-Making in Times of Stress (PDF)

Jack Bao, Maureen O'Hara, and Alex Zhou

Abstract: Focusing on downgrades as stress events that drive the selling of corporate bonds, we document that the illiquidity of stressed bonds has increased after the Volcker Rule. Dealers regulated by the Rule have decreased their market-making activities while non-Volcker-affected dealers have stepped in to provide some additional liquidity. Furthermore, even Volcker-affected dealers that are not constrained by Basel III and CCAR regulations change their behavior, inconsistent with the effects being driven by these other regulations. Since Volcker-affected dealers have been the main liquidity providers, the net effect is that bonds are less liquid during times of stress due to the Volcker Rule.

Keywords: Capital Commitment, Corporate Bond Illiquidity, Dealer Inventory, Financial Crisis, Market-Making, Regulation, Volcker Rule

DOI: https://doi.org/10.17016/FEDS.2016.102

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FEDS 2016-101
The Effect of Banks' Financial Position on Credit Growth: Evidence from OECD Countries (PDF)

Abstract: This paper presents empirical evidence on the effect of banks' financial position on credit growth using a sample of 29 OECD countries. The failure of the exogeneity assumption of explanatory variables is addressed using dynamic panel type instruments. The empirical results show that among capital, profits and liquidity at the end of the previous year, capital is the most important predictor of credit growth in the current year. The relationship between capital and credit growth is non-linear. Point estimates from the preferred econometric specification imply that at the sample mean a one standard deviation increase (decrease) in capital is associated with an increase (decrease) of 0.8 (0.3) percentage points in credit growth upon impact and 1.6 (0.6) percentage points in the long-run.

Keywords: Bank lending, OECD, bank financial position, banking, credit supply

DOI: https://doi.org/10.17016/FEDS.2016.101

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FEDS 2016-100
Does Hedging with Derivatives Reduce the Market's Perception of Credit Risk? (PDF)

Sriya Anbil, Alessio Saretto, and Heather Tookes

Abstract: Risk management is the most widely-cited reason that non-financial corporations use derivatives. If hedging programs are effective, then firms using derivatives should have lower credit risk than those that do not. Surprisingly, we find that firms with derivative positions without a hedge accounting designation (typically higher basis risk) have higher CDS spreads than firms that do not hedge at all. We do not find evidence that these non-designated positions are associated with future credit realizations. We examine alternative explanations and find evidence that is consistent with a market penalty for high basis risk positions when overall market conditions are poor.

Keywords: Counterparty credit risk, Derivatives, futures, and options, Risk management, hedging

DOI: https://doi.org/10.17016/FEDS.2016.100

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FEDS 2016-099
When Can Trend-Cycle Decompositions Be Trusted? (PDF)

Abstract: In this paper, we examine the results of GDP trend-cycle decompositions from the estimation of bivariate unobserved components models that allow for correlated trend and cycle innovations. Three competing variables are considered in the bivariate setup along with GDP: the unemployment rate, the inflation rate, and gross domestic income. We find that the unemployment rate is the best variable to accompany GDP in the bivariate setup to obtain accurate estimates of its trend-cycle correlation coefficient and the cycle. We show that the key feature of unemployment that allows for precise estimates of the cycle of GDP is that its nonstationary component is "small" relative to its cyclical component. Using quarterly GDP and unemployment rate data from 1948:Q1 to 2015:Q4, we obtain the trend-cycle decomposition of GDP and find evidence of correlated trend and cycle components and an estimated cycle that is about 2 percent below its trend at the end of the sample.

Keywords: Unobserved components model, trend-cycle correlation, trend-cycle decomposition

DOI: https://doi.org/10.17016/FEDS.2016.099

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FEDS 2016-098
The Effects of Mortgage Credit Availability: Evidence from Minimum Credit Score Lending Rules (PDF)

Abstract: Since the housing bust and financial crisis, mortgage lenders have introduced progressively higher minimum thresholds for acceptable credit scores. Using loan-level data, we document the introduction of these thresholds, as well as their effects on the distribution of newly originated mortgages. We then use the timing and nonlinearity of these supply-side changes to credibly identify their short- and medium-run effects on various individual outcomes. Using a large panel of consumer credit data, we show that the credit score thresholds have very large negative effects on borrowing in the short run, and that these effects attenuate over time but remain sizable up to four years later. The effects are particularly concentrated among younger adults and those living in middle-income or moderately black census tracts. In aggregate, we estimate that lenders' use of minimum credit scores reduced the total number of newly originated mortgages by about 2 percent in the years foll owing the financial crisis. We also find that, among individuals who already had mortgages, retaining access to mortgage credit reduced delinquency on both mortgage and non-mortgage debt and increased their propensity to take out auto loans, but had little effect on migration across metropolitan areas.

Keywords: Credit scores, Credit supply, Mortgages and credit, Residential Real Estate

DOI: https://doi.org/10.17016/FEDS.2016.098

Accessible materials (.zip)

FEDS 2016-097
Options, Equity Risks, and the Value of Capital Structure Adjustments (PDF)

Paul Borochin and Jie Yang

Abstract: We use exchange-traded options to identify risks relevant to capital structure adjustments in firms. These forward-looking market-based risk measures provide significant explanatory power in predicting net leverage changes in excess of accounting data. They matter most during contractionary periods and for growth firms. We form market-based indices that capture firms' magnitudes of, and propensity for, net leverage increases. Firms with larger predicted leverage increases outperform firms with lower predicted increases by 3.1% to 3.9% per year in buy-and-hold abnormal returns. Finally, consistent with the quality, leverage, and distress risk puzzles, firms with lower predicted leverage increases are riskier but earn lower abnormal returns.

Keywords: Capital Structure, Financial Leverage, Implied Volatility, Options

DOI: https://doi.org/10.17016/FEDS.2016.097

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FEDS 2016-096
Monetary Policy Implementation and Private Repo Displacement: Evidence from the Overnight Reverse Repurchase Facility (PDF)

Abstract: In recent years, the scale and scope of major central banks' intervention in financial markets has expanded in unprecedented ways. In this paper, we demonstrate how monetary policy implementation that relies on such intervention in financial markets can displace private transactions. Specifically, we examine the experience with the Federal Reserve's newest policy tool, known as the overnight reverse repurchase (ONRRP) facility, to understand its effects on the repo market. Using exogenous variation in the parameters of the ONRRP facility, we show that participation in the ONRRP comes from substitution out of private repo. However, we also demonstrate that cash lenders, when investing in the ONRRP, do not cease trading with any of their dealer counterparties, highlighting the importance of lending relationships in the repo market. Lastly, using a confidential data set of repo transactions, we find that the presence of the Fed as a borrower in the repo market increases th e bargaining power of cash lenders, who are able to command higher rates in their remaining private repo transactions.

Keywords: Federal Reserve, Monetary policy, Money market mutual funds, Repo

DOI: https://doi.org/10.17016/FEDS.2016.096

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FEDS 2016-095
Distributed ledger technology in payments, clearing, and settlement (PDF)

David Mills, Kathy Wang, Brendan Malone, Anjana Ravi, Jeff Marquardt, Clinton Chen, Anton Badev, Timothy Brezinski, Linda Fahy, Kimberley Liao, Vanessa Kargenian, Max Ellithorpe, Wendy Ng, and Maria Baird

Abstract: Digital innovations in finance, loosely known as fintech, have garnered a great deal of attention across the financial industry. Distributed ledger technology (DLT) is one such innovation that has been cited as a means of transforming payment, clearing, and settlement processes, including how funds are transferred and how securities, commodities, and derivatives are cleared and settled. An important goal of this paper is to examine how this technology might be used in the area of payments, clearing, and settlement and to identify both the opportunities and challenges facing its practical implementation and possible long-term adoption. DLT has the potential to provide new ways to transfer and record the ownership of digital assets; immutably and securely store information; provide for identity management; and other evolving operations through peer-to-peer networking, access to a distributed but common ledger among participants, and cryptography. Potential use cases in payments, clearing, and settlement include cross-border payments and the post-trade clearing and settlement of securities. These use cases could address operational and financial frictions around existing services. Nonetheless, the industry�s understanding and application of this technology is still in its infancy, and stakeholders are taking a variety of approaches toward its development. Given the technology�s early stage, a number of challenges to development and adoption remain, including in how issues around business cases, technological hurdles, legal considerations, and risk management considerations are addressed. To understand fast moving developments in this area, a team of Federal Reserve staff conducted a series of discussions with approximately 30 organizations, including financial institutions, financial market infrastructures, technology start-ups, established technology firms, and other government agencies.

Keywords: blockchain, distributed ledger, fintech

DOI: https://doi.org/10.17016/FEDS.2016.095

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FEDS 2016-094
Trade Liberalization and Mortality: Evidence from U.S. Counties (PDF)

Justin R. Pierce and Peter K. Schott

Abstract: We investigate the impact of a large economic shock on mortality. We find that counties more exposed to a plausibly exogenous trade liberalization exhibit higher rates of suicide and related causes of death, concentrated among whites, especially white males. These trends are consistent with our finding that more-exposed counties experience relative declines in manufacturing employment, a sector in which whites and males are over-represented. We also examine other causes of death that might be related to labor market disruption and find both positive and negative relationships. More-exposed counties, for example, exhibit lower rates of fatal heart attacks.

Keywords: International Trade, Mortality, Trade Policy, Unemployment

DOI: https://doi.org/10.17016/FEDS.2016.094

Accessible materials (.zip)

FEDS 2016-093
Learning from History: Volatility and Financial Crises (PDF)

Jon Danielsson, Marcela Valenzuela, and Ilknur Zer

Abstract: We study the effects of volatility on financial crises by constructing a cross-country database spanning over 200 years. Volatility is not a significant predictor of crises whereas unusually high and low volatilities are. Low volatility is followed by credit build-ups, indicating that agents take more risk in periods of low financial risk consistent with Minsky hypothesis, and increasing the likelihood of a banking crisis. The impact is stronger when financial markets are more prominent and less regulated. Finally, both high and low volatilities make stock market crises more likely, while volatility in any form has no impact on currency crises.

Keywords: Minsky hypothesis, Stock market volatility, financial crises predictability, financial instability, risk-taking, volatility paradox

DOI: https://doi.org/10.17016/FEDS.2016.093

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FEDS 2016-092
Gradualism and Liquidity Traps (PDF)

Taisuke Nakata and Sebastian Schmidt

Abstract: Modifying the objective function of a discretionary central bank to include an interest-rate smoothing objective increases the welfare of an economy in which large contractionary shocks occasionally force the central bank to lower the policy rate to its effective lower bound. The central bank with an interest-rate smoothing objective credibly keeps the policy rate low for longer than the central bank with the standard objective function. Through expectations, the temporary overheating of the economy associated with such a low-for-long interest rate policy mitigates the declines in inflation and output when the lower bound constraint is binding. In a calibrated model, we find that the introduction of an interest-rate smoothing objective can reduce the welfare costs associated with the lower bound constraint by more than one-half.

Keywords: Gradualism, Inflation Targeting, Interest-Rate Smoothing, Liquidity Traps, Zero Lower Bound

DOI: https://doi.org/10.17016/FEDS.2016.092

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FEDS 2016-091
Institutional Herding and Its Price Impact: Evidence from the Corporate Bond Market (PDF)

Abstract: Among growing concerns about potential financial stability risks posed by the asset management industry, herding has been considered as an important risk amplification channel. In this paper, we examine the extent to which institutional investors herd in their trading of U.S. corporate bonds and quantify the price impact of such herding behavior. We find that, relative to what is documented for the equity market, the level of institutional herding is much higher in the corporate bond market, particularly among speculative-grade bonds. In addition, mutual funds have become increasingly likely to herd when they sell, a trend not observed among insurance companies and pension funds. We also show that bond investors herd not only within a quarter, but also over adjacent quarters. Such persistence in trading is largely driven by funds imitating the trading behavior of other funds in the previous quarter. Finally, we find that there is an asymmetry in the price impact of herding. While buy herding is associated with a permanent price impact that is consistent with price discovery, sell herding results in transitory yet significant price distortions. The price destabilizing effect of sell herding is particularly strong for high-yield bonds, small bonds, and illiquid bonds and during the recent global financial crisis.

Keywords: Corporate Bond, Herding, Institutional Investors, Liquidity, Return Reversal

DOI: https://doi.org/10.17016/FEDS.2016.091

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FEDS 2016-090
The Effects of Liquidity Regulation on Bank Demand in Monetary Policy Operations (PDF)

Marcelo Rezende, Mary-Frances Styczynski, and Cindy M. Vojtech

Abstract: 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 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.

Keywords: Basel III, monetary policy, excess reserves, liquidity coverage ratio, term deposit facility

DOI: https://doi.org/10.17016/FEDS.2016.090

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FEDS 2016-089
Exploring Online and Offline Informal Work: Findings from the Enterprising and Informal Work Activities (EIWA) Survey (PDF)

Barbara Robles and Marysol McGee

Abstract: The growing prevalence of alternative work arrangements has accelerated with the rapidly evolving digital platform transformations in local and global markets (Kenny and Zysman, 2015 and 2016). Although traditional (offline) informal paid work has always been a part of the labor sector (BLS-Contingent Worker Survey, 2005; GAO, 2015 and Katz and Krueger, 2016), the rise of online enabled paid work activities requires new approaches to measure this growing trend (Farrell and Greig, 2016; Gray et al, 2016; Sundararajan, 2016 and Schor, 2015). In the fourth quarter of 2015, the Federal Reserve Board conducted a nationally representative survey of adults 18 and older to track online and offline income-generating activities as well as their employment status during the six months prior to the surveys. Survey results indicate that 36 percent of respondents undertook informal paid work activities either as a complement to or as a substitute for more traditional and formal w ork arrangements. We explore the rationale behind respondents' participation in alternative work arrangements by setting questions that capture participant motives and attitudes towards informal offline and online paid work activities. Sixty-five percent of qualified survey respondents indicate that a main reason for participating in informal work is to earn extra income.

Keywords: Digital economy, gig economy, inceome-patching, on-demand economy, online fee for tasks, platform economy, sharing economy

DOI: https://doi.org/10.17016/FEDS.2016.089

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FEDS 2016-088
The Effects of Institutional Investor Objectives on Firm Valuation and Governance (PDF)

Paul Borochin and Jie Yang

Abstract: We find that ownership by different types of institutional investor has different implications for future firm misvaluation and governance characteristics. Dedicated institutional investors decrease future firm misvaluation relative to fundamentals, as well as the magnitude of this misvaluation. In contrast, transient institutional investors have the opposite effect. Using SEC Regulation FD as an exogenous shock to information dissemination, we find evidence consistent with dedicated institutions having an information advantage. The valuation effects are primarily driven by institutional portfolio concentration while the governance effects are driven by portfolio turnover. These results imply a more nuanced relationship between institutional ownership and firm value and corporate governance.

Keywords: Institutional investors, investor type, dedicated, transient, misvaluation, corporate governance, blockholding, portfolio turnover, information dissemination, SEC Regulation FD

DOI: https://doi.org/10.17016/FEDS.2016.088

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FEDS 2016-087
Counterparty Risk and Counterparty Choice in the Credit Default Swap Market (PDF)

Wenxin Du, Salil Gadgil, Michael B. Gordy, and Clara Vega

Abstract: We investigate how market participants price and manage counterparty risk in the post-crisis period using confidential trade repository data on single-name credit default swap (CDS) transactions. We find that counterparty risk has a modest impact on the pricing of CDS contracts, but a large impact on the choice of counterparties. We show that market participants are significantly less likely to trade with counterparties whose credit risk is highly correlated with the credit risk of the reference entities and with counterparties whose credit quality is relatively low. Furthermore, we examine the impact of central clearing on CDS pricing. Contrary to the previous literature, but consistent with our main findings on pricing, we find no evidence that central clearing increases transaction spreads.

Keywords: Counterparty credit risk, central clearing, credit default swaps

DOI: https://doi.org/10.17016/FEDS.2016.087

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FEDS 2016-086
Earnings Management and Corporate Investment Decisions (PDF)

Brandon Julio and Youngsuk Yook

Abstract: We investigate the relationship between earnings management and the efficiency of corporate investment decisions. Using discretionary accruals to measure intertemporal transfers of earnings, we show that earnings management exhibits a concave relationship with the investment sensitivity to investment opportunities as measured by Tobin's Q. We find that the association is concentrated among high Q firms. The effect is present among well governed firms, suggesting that better governed firms manage accruals strategically. The concave relationship suggests that the marginal impact of earnings management on investment efficiency decreases with the amount of earnings management. Using cases of misreporting, we document that excessive earnings management does not improve investment efficiency. Taken together, these results support the view that a moderate amount of earnings management helps improve corporate investment decisions while an excessive amount undoes the benefit of earnings management.

Keywords: Corporate Investment Decisions, Earnings Management

DOI: https://doi.org/10.17016/FEDS.2016.086

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FEDS 2016-085
Equilibrium Yield Curves and the Interest Rate Lower Bound (PDF)

Abstract: We study the term structure of default-free interest rates in a sticky-price model with an occasionally binding effective lower bound (ELB) constraint on interest rates and recursive preferences. The ELB constraint induces state-dependency in the dynamics of term premiums by affecting macroeconomic uncertainty and interest-rate sensitivity to economic activities. In a model calibrated to match key features of the aggregate economy and term structure dynamics in the U.S. above and at the ELB, we find that the ELB constraint typically lowers the absolute size of term premiums at the ELB and increases their volatility around the time of liftoff. The central bank's announcement to keep the policy rate at the ELB for longer than previously expected lowers the expected short rate path, but its effect on term premiums depends on the risk exposure of bonds to the macroeconomy; while the announcement increases term premiums if bonds are a hedge against economic downturns, it decreases them otherwise.

Keywords: Effective Lower Bound, Forward Guidance, New Keynesian Model, Recursive Preference, Term Premiums, Term Structure of Interest Rates, Yield Curves

DOI: https://doi.org/10.17016/FEDS.2016.085

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FEDS 2016-084
Effects of Changing Monetary and Regulatory Policy on Overnight Money Markets (PDF)

Abstract: Money markets have been operating under a new monetary policy implementation framework since the Federal Reserve started paying interest on bank reserves in late 2008. The regulatory environment has also evolved substantially over this period. We develop and test hypotheses regarding the effects of changes in the monetary and regulatory policy on dynamics of key overnight funding markets. We find that the federal funds rate continued to provide an anchor, albeit weaker, for unsecured funding rates amid substantial decline in activity and changing composition of trades, while its transmission to the repo market had been hampered. The overnight reverse repurchase (ON RRP) operations that started in late 2013 contributed to stronger co-movement among overnight funding rates and markedly reduced their volatility. The change in the FDIC assessment fees and Basel III leverage ratio regulations have exacerbated financial-reporting-day effects in unsecured markets. In contrast, consistent with lower dealer leverage in the post-crisis period, such effects have weakened in the repo market, especially after the inception of the ON RRP facility. Finally, superabundant bank reserves appear to have significantly diminished the effects of reserve-maintenance on the money market rates.

Keywords: Eurodollar, GARCH models, Overnight money markets, VAR models, Commercial paper, Federal funds, Repo

DOI: https://doi.org/10.17016/FEDS.2016.084

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FEDS 2016-083
Closed-Form Estimation of Finite-Order ARCH Models: Asymptotic Theory and Finite-Sample Performance (PDF)

Abstract: Covariances between contemporaneous squared values and lagged levels form the basis for closed-form instrumental variables estimators of ARCH processes. These simple estimators rely on asymmetry for identification (either in the model's rescaled errors or the conditional variance function) and apply to threshold ARCH(1) and ARCH(p) with p < ∞ processes. Limit theory for these estimators is established in the case where the ARCH processes are regularly varying with a well-defined third and sixth moment of the raw returns and rescaled errors, respectively. The resulting limits are highly non-normal in empirically relevant cases, with slow rates of convergence relative to the thin-tailed √n-case. Nevertheless, Monte Carlo studies of a heavy-tailed ARCH(1) process show the simple IV estimator to outperform standard QMLE in (relatively) small samples when the data are (heavily) skewed. Methods for determining confidence intervals for the ARCH estimates are also discussed.

Revised Appendix (PDF)

Keywords: ARCH, Closed form estimation, Heavy tails, Instrumental variables, Regular variation, Three-step estimation

DOI: https://doi.org/10.17016/FEDS.2016.083r1

Accessible materials (.zip)

Original: Full Paper (PDF) | Accessible materials (.zip) | Appendix (PDF)

Original DOI: https://doi.org/10.17016/FEDS.2016.083

FEDS 2016-082
Evidence for the Effects of Mergers on Market Power and Efficiency (PDF)

Bruce A. Blonigen and Justin R. Pierce

Abstract: Study of the impact of mergers and acquisitions (M&As) on productivity and market power has been complicated by the difficulty of separating these two effects. We use newly-developed techniques to separately estimate productivity and markups across a wide range of industries using detailed plant-level data. Employing a difference-in-differences framework, we find that M&As are associated with increases in average markups, but find little evidence for effects on plant-level productivity. We also examine whether M&As increase efficiency through reallocation of production to more efficient plants or through reductions in administrative operations, but again find little evidence for these channels, on average. The results are robust to a range of approaches to address the endogeneity of firms' merger decisions.

Keywords: Acquisitions, Efficiency, Market Power, Markups, Mergers, Productivity

DOI: https://doi.org/10.17016/FEDS.2016.082

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FEDS 2016-081
Do Mortgage Subsidies Help or Hurt Borrowers? (PDF)

Abstract: Mortgage subsidies affect homeownership costs by reducing effective mortgage rates and increasing house prices. I show analytically the role of mortgage subsidies in determining house price changes, economic incidence, and efficiency costs using a theoretical framework for applied welfare analysis. I derive simple expressions for these effects, as functions of reduced-form sufficient statistics, which I use to measure the effects from eliminating mortgage deductions. My main results characterize the distributional impact of mortgage subsidies among buyers and owners and how house price responses attenuate efficiency losses. My results provide broader methodological insights into the welfare analysis of credit policies.

Statistics by metro area data (CSV)

Keywords: MID, Public economics, house prices, incidence, mortgage interest deductions, mortgage subsidies, optimal taxation

DOI: https://doi.org/10.17016/FEDS.2016.081

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FEDS 2016-080
Understanding the New Normal: The Role of Demographics (PDF)

Abstract: Since the onset of the Great Recession, the U.S. economy has experienced low real GDP growth and low real interest rates, including for long maturities. We show that these developments were largely predictable by calibrating an overlapping-generation model with a rich demographic structure to observed and projected changes in U.S. population, family composition, life expectancy, and labor market activity. The model accounts for a 1 1/4-percentage point decline in both real GDP growth and the equilibrium real interest rate since 1980--essentially all of the permanent declines in those variables according to some estimates. The model also implies that these declines were especially pronounced over the past decade or so because of demographic factors most-directly associated with the baby boom and the passing of the information technology boom. Our results further suggest that real GDP growth and real interest rates will remain low in coming decades, consistent with the U.S economy having reached a "new normal."

Keywords: GDP growth, demographics, equilibrium real interest rate, new normal

DOI: http://dx.doi.org/10.17016/FEDS.2016.080

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FEDS 2016-079
Reserve Balances, the Federal Funds Market and Arbitrage in the New Regulatory Framework (PDF)

Abstract: We study developments in reserve balances and the federal funds market in the context of two banking regulatory changes: the widening of the Federal Deposit Insurance Corporation (FDIC) assessment base and the introduction of the Basel III leverage ratio. Using a novel data set that includes FDIC fees and balance sheet data for depository institutions, we find that, as most foreign banks were not subject to the FDIC fee, they absorbed increasing amounts of reserve balances. Furthermore, foreign banks experienced positive and improving conditions for arbitraging between borrowing reserve balances in the federal funds market and earning interest on excess reserves by holding those reserves at the Federal Reserve Banks, contributing to an increase in federal funds borrowing by foreign banks relative to domestic banks. However, the implementation of the Basel III leverage ratio was associated with temporary declines in foreign bank federal funds borrowing at reporting dates.

Keywords: Basel III ratios, FDIC fees, IOER arbitrage, reserve balances, federal funds market

DOI: http://dx.doi.org/10.17016/FEDS.2016.079

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FEDS 2016-078
Non-Linear Phillips Curves with Inflation Regime-Switching (PDF)

Abstract: Building on the results in Nalewaik (FEDS 2015-93), this work models wage growth and core PCE price inflation as regime-switching processes, whose characteristics in the 1970s, 1980s and early 1990s differ fundamentally from their characteristics in the 1960s and from the mid-1990s to present. The key innovation here is the addition to the models of fundamental driving variables like labor-market slack, and the evidence strongly suggests a non-linear effect of slack on wage growth and core PCE price inflation that becomes much larger after labor markets tighten beyond a certain point. The results are informative for assessing the likelihood and risks of meeting certain inflation targets on a sustained basis.

Keywords: Markov-switching, NAIRU, threshold regression, wage inflation, core PCE prices

DOI: http://dx.doi.org/10.17016/FEDS.2016.078

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FEDS 2016-077
Near-Money Premiums, Monetary Policy, and the Integration of Money Markets: Lessons from Deregulation (PDF)

Mark Carlson and David C. Wheelock

Abstract: The 1960s and 1970s witnessed rapid growth in the markets for new money market instruments, such as negotiable certificates of deposit (CDs) and Eurodollar deposits, as banks and investors sought ways around various regulations affecting funding markets. In this paper, we investigate the impacts of the deregulation and integration of the money markets. We find that the pricing and volume of negotiable CDs and Eurodollars issued were influenced by the availability of other short-term safe assets, especially Treasury bills. Banks appear to have issued these money market instruments as substitutes for other types of funding. The integration of money markets and ability of banks to raise funds using a greater variety of substitutable instruments has implications for monetary policy. We find that, when deregulation reduced money market segmentation, larger open market operations were required to produce a given change in the federal funds rate, but that the pass through of c hanges in the funds rate to other market rates was also greater.

Keywords: Deregulation, eurodollars, market integration, monetary policy implementation, money markets, regulation Q

DOI: http://dx.doi.org/10.17016/FEDS.2016.077

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FEDS 2016-076
Measuring the Informativeness of Market Statistics (PDF)

Abstract: Market statistics can be viewed as noisy signals for true variables of interest. These signals are used by individual recipients of the statistics to imperfectly infer different variables of interest. This paper presents a framework under which the 'informativeness' of statistics is defined as their efficacy as the basis of such inference, and is quantified as expected distortion, a concept from information theory. The framework can be used to compare the informativeness of a set of statistics with that of another set or its theoretical limits. Also, the proposed informativeness measure can be computed as solutions to familiar problems under a range of assumptions. As an application, the measure is used to explain the difference in usage levels of temperature derivatives across different base weather stations. The informativeness measure is found to be at least as effective as city size measures in explaining the difference in usage levels.

Keywords: Derivatives, futures, and options, financial markets

DOI: http://dx.doi.org/10.17016/FEDS.2016.076

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FEDS 2016-075
Search, Matching and Training (PDF)

Christopher Flinn, Ahu Gemici and Steven Laufer

Abstract: We estimate a partial and general equilibrium search model in which firms and workers choose how much time to invest in both general and match-specific human capital. To help identify the model parameters, we use NLSY data on worker training and we match moments that relate the incidence and timing of observed training episodes to outcomes such as wage growth and job-to-job transitions. We use our model to offer a novel interpretation of standard Mincer wage regressions in terms of search frictions and returns to training. Finally, we show how a minimum wage can reduce training opportunities and decrease the amount of human capital in the economy.

Keywords: Minimum wage, on-the-job training, wage growth

DOI: http://dx.doi.org/10.17016/FEDS.2016.075

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FEDS 2016-074
Endogenous Debt Maturity and Rollover Risk (PDF)

Emanuele Brancati and Marco Macchiavelli

Abstract: We challenge the common view that short-term debt, by having to be rolled over continuously, is a risk factor that exposes banks to higher default risk. First, we show that the average effect of expiring obligations on default risk is insignificant; it is only when a bank has limited access to new funds that maturing debt has a detrimental impact on default risk. Next, we show that both limited access to new funds and shorter maturities are causally determined by deteriorating market expectations about the bank's future profitability. In other words, short-term debt is not a cause of fragility but the result of creditors losing faith in the long-run prospects of the bank, hence forcing it to shorten its debt maturity. Finally, we build a model that endogenizes the debt maturity structure and predicts that worse market expectations lead to a maturity shortening.

Keywords: Banks, debt issuance, financial crisis, maturity structure, rollover risk

DOI: http://dx.doi.org/10.17016/FEDS.2016.074

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FEDS 2016-073
Measuring the Natural Rate of Interest: International Trends and Determinants (PDF)

Kathryn Holston, Thomas Laubach, and John C. Williams

Abstract: U.S. estimates of the natural rate of interest ? the real short-term interest rate that would prevail absent transitory disturbances ? have declined dramatically since the start of the global financial crisis. For example, estimates using the Laubach-Williams (2003) model indicate the natural rate in the United States fell to close to zero during the crisis and has remained there through the end of 2015. Explanations for this decline include shifts in demographics, a slowdown in trend productivity growth, and global factors affecting real interest rates. This paper applies the Laubach-Williams methodology to the United States and three other advanced economies ? Canada, the Euro Area, and the United Kingdom. We find that large declines in trend GDP growth and natural rates of interest have occurred over the past 25 years in all four economies. These country-by-country estimates are found to display a substantial amount of comovement over time, suggesting an important role for global factors in shaping trend growth and natural rates of interest.

Keywords: Kalman filter, monetary policy rules, natural rate of output, trend growth

DOI: http://dx.doi.org/10.17016/FEDS.2016.073

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FEDS 2016-072
Tempered Particle Filtering (PDF)

Edward Herbst and Frank Schorfheide

Abstract: The accuracy of particle filters for nonlinear state-space models crucially depends on the proposal distribution that mutates time t-1 particle values into time t values. In the widely-used bootstrap particle filter this distribution is generated by the state-transition equation. While straightforward to implement, the practical performance is often poor. We develop a self-tuning particle filter in which the proposal distribution is constructed adaptively through a sequence of Monte Carlo steps. Intuitively, we start from a measurement error distribution with an inflated variance, and then gradually reduce the variance to its nominal level in a sequence of steps that we call tempering. We show that the filter generates an unbiased and consistent approximation of the likelihood function. Holding the run time fixed, our filter is substantially more accurate in two DSGE model applications than the bootstrap particle filter.

Keywords: Bayesian Analysis, DSGE Models, Monte Carlo Methods, Nonlinear Filtering

DOI: http://dx.doi.org/10.17016/FEDS.2016.072

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FEDS 2016-071
Mutual Fund Flows, Monetary Policy and Financial Stability (PDF)

Ayelen Banegas, Gabriel Montes-Rojas, and Lucas Siga

Abstract: We study the links between monetary policy and mutual fund flows, and the potential risks to financial stability that might arise from such flows, using data over the 2000-14 period. We find that monetary policy can have a direct influence on the allocation decisions of mutual fund investors. In particular, we show that monetary policy shocks explain mutual fund flow dynamics and that the effect of these shocks differs by investment strategy. Results suggest that positive shocks to the path of monetary policy (unexpected tightening) are associated with persistent outflows from bond mutual funds. Conversely, a tighter-than-expected monetary policy path will cause net inflows into equity funds. In an industry that "mutualizes" redemption costs and where many funds may engage in liquidity transformation, our flow-performance analysis provides evidence of the potential existence of a first-mover advantage in less liquid segments of the market.

Keywords: First-mover advantage, Monetary policy, Mutual fund flows

DOI: http://dx.doi.org/10.17016/FEDS.2016.071

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FEDS 2016-070
Benchmarking Operational Risk Models (PDF)

Filippo Curti, Ibrahim Ergen, Minh Le, Marco Migueis, and Robert Stewart

Abstract: The 2004 Basel II accord requires internationally active banks to hold regulatory capital for operational risk, and the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) requires banks to project operational risk losses under stressed scenarios. As a result, banks subject to these rules have measured and managed operational risk more rigorously. But some types of operational risk - particularly legal risk - are challenging to model because such exposures tend to be fat-tailed. Tail operational risk losses have significantly impacted banks' balance sheets and income statements, even post crisis. So, operational risk practitioners, bank analysts, and regulators must develop reasonable methods to assess the efficacy of operational risk models and associated equity financing. We believe benchmarks should be used extensively to justify model outputs, improve model stability, and maintain capital reasonableness. Since any individual benchmark can be misleading, we outline a set of principles for using benchmarks effectively and describe how these principles can be applied to operational risk models. Also, we provide some examples of the benchmarks that have been used by US regulators in assessing Advanced Measurement Approach (AMA) capital reasonableness and that can be used in CCAR to assess the reasonableness of operational risk loss projections. We believe no single model's output and no single benchmark offers a comprehensive view, but that practitioners, analysts, and regulators must use models combined with rigorous benchmarks to determine operational risk capital and assess its adequacy.

Keywords: Banking regulation, Benchmarking, Operational risk, Risk management

DOI: http://dx.doi.org/10.17016/FEDS.2016.070

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FEDS 2016-069
The Bank as Grim Reaper: Debt Composition and Bankruptcy Thresholds (PDF)

Abstract: We offer a model and evidence that private debtholders play a key role in setting the endogenous asset value threshold below which corporations declare bankruptcy. The model, in the spirit of Black and Cox (1976), implies that the recovery rate at emergence from bankruptcy on all of the firm's debt taken together is increasing in the pre-bankruptcy share of private debt in all debt. Empirical evidence supports this and other implications of the model. Indeed, debt composition has a more economically material empirical influence on recovery than all other variables we try taken together.

Keywords: Bankruptcy, credit risk, debt default, recovery rates

DOI: http://dx.doi.org/10.17016/FEDS.2016.069

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FEDS 2016-068
Gauging the Ability of the FOMC to Respond to Future Recessions (PDF)

David Reifschneider

Abstract: Current forecasts suggest that the federal funds rate in the future is likely to level out at a rather low level by historical standards. If so, then the FOMC will have less ability than in the past to cut short-term interest rates in response to a future recession, suggesting a risk that economic downturns could turn out to be more severe as a result. However, simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited to cut short-term interest rates in most, but probably not all, circumstances.

Keywords: Monetary policy, asset purchases, forward guidance, zero lower bound

DOI: http://dx.doi.org/10.17016/FEDS.2016.068

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FEDS 2016-067
Financial Stability and Optimal Interest-Rate Policy (PDF)

Abstract: We study optimal interest-rate policy in a New Keynesian model in which the economy can experience financial crises and the probability of a crisis depends on credit conditions. The optimal adjustment to interest rates in response to credit conditions is (very) small in the model calibrated to match the historical relationship between credit conditions, output, inflation, and likelihood of financial crises. Given the imprecise estimates of key parameters, we also study optimal policy under parameter uncertainty. We find that Bayesian and robust central banks will respond more aggressively to financial instability when the probability and severity of financial crises are uncertain.

Keywords: Financial crises, Financial stability and risk, Leverage, Monetary policy, Optimal policy

DOI: http://dx.doi.org/10.17016/FEDS.2016.067

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FEDS 2016-066
Sectoral Dynamics and Business Cycles (PDF)

Abstract: I construct an index of sectoral dynamics to characterize changes in the sectoral composition of economic activity. There is evidence of asymmetry in different phases of business cycles with recessions being associated with larger changes in sectoral composition than expansions. I find that the correlation between dynamics in sectoral employment and aggregate output has weakened since the 1990s. Also, sectoral changes appear to be smaller and spread across more sectors, while their contribution to aggregate volatility has been increasing. I also perform a simulation exercise and replicate these documented facts. The results suggest that shifts in the sectoral composition of the economy likely contribute to the formation of business cycles. Also the duration of recessions implied by the impulse response functions from a VAR model of sectoral dynamics and aggregate output growth matches the duration of recessions observed in the data.

Keywords: Structural changes, business cycles, employment, labor share

DOI: http://dx.doi.org/10.17016/FEDS.2016.066

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FEDS 2016-065
Accurate Evaluation of Expected Shortfall for Linear Portfolios with Elliptically Distributed Risk Factors (PDF)

Abstract: We provide an accurate closed-form expression for the expected shortfall of linear portfolios with elliptically distributed risk factors. Our results aim to correct inaccuracies that originate in Kamdem (2005) and are present also in at least thirty other papers referencing it, including the recent survey by Nadarajah, Zhang, and Chan (2014) on estimation methods for expected shortfall. In particular, we show that the correction we provide in the popular multivariate Student t setting eliminates understatement of expected shortfall by a factor varying from at least 4 to more than 100 across different tail quantiles and degrees of freedom. As such, the resulting economic impact in financial risk management applications could be significant. We further correct such errors encountered also in closely related results in Kamdem (2007, 2009) for mixtures of elliptical distributions. More generally, our findings point to the extra scrutiny required when deploying new methods for expected shortfall estimation in practice.

Keywords: Expected shortfall, accurate closed-form expression, elliptical distributions, multivariate Student t distribution

DOI: http://dx.doi.org/10.17016/FEDS.2016.065r1

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Original: Full Paper

Original DOI: http://dx.doi.org/10.17016/FEDS.2016.065

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FEDS 2016-064
Trading Relationships in the OTC Market for Secured Claims: Evidence from Triparty Repos (PDF)

Song Han and Kleopatra Nikolaou

Abstract: We use a new panel data set on intraday transactions of triparty repos (TPR) to study trading relationships in the over-the-counter market. We test the prediction that search frictions lead to relationship formation. We find that TPR trading parties form relationships with a broad number of counterparties but tend to focus their transaction volumes on only a small set of counterparties. We also find that having stable relationships and broader interactions across other funding markets positively shapes the relationships of investors with dealers in the TPR market. Finally, our results suggest that relationships affect the likelihood of a trade and terms of trade and help buffer demand and supply shocks to liquidity. Specifically, the Fed's Reverse Repurchase (RRP) exercise draws funds away from lenders in the TPR market, effectively generating a negative shock to the supply of funds for dealers. Meanwhile, Treasury auctions introduce a positive shock to the demand for funds by dealers. We find that in both cases, shocks are absorbed better by trade partners with stronger relationships.

Keywords: Search frictions, OTC markets, RRP exercise, Trade relationship, Treasury Auctions, Triparty repos

DOI: http://dx.doi.org/10.17016/FEDS.2016.064

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FEDS 2016-063
Heterogeneity in the Dynamics of Disaggregate Unemployment (PDF)

Abstract: This paper explores the role that unobserved heterogeneity within an observed category plays in the dynamics of disaggregate unemployment and in the cross-sectional differences across individuals of the duration of unemployment spells. The distribution of unobserved heterogeneity is characterized as a mixture of two distributions with each mean and weight determined by the inflows and outflows of workers with unobserved types H and L, which are identified based on the nonlinear state-space model of Ahn and Hamilton (2016). I found that the contribution of each factor to the dynamics of disaggregate unemployment differs by observed category. The inflow of type L workers is the most important factor in the majority of demographic groups in the business-cycle frequency. I identify permanent job loss to be the observable characteristic most closely associated with the type L attribute. A simple model of heterogeneity based on two unobserved types can explain more than 50 percent of the cross-sectional dispersion in completed-duration spells after the Great Recession, while observed heterogeneity makes only a minor contribution.

Keywords: Great Recession, extended Kalman filter, genuine duration dependence, state space model, unemployment dynamics, unobserved heterogeneity

DOI: http://dx.doi.org/10.17016/FEDS.2016.063

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FEDS 2016-062
International Aspects of Central Banking: Diplomacy and Coordination (PDF)

Robert B. Kahn and Ellen E. Meade

Abstract: In this paper, we discuss the evolution of central bank interactions since the early 1970s following the breakdown of the managed exchange-rate system that was negotiated at Bretton Woods. We review the most important forums or organizations through which central banks have engaged in diplomacy. We then discuss the mobilization of coordination through diplomacy using three examples over the past 30 years: the Plaza Accord in 1985 negotiated by the G-5; the response to the Asian financial crisis in 1997-98, led by the International Monetary Fund (IMF) with heavy participation from G-7 finance ministries and central banks; and the response to the global financial crisis that began in 2007. For each of these examples, we provide the economic circumstances at the time, discuss how the response was mobilized, and evaluate its success. Our main conclusion is that the relationship-building that is inherent in multilateral interaction has provided a springboard for coordination in times of stress or crisis. Moreover, crises matter in that they can be turning points in terms of the actions taken and the countries included in the dialogue; thus, the groupings themselves are to some extent endogenous to events. Finally, we use the lens of diplomacy and coordination to trace out the path for central bank diplomacy going forward.

Keywords: Central bank coordination, Global financial institutions, International monetary system

DOI: http://dx.doi.org/10.17016/FEDS.2016.062

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FEDS 2016-061
The Risk-Adjusted Monetary Policy Rule (PDF)

Taisuke Nakata and Sebastian Schmidt

Abstract: Macroeconomists are increasingly using nonlinear models to account for the effects of risk in the analysis of business cycles. In the monetary business cycle models widely used at central banks, an explicit recognition of risk generates a wedge between the inflation-target parameter in the monetary policy rule and the risky steady state (RSS) of inflation---the rate to which inflation will eventually converge---which can be undesirable in some practical applications. We propose a simple modification to the standard monetary policy rule to eliminate the wedge. In the proposed risk-adjusted policy rule, the intercept of the rule is modified so that the RSS of inflation equals the inflation-target parameter in the policy rule.

Keywords: Effective Lower Bound, Inflation Targeting, Monetary Policy Rule, Risk, Risky Steady State

DOI: http://dx.doi.org/10.17016/FEDS.2016.061

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FEDS 2016-060
The Political Origin of Home Bias: the case of Europe (PDF)

Filippo De Marco and Marco Macchiavelli

Abstract: We show that politics is at the root of the banks-sovereign nexus that exacerbated the Eurozone crisis. First, government-owned banks or banks with politicians in the board of directors display higher home bias in sovereign debt compared to privately-owned banks throughout the 2010-2013 period. Second, only government-owned banks increased the home bias during the sovereign crisis (moral suasion). We exploit the fact that equity injections (bail-outs) by domestic governments were not directly targeted to politically connected banks to show that, upon receiving such assistance, only government-owned banks purchase domestic debt. Moral suasion is stronger in countries under stress.

Keywords: Banks' recapitalization, Banks-sovereign nexus, Board of directors, Government-owned banks, Home bias, Moral suasion

DOI: http://dx.doi.org/10.17016/FEDS.2016.060

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FEDS 2016-059
Did the Founding of the Federal Reserve Affect the Vulnerability of the Interbank System to Systemic Risk? (PDF)

Mark Carlson and David C. Wheelock

Abstract: As a result of legal restrictions on branch banking, an extensive interbank system developed in the United States during the 19th century to facilitate interregional payments and flows of liquidity and credit. Vast sums moved through the interbank system to meet seasonal and other demands, but the system also transmitted shocks during banking panics. The Federal Reserve was established in 1914 to reduce reliance on the interbank market and correct other defects that caused banking system instability. Drawing on recent theoretical work on interbank networks, we examine how the Fed?s establishment affected the system?s resilience to solvency and liquidity shocks and whether these shocks might have been contagious. We find that the interbank system became more resilient to solvency shocks but less resilient to liquidity shocks as banks sharply reduced their liquidity after the Fed?s founding. The industry?s response illustrates how the introduction of a lender of last resort can alter private behavior in a way that increases the likelihood that the lender will be needed.

Keywords: Federal Reserve System, National Banking System, banking panics, contagion, interbank networks, seasonal liquidity demand, systemic risk

DOI: http://dx.doi.org/10.17016/FEDS.2016.059

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FEDS 2016-058
Does Anyone Listen when Politicians Talk? The Effect of Political Commentaries on Policy Rate Decisions and Expectations (PDF)

Selva Demiralp, Sharmila King, and Chiara Scotti

Abstract: This paper investigates the effects of political commentaries on policy rate decisions and policy expectations in the United States and the euro area. The results suggest that political commentaries do influence policy rate expectations in both regions, even after controlling for macroeconomic releases and immediate interest rate expectations. The findings regarding the policy reaction functions reveal that market expectations are mostly rational. There is no evidence that the Federal Reserve responds to political commentaries that suggest rate hikes or easings. Meanwhile, the European Central Bank seems to have steered its policy in line with political commentaries that suggested further easings during the pre-crisis period, consistent with market expectations.

Keywords: Central bank independence, market expectations, unconventional policy

DOI: http://dx.doi.org/10.17016/FEDS.2016.058

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FEDS 2016-057
Bank Capital Regulations around the World: What Explains the Differences? (PDF)

Abstract: Despite the extensive attention that the Basel capital adequacy standards have received internationally, significant variation exists in the implementation of these standards across countries. Furthermore, a significant number of countries increase or decrease the stringency of capital regulations over time. The paper investigates the empirical determinants of the variation in the data based on the theories of bank capital regulation. The results show that countries with high average returns to investment and a high ratio of government ownership of banks choose less stringent capital regulation standards. Capital regulations may also be less stringent in countries with more concentrated banking sectors.

Keywords: Basel capital accord, Capital requirements, Financial regulation, international policy coordination

DOI: http://dx.doi.org/10.17016/FEDS.2016.057

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FEDS 2016-056
For Better and for Worse? Effects of Access to High-Cost Consumer Credit (PDF)

Abstract: I provide empirical evidence that the effect of high-cost credit access on household material well-being depends on if a household is experiencing temporary financial distress. Using detailed data on household consumption and location, as well as geographic variation in access to high-cost payday loans over time, I find that payday credit access improves well-being for households in distress by helping them smooth consumption. In periods of temporary financial distress--after extreme weather events like hurricanes and blizzards--I find that payday loan access mitigates declines in spending on food, mortgage payments, and home repairs. In an average period, however, I find that access to payday credit reduces well-being. Loan access reduces spending on nondurable goods overall and reduces housing- and food-related spending particularly. These results highlight the state-dependent nature of the effects of high-cost credit as well as the consumption-smoothing role that it plays for households with limited access to other forms of credit.

Keywords: Consumer credit, Consumption, Household finance, Payday loans

DOI: http://dx.doi.org/10.17016/FEDS.2016.056

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FEDS 2016-055
Financial Vulnerabilities, Macroeconomic Dynamics, and Monetary Policy (PDF)

David Aikman, Andreas Lehnert, Nellie Liang, and Michele Modugno

Abstract: We define a measure to be a financial vulnerability if, in a VAR framework that allows for nonlinearities, an impulse to the measure leads to an economic contraction. We evaluate alternative macrofinancial imbalances as vulnerabilities: nonfinancial sector credit, risk appetite of financial market participants, and the leverage and short-term funding of financial firms. We find that nonfinancial credit is a vulnerability: impulses to the credit-to-GDP gap when it is high leads to a recession. Risk appetite leads to an economic expansion in the near-term, but also higher credit and a recession in later years, suggesting an intertemporal tradeoff. Monetary policy is generally ineffective at slowing the economy once the credit-to-GDP gap is high, suggesting important benefits from avoiding excessive credit growth. Financial sector leverage and short-term funding do not lead directly to contractions and thus are not vulnerabilities by our definition.

Keywords: Financial stability and risk, credit, monetary policy

DOI: http://dx.doi.org/10.17016/FEDS.2016.055

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FEDS 2016-054
Optimal Unemployment Insurance and International Risk Sharing (PDF)

Stéphane Moyen, Nikolai Stähler, and Fabian Winkler

Abstract: We discuss how cross-country unemployment insurance can be used to improve international risk sharing. We use a two-country business cycle model with incomplete financial markets and frictional labor markets where the unemployment insurance scheme operates across both countries. Cross-country insurance through the unemployment insurance system can be achieved without affecting unemployment outcomes. The Ramsey-optimal policy however prescribes a more countercyclical replacement rate when international risk sharing concerns enter the unemployment insurance trade-off. We calibrate our model to Eurozone data and find that optimal stabilizing transfers through the unemployment insurance system are sizable and mainly stabilize consumption in the periphery countries, while optimal replacement rates are countercylical overall. Moreover, we find that debt-financed national policies are a poor substitute for fiscal transfers.

Keywords: Fiscal Union, International Business Cycles, International Risk Sharing, Unemployment Insurance

DOI: http://dx.doi.org/10.17016/FEDS.2016.054

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FEDS 2016-053
Labor Force Transitions at Older Ages: Burnout, Recovery, and Reverse Retirement (PDF)

Lindsay Jacobs and Suphanit Piyapromdee

Abstract: Partial and reverse retirement are two key behaviors characterizing labor force dynamics for individuals at older ages, with half working part-time and over a third leaving and later re-entering the labor force. The high rate of exit and re-entry is especially surprising given the declining wage profile at older ages and opportunities for re-entry in the future being uncertain. In this paper we study the effects of wage and health transition processes as well as the role of accrues work-related strain on the labor force participation on older males. We find that a model incorporating a work burnout-recovery process can account for such reverse retirement behavior that cannot be generated by health and wealth shocks alone, suggesting re-entry patterns result in large part from planned behavior. We first present descriptive statistics of the frequency and timing of re-entry and characteristics of those who re-enter using Health and Retirement Study (HRS) panel data. We then develop and estimate a dynamic model of retirement that captures the occurrence and timing of re-entry decisions observed in the data--as well as the transition to part-time work--while incorporating uncertainty in earnings, health, and stress accumulation. The burnout-recovery process allows us to account of for about 40 percent of re-entry, and one-quarter of the shifts to part-time work with age. We also consider the lower exit and re-entry rates after 2008, and attribute this to high option values of work in an environment where future re-entry is less certain. Consistent with out burnout-recovery model, we see that respondents are more likely to report high levels of job stress as they continue to work when they would have otherwise stopped working, recovered, and re-entered. This offers us some information about the relative option value of work versus the burnout-recovery process.

Keywords: labor supply, retirement

DOI: http://dx.doi.org/10.17016/FEDS.2016.053

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FEDS 2016-052
Funding Liquidity Risk and the Cross-section of MBS Returns (PDF)

Abstract: This paper shows that funding liquidity risk is priced in the cross-section of excess returns on agency mortgage-backed securities (MBS). We derive a measure of funding liquidity risk from dollar-roll implied financing rates (IFRs), which reflect security-level costs of financing positions in the MBS market. We show that factors representing higher net MBS supply are generally associated with higher IFRs, or higher funding costs. In addition, we find that exposure to systematic funding liquidity shocks embedded in the IFRs is compensated in the cross-section of expected excess returns--agency MBS that are better hedges to funding liquidity shocks on average deliver lower excess returns--and that these premiums are separate from the premiums associated with prepayment risks.

Keywords: Agency mortgage-backed securities, Dollar rolls, Expected returns, Implied financing rates, Large Scale Asset Purchase programs, Liquidity

DOI: http://dx.doi.org/10.17016/FEDS.2016.052

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FEDS 2016-051
Occupational Choice, Retirement, and the Effects of Disability Insurance (PDF)

Abstract: There is much variation in the physical requirements across occupations, giving rise to great differences in later-life productivity, disability risk, and the value of Social Security Disability Insurance (SSDI). In this paper, I look at how such differences across occupations affect initial career choice as well as the extent to which SSDI, which insures shocks to productivity due to disability, prompts more people to choose physically intense occupations. Using data from the Health and Retirement Study (HRS) and the Current Population Survey (CPS), I estimate a dynamic model of occupational choice and retirement with heterogeneous agents and equilibrium effects on earnings across occupations. I document the differences between blue-collar and white-collar occupations in the effects of declining health and disability on productivity, which affects labor supply in later life and, in the context of a life-cycle model, influences the occupation decision. Thro ugh counterfactual exercises, I show that the additional disability risk in blue-collar jobs relative to white-collar jobs is equivalent to an additional six percentage point reduction in lifetime consumption and that the absence of SSDI, which insures some of this risk, would be equivalent to, respectively, a twelve and seven percent reduction in consumption for those in blue- and white-collar jobs. Furthermore, I find that the presence of SSDI results in three percent more individuals choosing blue-collar occupations, which is comparable to the effect on occupation selection resulting from an eight-percent increase in blue-collar earnings. This overall effect, however, masks the importance of the selection of less risk-averse individuals into blue-collar jobs and the equilibrium effects on wages; earnings for the most risk-averse type would have to be nearly fifteen percent greater to choose blue-collar occupations in the absence of SSDI.

Keywords: Disability, life-cycle modeling, occupational choice, retirement

DOI: http://dx.doi.org/10.17016/FEDS.2016.051

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FEDS 2016-050
Securities Lending as Wholesale Funding: Evidence from the U.S. Life Insurance Industry (PDF)

Abstract: The existing literature implicitly or explicitly assumes that securities lenders primarily respond to demand from borrowers and reinvest their cash collateral through short-term markets. Using a new dataset that matches every U.S. life insurer's bond portfolio, as well as their lending and reinvestment decisions, to the universe of securities lending transactions, we offer compelling evidence for an alternative strategy, in which securities lending programs are used to finance a portfolio of long-dated assets. We discuss how the liquidity and maturity mismatch associated with using securities lending as a source of wholesale funding could potentially impair the functioning of the securities market.

Keywords: Life insurers, market liquidity, securities lending, wholesale funding

DOI: http://dx.doi.org/10.17016/FEDS.2016.050

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FEDS 2016-049
Monetary Policy, Real Activity, and Credit Spreads: Evidence from Bayesian Proxy SVARs (PDF)

Abstract: This paper studies the interaction between monetary policy, financial markets, and the real economy. We develop a Bayesian framework to estimate proxy structural vector autoregressions (SVARs) in which monetary policy shocks are identified by exploiting the information contained in high frequency data. For the Great Moderation period, we find that monetary policy shocks are key drivers of fluctuations in industrial output and corporate credit spreads, explaining about 20 percent of the volatility of these variables. Central to this result is a systematic component of monetary policy characterized by a direct and economically significant reaction to changes in credit spreads. We show that the failure to account for this endogenous reaction induces an attenuation bias in the response of all variables to monetary shocks.

Keywords: Bayesian Inference, Monetary policy, Vector Autoregressions

DOI: http://dx.doi.org/10.17016/FEDS.2016.049

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FEDS 2016-048
News versus Sentiment: Predicting Stock Returns from News Stories (PDF)

Steven L. Heston and Nitish R. Sinha

Abstract: This paper uses a dataset of more than 900,000 news stories to test whether news can predict stock returns. We measure sentiment with a proprietary Thomson-Reuters neural network. We find that daily news predicts stock returns for only 1 to 2 days, confirming previous research. Weekly news, however, predicts stock returns for one quarter. Positive news stories increase stock returns quickly, but negative stories have a long delayed reaction. Much of the delayed response to news occurs around the subsequent earnings announcement.

Keywords: News, Text Analysis

DOI: http://dx.doi.org/10.17016/FEDS.2016.048

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FEDS 2016-047
Why are Inventory-Sales Ratios at U.S. Auto Dealerships so High? (PDF)

Abstract: Motor vehicle dealerships in the United States tend to hold inventories equivalent to around 65 days' worth of sales, a relatively high level that has been nearly unchanged for 50 years. Despite playing a prominent role in the volatility of U.S. business cycles, very little is known about why the auto industry targets inventory stocks at such a high level. We use a panel of inventory and sales data from 41 vehicle brands over 30 years and the solutions to two well-known inventory planning problems to show that vehicle inventories appear to be related to (1) the size of dealership franchise networks, which tend to be large; (2) product variety, which tends to be high; and (3) the volatility of new vehicle sales, which also tends to be high. We show that differences across brands in these variables explain a good bit of the cross-section dispersion in brand inventory-sales ratios. Offsetting changes in these factors over time also help explain why the industry's overall inventory-sales ratio has been quite flat for many decades. More recently, the net increase observed in the inventory-sales ratio in the past couple of years is in contrast to fit of the model, which might suggest that some of that increase could reverse in the coming years.

Keywords: Inventories, Motor Vehicles

DOI: http://dx.doi.org/10.17016/FEDS.2016.047

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FEDS 2016-046
Do Rising Top Incomes Lead to Increased Borrowing in the Rest of the Distribution? (PDF)

Abstract: One potential consequence of rising concentration of income at the top of the distribution is increased borrowing, as less affluent households attempt to maintain standards of living with less income. This paper explores the "keeping up with the Joneses" phenomenon using data from the Survey of Consumer Finances. Specifically, it examines the responsiveness of payment-to-income ratios for different debt types at different parts of the income distribution to changes in the income thresholds at the 95th and 99th percentiles. The analysis provides some evidence indicating that household debt payments are responsive to rising top incomes. Middle and upper-middle income households take on more housing-related debt and have higher housing debt payment to income ratios in places with higher top income levels. Among households at the bottom of the income distribution there is a decline in non-mortgage borrowing and debt payments in areas with rising top-income levels, consistent with restrictions in the supply of credit. The analysis also consistently shows that 95th percentile income has a greater influence on borrowing and debt payment across in the rest of the distribution than the more affluent 99th percentile level.

Keywords: Consumption, Debt, Inequality

DOI: http://dx.doi.org/10.17016/FEDS.2016.046

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FEDS 2016-045
Accounting for Productivity Dispersion over the Business Cycle (PDF)

Robert J. Kurtzman and David Zeke

Abstract: This paper presents accounting decompositions of changes in aggregate labor and capital productivity. Our simplest decomposition breaks changes in an aggregate productivity ratio into two components: A mean component, which captures common changes to firm factor productivity ratios, and a dispersion component, which captures changes in the variance and higher order moments of their distribution. In standard models with heterogeneous firms and frictions to firm input decisions, the dispersion component is a function of changes in the second and higher moments of the log of marginal revenue factor productivities and reflects changes in the extent of distortions to firm factor input allocations across firms. We apply our decomposition to public firm data from the United States and Japan. We find that the mean component is responsible for most of the variation in aggregate productivity over the business cycle, while the dispersion component plays a modest role.

Keywords: Accounting Decomposition, Business Cycles, Misallocation, Productivity

DOI: http://dx.doi.org/10.17016/FEDS.2016.045

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FEDS 2016-044
Nowcasting Turkish GDP and News Decomposition (PDF)

Michele Modugno, Baris Soybilgen, and Ege Yazgan

Abstract: Real gross domestic product (GDP) data in Turkey are released with a very long delay compared with other economies, between 10 and 13 weeks after the end of the reference quarter. To infer the current state of the economy, policy makers, media, and market practitioners examine data that are more timely, that are released at higher frequencies than the GDP. In this paper, we propose an econometric model that automatically allows us to read through these more current and higher-frequency data and translate them into nowcasts for the Turkish real GDP. Our model outperforms nowcasts produced by the Central Bank of Turkey, the International Monetary Fund, and the Organization for Economic Co-operation and Development. Moreover, our model allows us to quantify the importance of each variable in our dataset in nowcasting Turkish real GDP. In line with findings for other economies, we find that real variables play the most important role; however, contrary to the findings for other economies, we find that financial variables are as important as surveys.

Keywords: Developing economy, dynamic factor model, emerging market, gross domestic product, news, nowcasting

DOI: http://dx.doi.org/10.17016/FEDS.2016.044

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FEDS 2016-043
Firm Entry and Macroeconomic Dynamics: A State-level Analysis (PDF)

Francois Gourio, Todd Messer, and Michael Siemer

Abstract: Using an annual panel of US states over the period 1982-2014, we estimate the response of macroeconomic variables to a shock to the number of new firms (startups). We find that these shocks have significant effects that persist for many years on real GDP, productivity, and population. This is consistent with simple models of firm dynamics where a "missing generation" of firms affects productivity persistently.

Keywords: Productivity, business dynamics, employment, firm entry, missing generation, new business formation

DOI: http://dx.doi.org/10.17016/FEDS.2016.043

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FEDS 2016-042
Credit Default Swaps in General Equilibrium: Spillovers, Credit Spreads, and Endogenous Default (PDF)

R. Matthew Darst and Ehraz Refayet

Abstract: This paper highlights two new effects of credit default swap markets (CDS) in a general equilibrium setting. First, when firms' cash flows are correlated, CDSs impact the cost of capital?credit spreads?and investment for all firms, even those that are not CDS reference entities. Second, when firms internalize the credit spread changes, the incentive to issue safe rather than risky bonds is fundamentally altered. Issuing safe debt requires a transfer of profits from good states to bad states to ensure full repayment. Alternatively, issuing risky bonds maximizes profits in good states at the expense of default in bad states. Profits fall when credit spreads increase, which raises the opportunity cost of issuing risky debt compared to issuing safe debt. Symmetrically, lower credit spreads reduce the opportunity cost of issuing risky debt relative to safe debt. CDSs affect the credit spread at which firms issue risky debt, and ultimately the opportunity cost of issuing defa ultable bonds even when underlying firm fundamentals remain unchanged. Hedging (Speculating on) credit risk lowers (raises) credit spreads and enlarges (reduces) the parameter region over which firms choose to issue risky debt.

Keywords: Credit derivatives, default risk, investment, spillovers

DOI: http://dx.doi.org/10.17016/FEDS.2016.042r1

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Original paper (PDF)

Original DOI: http://dx.doi.org/10.17016/FEDS.2016.042

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FEDS 2016-041
What does it take to list abroad? The Role of Global Underwriters (PDF)

Cecilia R. Caglio, Kathleen Weiss Hanley, and Jennifer Marietta-Westberg

Abstract: This paper examines which firms benefit the most from going public abroad and how a robust IPO market affects the trend toward greater globalization of capital. We show that the decision to do an IPO outside the home country is affected not only by the home country's market characteristics but also the extent to which it is financially integrated with the world economy. In addition, we provide evidence that the decisions of whether to go public abroad, where to list, and the amount of proceeds raised are determined by the presence of global underwriters. Our results suggest that the rise of global underwriters facilitates the movement of capital across nations and is one of the channels by which world globalization can affect the IPO process.

Keywords: IPO, globalization, proceeds, underwriter

DOI: http://dx.doi.org/10.17016/FEDS.2016.041

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FEDS 2016-040
A New Approach to Identifying the Real Effects of Uncertainty Shocks (PDF)

Minchul Shin and Molin Zhong

Abstract: This paper proposes a multivariate stochastic volatility-in-vector autoregression model called the conditional autoregressive inverse Wishart-in-VAR (CAIW-in-VAR) model as a framework for studying the real effects of uncertainty shocks. We make three contributions to the literature. First, the uncertainty shocks we analyze are estimated directly from macroeconomic data so they are associated with changes in the volatility of the shocks hitting the macroeconomy. Second, we advance a new approach to identify uncertainty shocks by placing limited economic restrictions on the first and second moment responses to these shocks. Third, we consider an extension of the sign restrictions methodology of Uhlig (2005) to uncertainty shocks. To illustrate our methods, we ask what is the role of financial markets in transmitting uncertainty shocks to the real economy? We find evidence that an increase in uncertainty leads to a decline in industrial production only if associated with a deterioration in financial conditions.

Keywords: Multivariate stochastic volatility, Uncertainty, Vector autoregression, Volatility-in-mean, Wishart process

DOI: http://dx.doi.org/10.17016/FEDS.2016.040

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FEDS 2016-039
Does Trade Liberalization with China Influence U.S. Elections? (PDF)

Yi Che, Yi Lu, Justin R. Pierce, Peter K. Schott, and Zhigang Tao

Abstract: This paper examines the impact of trade liberalization on U.S. Congressional elections. We find that U.S. counties subject to greater competition from China via a change in U.S. trade policy exhibit relative increases in turnout, the share of votes cast for Democrats and the probability that the county is represented by a Democrat. We find that these changes are consistent with Democrats in office being more likely than Republicans to support legislation limiting import competition or favoring economic assistance.

Keywords: China, Elections, Import Competition, Normal Trade Relations, Voting, World Trade Organization

DOI: http://dx.doi.org/10.17016/FEDS.2016.039

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FEDS 2016-038
The Distributional Effects of a Carbon Tax on Current and Future Generations (PDF)

Stephie Fried, Kevin Novan, and William B. Peterman

Abstract: This paper examines the non-environmental welfare effects of introducing a revenue-neutral carbon tax policy. Using a life cycle model, we find that the welfare effects of the policy differ substantially for agents who are alive when the policy is enacted compared to those who are born into the new steady state with the carbon tax in place. Consistent with previous studies, we demonstrate that, for those born in the new steady state, the welfare costs are always lower when the carbon tax revenue is used to reduce an existing distortionary tax as opposed to being returned in the form of lump-sum payments. In contrast, during the transition, we find that rebating the revenue with a lump sum transfer is less costly than using the revenue to reduce the distortionary labor tax. Additionally, we find that the tax policy is substantially more regressive over the transition than in the steady state, regardless of what is done with the revenue. Overall, our results demonstrate that estimates of the non-environmental welfare costs of carbon tax policies that are based solely on the long-run, steady state outcomes may ultimately paint too rosy of a picture. Thus, when designing climate policies, policymakers must pay careful attention to not only the long-run outcomes, but also the transitional welfare costs and regressivity of the policy.

Keywords: Carbon taxation, overlapping generations

DOI: http://dx.doi.org/10.17016/FEDS.2016.038

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FEDS 2016-037
Political Conflict and Foreign Portfolio Investment: Evidence from North Korean Attacks (PDF)

Jeffrey R. Gerlach and Youngsuk Yook

Abstract: We examine the response of foreign investors to escalating political conflict and its impact on the South Korean stock market surrounding 13 North Korean military attacks between 1999 and 2010. Using domestic institutions and domestic individuals as benchmarks, we evaluate the trading behavior and performance of foreign investors. Following attacks, foreigners increase their holdings of Korean stocks and buy more shares of risky stocks. Performance results show foreigners maintain their pre-attack level of performance while domestic individuals, who make the overwhelming majority of domestic trades, perform worse. In addition, domestic institutions improve their performance. Overall, the results are consistent with the predictions based on the benefits of international diversification. Unlike domestic individuals, foreigners trade more shares than usual and deviate from their general strategy of positive feedback trading.

Keywords: Foreign portfolio investment, North Korean attacks, Political conflict

DOI: http://dx.doi.org/10.17016/FEDS.2016.037

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FEDS 2016-036
A Nowcasting Model for Canada: Do U.S. Variables Matter? (PDF)

Daniela Bragoli and Michele Modugno

Abstract: We propose a dynamic factor model for nowcasting the growth rate of quarterly real Canadian gross domestic product. We show that the proposed model produces more accurate nowcasts than those produced by institutional forecasters, like the Bank of Canada, the The Organisation for Economic Co-operation and Development (OECD), and the survey collected by Bloomberg, which reflects the median forecast of market participants. We show that including U.S. data in a nowcasting model for Canada dramatically improves its predictive accuracy, mainly because of the absence of timely production data for Canada. Moreover, Statistics Canada produces a monthly real GDP measure along with the quarterly one, and we show how to modify the state space representation of our model to properly link the monthly GDP with its quarterly counterpart.

Keywords: Dynamic Factor Model, Nowcasting, Updating

DOI: http://dx.doi.org/10.17016/FEDS.2016.036

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FEDS 2016-035
Inflation Expectations and the Stabilization of Inflation: Alternative Hypotheses (PDF)

Abstract: This paper examines two candidate hypotheses explaining the stabilization of U.S. inflation since the 1970s and 1980s. The first explanation credits the stabilization of inflation expectations, and assumes those expectations have a strong positive causal effect on actual subsequent inflation, while the second explanation credits the disappearance of such a strong positive causal effect. The paper reports statistical tests favorable to both a stabilization of inflation expectations and a marked decline in the effect of the general public's inflation expectations on subsequent inflation.

Keywords: Inflation, Phillips Curve

DOI: http://dx.doi.org/10.17016/FEDS.2016.035

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FEDS 2016-034
Microstructure Invariance in U.S. Stock Market Trades (PDF)

Albert S. Kyle, Anna A. Obizhaeva, and Tugkan Tuzun

Abstract: This paper studies invariance relationships in tick-by-tick transaction data in the U.S. stock market. Over the period 1993-2001, the estimated monthly regression coefficients of the log of trade arrival rate on the log of trading activity have an almost constant value of 0.666, strikingly close to the value of 2/3 predicted by invariance hypothesis. Over the period 2001-2014, the estimated coefficients rise, and their average value is equal to 0.79, suggesting that the reduction in tick size in 2001 and subsequent increase in algorithmic trading resulted in a more intense order shredding in more liquid stocks. The distributions of trade sizes, adjusted for differences in trading activity, resemble a log-normal before 2001; there are clearly visible truncation at the round-lot boundary and clustering of trades at even-levels. These distributions change dramatically over the period 2001-2014 with their means shifting downwards. The invariance hypothesis explains about 88% of the cross-sectional variation in trade arrival rates and average trade sizes; additional explanatory variables include invariance-implied measure of effective price volatility.

Keywords: TAQ data, market frictions, market microstructure, order shredding, tick size, trade size, transactions data

DOI: http://dx.doi.org/10.17016/FEDS.2016.034

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FEDS 2016-033
Time Series Model of Interest Rates With the Effective Lower Bound (PDF)

Benjamin K. Johannsen and Elmar Mertens

Abstract: Modeling interest rates over samples that include the Great Recession requires taking stock of the effective lower bound (ELB) on nominal interest rates. We propose a flexible time--series approach which includes a "shadow rate''---a notional rate that is less than the ELB during the period in which the bound is binding---without imposing no--arbitrage assumptions. The approach allows us to estimate the behavior of trend real rates as well as expected future interest rates in recent years.

Keywords: Bayesian Econometrics, Effective Lower Bound, Shadow Rate, State-Space Model, Term Structure of Interest Rates

DOI: http://dx.doi.org/10.17016/FEDS.2016.033

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FEDS 2016-032
Real and Nominal Equilibrium Yield Curves: Wage Rigidities and Permanent Shocks (PDF)

Alex Hsu, Erica X.N. Li, and Francisco Palomino

Abstract: The links between real and nominal bond risk premia and macroeconomic dynamics are explored quantitatively in a model with nominal rigidities and monetary policy. The estimated model captures macroeconomic and yield curve properties of the U.S. economy, implying significantly positive real term and inflation risk bond premia. In contrast to previous literature, both premia are positive and generated by wage rigidities as a compensation for permanent productivity shocks. Stronger policy-rule responses to inflation (output) increase (decrease) both premia, while policy surprises generate negligible risk premia. Empirical evidence of the economic mechanism is provided.

Keywords: Bond risk premia, Monetary policy, Nominal rigidities, Yield curve

DOI: http://dx.doi.org/10.17016/FEDS.2016.032

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FEDS 2016-031
FHA, Fannie Mae, Freddie Mac, and the Great Recession (PDF)

Abstract: The Great Recession provides an opportunity to test the proposition that government mortgage insurance programs mitigated the effects of the financial crisis and enhanced the economic recovery from 2009 to 2014. We find that government-sponsored mortgage insurance programs have been responsible for better economic outcomes in counties that participated heavily in these programs. In particular, counties with high levels of participation from government-sponsored enterprises and the Federal Housing Authority had relatively lower unemployment rates, higher home sales, higher home prices, lower mortgage delinquency rates, and less foreclosure activity, both in 2009 (soon after the peak of the financial crisis) and in 2014 (six years after the crisis) than did counties with lower levels of participation. The persistence of better outcomes in counties with heavy participation in federal government programs is consistent with a view that lower government liquidity premiums , lower government credit-risk premiums, and looser government mortgage-underwriting standards yield higher private-sector economic activity after a financial crisis.

Keywords: Financial crisis, Great Recssion, government policy, mortgages

DOI: http://dx.doi.org/10.17016/FEDS.2016.031

Accessible materials (.zip)

Original paper: PDF | Accessible materials (.zip)


FEDS 2016-030
Only Winners in Tough Times Repeat: Hedge Fund Performance Persistence over Different Market Conditions (PDF)

Zheng Sun, Ashley W. Wang, and Lu Zheng

Abstract: We provide novel evidence that hedge fund performance is persistent following weak hedge fund markets, but is not persistent following strong markets. Specifically, we construct two performance measures, DownsideReturns and UpsideReturns, conditioned on the level of overall hedge fund sector returns. After adjusting for risks, funds in the highest DownsideReturns quintile outperform funds in the lowest quintile by about 7% in the subsequent year, whereas funds with better UpsideReturns do not outperform subsequently. The DownsideReturns can predict future fund performance over a horizon as long as 3 years, for both winners and losers, and for funds with few share restrictions.

Keywords: Conditional performance, Hedge funds, Performance Persistence

DOI: http://dx.doi.org/10.17016/FEDS.2016.030

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FEDS 2016-029
Banking Consolidation and Small Firm Financing for Research and Development (PDF)

Abstract: This paper examines the effect of increased market concentration of the banking industry caused by the Riegle-Neal Interstate Banking and Branching Efficiency Act (IBBEA) on the availability of finance for small firms engaged in research and development (R&D). I measure the financing decisions of these small firms using a balanced panel of Small Business Innovation Research (SBIR) applications. Using difference-in-differences, I find IBBEA decreased the supply of finance for small R&D firms. This effect is larger for late adopters of IBBEA, which tended to be states with stronger small banking sectors pre-IBBEA.

Keywords: Banking Deregulation, IBBEA, Interstate Bank Branching Deregulation, Market Concentration, Research and Development, Riegle-Neal, Small Business Innovation Research

DOI: http://dx.doi.org/10.17016/FEDS.2016.029

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FEDS 2016-028
State Capacity and Public Goods: Institutional Change, Human Capital, and Growth in Early Modern Germany (PDF)

Jeremiah E. Dittmar and Ralf R. Meisenzahl

Abstract: What are the origins and consequences of the state as a provider of public goods? We study legal reforms that established mass public education and increased state capacity in German cities during the 1500s. These fundamental changes in public goods provision occurred where ideological competition during the Protestant Reformation interacted with popular politics at the local level. We document that cities that formalized public goods provision in the 1500s began differentially producing and attracting upper tail human capital and grew to be significantly larger in the long-run. We study plague outbreaks in a narrow time period as exogenous shocks to local politics and find support for a causal interpretation of the relationship between public goods institutions, human capital, and growth. More broadly, we provide evidence on the origins of state capacity directly targeting welfare improvement.

Keywords: Education, Growth, Human Capital, Institutions, Persistence, State Capacity

DOI: http://dx.doi.org/10.17016/FEDS.2016.028

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FEDS 2016-027
From Which Consumption-Based Asset Pricing Models Can Investors Profit? Evidence from Model-Based Priors (PDF)

Abstract: This paper compares consumption-based asset pricing models based on the forecasting performance of investors who use economic constraints derived from the models to predict the equity premium. Three prominent asset pricing models are considered: Habit Formation, Long Run Risk, and Prospect Theory. I propose a simple Bayesian framework through which the investors impose the economic constraints as model-based priors on the parameters of their predictive regressions. An investor whose prior beliefs are rooted in the Long Run Risk model achieves more accurate forecasts overall. The greatest difference in performance occurs during the bull market of the late 1990s. During this period, the weak predictability of the equity premium implied by the Long Run Risk model helps the investor to not prematurely anticipate falling stock prices.

Keywords: Bayesian econometrics, consumption-based asset pricing, return predictability

DOI: http://dx.doi.org/10.17016/FEDS.2016.027r1

Accessible materials (.zip)

Original: Full paper | Accessible materials (.zip)

FEDS 2016-026
Bank regulation under fire sale externalities (PDF)

Gazi I. Kara and S. Mehmet Ozsoy

Abstract: This paper examines the optimal design of and interaction between capital and liquidity regulations in a model characterized by fire sale externalities. In the model, banks can insure against potential liquidity shocks by hoarding sufficient precautionary liquid assets. However, it is never optimal to fully insure, so realized liquidity shocks trigger an asset fire sale. Banks, not internalizing the fire sale externality, overinvest in the risky asset and underinvest in the liquid asset in the unregulated competitive equilibrium. Capital requirements can lead to less severe fire sales by addressing the inefficiency and reducing risky assets--however, we show that banks respond to stricter capital requirements by decreasing their liquidity ratios. Anticipating this response, the regulator preemptively sets capital ratios at high levels. Ultimately, this interplay between banks and the regulator leads to inefficiently low levels of risky assets and liquidity. Macroprudential liquidity requirements that complement capital regulations, as in Basel III, restore constrained efficiency, improve financial stability and allow for a higher level of investment in risky assets.

Keywords: Bank capital regulation, Basel III, fire sale externality, liquidity regulation

DOI: http://dx.doi.org/10.17016/FEDS.2016.026

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FEDS 2016-025
The impact of unconventional monetary policy on firm financing constraints: Evidence from the maturity extension program (PDF)

Nathan Foley-Fisher, Rodney Ramcharan, and Edison Yu

Abstract: This paper investigates the impact of unconventional monetary policy on firm financial constraints. It focuses on the Federal Reserve's maturity extension program (MEP), intended to lower longer term rates and flatten the yield curve by reducing the supply of long-term government debt. Consistent with those models that emphasize bond market segmentation and limits to arbitrage, around the MEP's announcement, stock prices rose most sharply for those firms that are more dependent on longer-term debt. These firms also issued more long-term debt during the MEP and expanded employment and investment. These responses are most pronounced for those firms that are larger and older, and hence less likely to be financially constrained. There is also evidence of "reach for yield" behavior among some institutional investors, as the demand for riskier corporate debt also rose during the MEP. Our results suggest that unconventional monetary policy might have helped to relax financial constraints for some types of firms in part by inducing gap-filling behavior and affecting the pricing of risk in the bond market.

Keywords: Bond markets, firm-financial constraints, unconventional monetary policy

DOI: http://dx.doi.org/10.17016/FEDS.2016.025

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FEDS 2016-024
Non-Stationary Dynamic Factor Models for Large Datasets (PDF)

Matteo Barigozzi, Marco Lippi, and Matteo Luciani

Abstract:We study a Large-Dimensional Non-Stationary Dynamic Factor Model where (1) the factors Ft are I(1) and singular, that is Ft has dimension r and is driven by q dynamic shocks with q < r, (2) the idiosyncratic components are either I(0) or I(1). Under these assumption the factors Ft are cointegrated and modeled by a singular Error Correction Model. We provide conditions for consistent estimation, as both the cross-sectional size n,and the time dimension T, go to infinity, of the factors, the loadings, the shocks, the ECM coefficients and therefore the Impulse Response Functions. Finally, the numerical properties of our estimator are explored by means of a MonteCarlo exercise and of a real-data application, in which we study the effects of monetary policy and supply shocks on the US economy.

Keywords: Dynamic Factor models, unit root processes, cointegration, common trends, impulse response functions

DOI: http://dx.doi.org/10.17016/FEDS.2016.024r1

Accessible materials (.zip)

Original: Full Paper (PDF) | Accessible materials (.zip)

Original DOI: http://dx.doi.org/10.17016/FEDS.2016.024

FEDS 2016-023
Modelling Overnight RRP Participation (PDF)

Abstract: We examine how market participants have used the Federal Reserve's overnight reverse repurchase (ON RRP) exercise and how short-term interest rates have evolved between December 2013 and November 2014. We show that money market fund (MMF) participation is sensitive to the spread between market repo rates and the ON RRP offering rate as well as Treasury bill issuance, government sponsored enterprise (GSE) participation is more heavily driven by calendar effects, dealers tend to only participate when rate spreads are negative, and banks generally do not participate. We also find that the effect of the ON RRP on overnight interest rates is more significant in the collateralized market than the uncollateralized market.

Keywords: Federal Reserve System operations, Monetary policy, federal funds, money market funds, overnight RRP, repurchase agreements

DOI: http://dx.doi.org/10.17016/FEDS.2016.023

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FEDS 2016-022
Time-varying Volatility and the Power Law Distribution of Stock Returns (PDF)

Abstract: While many studies find that the tail distribution of high frequency stock returns follow a power law, there are only a few explanations for this finding. This study presents evidence that time-varying volatility can account for the power law property of high frequency stock returns. The power law coefficients obtained by estimating a conditional normal model with nonparametric volatility show a striking correspondence to the power law coefficients estimated from returns data for stocks in the Dow Jones index. A cross-sectional regression of the data coefficients on the model-implied coefficients yields a slope close to one, supportive of the hypothesis that the two sets of power law coefficients are identical. Further, for most of the stocks in the sample taken individually, the model-implied coefficient falls within the 95 percent confidence interval for the coefficient estimated from returns data.

Keywords: High frequency returns, Power laws, Tail distributions, Time-varying volatility

DOI: http://dx.doi.org/10.17016/FEDS.2016.022

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FEDS 2016-021
What are the Perceived Barriers to Homeownership for Young Adults? (PDF)

Jeff Larrimore, Jenny Schuetz, and Samuel Dodini

Abstract: As the U.S. emerges from the Great Recession, there is concern about slowing rates of new household formation and declining interest in homeownership, especially among younger households. Potential reasons that have been posited include tight mortgage credit and housing supply, changing preferences over tenure in the wake of the foreclosure crisis, and weak labor markets for young workers. In this paper, we examine how individual housing choices, and the stated motivations for these choices, reflect local housing affordability and individual financial circumstances, focusing particularly on young households. The analysis makes use of new individual-level data from the Survey of Household Economics and Decisionmaking (SHED). We find that housing affordability is correlated with county-level tenure rates and individual-level probability of homeownership for households with heads under age 40. However, it appears that young households' perceived barriers to homeownership are more closely related to individual financial circumstances than local housing market conditions.

Keywords: Housing demand, consumer preferences, household formation, tenure choice

DOI: http://dx.doi.org/10.17016/FEDS.2016.021

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FEDS 2016-020
Does Zoning Help or Hinder Transit-Oriented (Re)Development? (PDF)

Jenny Schuetz, Genevieve Giuliano, and Eun Jin Shin

Abstract: Despite its reputation as a car-oriented city, the Los Angeles metropolitan area has made substantial investments in developing rail transit since 1990. In cities with older "legacy" rail systems, the built environment has developed over time around fixed transit infrastructure, creating land use patterns oriented towards long-standing rail stations. By contrast, rail stations in Los Angeles were added to an already dense built environment, with auto oriented zoning and established land use patterns. In this paper we ask whether redevelopment is occurring around Los Angeles' rail stations, and whether zoning and related public policies are facilitating or constraining transit-oriented development. We conduct case studies of six Metro rail stations in the Los Angeles region, documenting the existing built environment, key components of zoning and land use planning, and the extent and type of new development in the immediate vicinity of stations after they opened. Results illustrate that redevelopment around transit stations involves complex interactions between physical environment, economic conditions and public interventions. Incompatible zoning and related land use policies may constrain growth near stations, but TOD-friendly zoning alone is not sufficient to spur development.

Keywords: Public transportation, housing markets, land use planning, local government, urban spatial structure, zoning

DOI: http://dx.doi.org/10.17016/FEDS.2016.020

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FEDS 2016-019
The Role of Learning for Asset Prices and Business Cycles (PDF)

Abstract: I examine the implications of learning-based asset pricing in a model in which firms face credit constraints that depend partly on their market value. Agents learn about stock prices, but have conditionally model-consistent expectations otherwise. The model jointly matches key asset price and business cycle statistics, while the combination of financial frictions and learning produces powerful feedback between asset prices and real activity, adding substantial amplification. The model reproduces many patterns of forecast error predictability in survey data that are inconsistent with rational expectations. A reaction of the monetary policy rule to asset price growth increases welfare under learning.

Keywords: Asset Pricing, Credit Constraints, Learning, Monetary policy, Survey Data

Accessible materials (.zip)

DOI: http://dx.doi.org/10.17016/FEDS.2016.019r1

Original paper: PDF | Accessible materials (.zip)

FEDS 2016-018
Dynamic Factor Models, Cointegration, and Error Correction Mechanisms (PDF)

Matteo Barigozzi, Marco Lippi, and Matteo Luciani

Abstract: The paper studies Non-Stationary Dynamic Factor Models such that: (1) the factors F are I(1) and singular, i.e. F has dimension r and is driven by a q-dimensional white noise, the common shocks, with q < r, and (2) the idiosyncratic components are I(1). We show that F is driven by r-c permanent shocks, where c is the cointegration rank of F, and q-(r-c) < c transitory shocks, thus the same result as in the non-singular case for the permanent shocks but not for the transitory shocks. Our main result is obtained by combining the classic Granger Representation Theorem with recent results by Anderson and Deistler on singular stochastic vectors: if (1-L)F is singular and has rational spectral density then, for generic values of the parameters, F has an autoregressive representation with a finite-degree matrix polynomial fulfilling the restrictions of a Vector Error Correction Mechanism with c error terms. This result is the basis for consistent estimation of Non-Stat ionary Dynamic Factor Models. The relationship between cointegration of the factors and cointegration of the observable variables is also discussed.

Keywords: Cointegration for singular vectors, Dynamic Factor Models for I(1) variables, Granger Representation Theorem for singular vectors

DOI: http://dx.doi.org/10.17016/FEDS.2016.018

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FEDS 2016-017
Does the United States have a Productivity Slowdown or a Measurement Problem (PDF)

David M. Byrne, John G. Fernald, and Marshall B. Reinsdorf

Abstract: After 2004, measured growth in labor productivity and total-factor productivity (TFP) slowed. We find little evidence that the slowdown arises from growing mismeasurement of the gains from innovation in IT-related goods and services. First, mismeasurement of IT hardware is significant prior to the slowdown. Because the domestic production of these products has fallen, the quantitative effect on productivity was larger in the 1995-2004 period than since, despite mismeasurement worsening for some types of IT--so our adjustments make the slowdown in labor productivity worse. The effect on TFP is more muted. Second, many of the tremendous consumer benefits from smartphones, Google searches, and Facebook are, conceptually, non-market: Consumers are more productive in using their nonmarket time to produce services they value. These benefits do not mean that market-sector production functions are shifting out more rapidly than measured, even if consumer welfare is rising. Still, gains in non-market production appear too small to compensate for the loss in overall wellbeing from slower market-sector productivity growth. Third, other measurement issues we can quantify (such as increasing globalization and fracking) are also quantitatively small relative to the slowdown. Finally, we suggest high-priority areas for future research.

Keywords: Information technology, Measurement, Non-market production, Prices, Productivity

DOI: http://dx.doi.org/10.17016/FEDS.2016.017

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FEDS 2016-016
Federal Reserve Board Statistical Releases: a Publications History (PDF)

Sian L. Seldin

Abstract: The Board of Governors of the Federal Reserve System has published extensive statistical information on the U.S. economy and banking industry since 1914. This information has been published in various formats, usually referred to as "statistical releases." Titles and release numbers of the publications have changed frequently. Federal Reserve Board Statistical Releases: a Publications History describes these changes; it is a convenient tool that lightens the burden of tracing the titles and release numbers by providing history in a single location.

Keywords: Data collection and estimation, Economic history, Federal Reserve Board and Federal Reserve System

DOI: http://dx.doi.org/10.17016/FEDS.2016.016

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FEDS 2016-015
Understanding Declining Fluidity in the U.S. Labor Market (PDF)

Abstract: We document a clear downward trend in labor market fluidity that is common across a variety of measures of worker and job turnover. This trend dates to at least the early 1980s if not somewhat earlier. Next we pull together evidence on a variety of hypotheses that might explain this downward trend. It is only partly related to population demographics and is not due to the secular shift in industrial composition. Moreover, the decline in labor market fluidity seems unlikely to have been caused by an improvement in worker-firm matching, the formalization of hiring practices, or an increase in land use regulation or other regulations. Plausible avenues for further exploration include changes in the worker-firm relationship, particularly with regard to compensation adjustment; changes in firm characteristics such as firm size and age; and a decline in social trust, which may have increased the cost of job search or made both parties in the hiring process more risk averse.

Keywords: demographic trends, hires and separations, job creation and destruction, job turnover, labor market churn, labor market transitions, labor reallocation

DOI: http://dx.doi.org/10.17016/FEDS.2016.015

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FEDS 2016-014
Deadlines and Matching (PDF)

Garth Baughman

Abstract: Deadlines and fixed end dates are pervasive in matching markets including school choice, the market for new graduates, and even financial markets such as the market for federal funds. Deadlines drive fundamental non-stationarity and complexity in behavior, generating significant departures from the steady-state equilibria usually studied in the search and matching literature. I consider a two-sided matching market with search frictions where vertically differentiated agents attempt to form bilateral matches before a deadline. I give conditions for existence and uniqueness of equilibria, and show that all equilibria exhibit an "anticipation effect" where less attractive agents become increasingly choosy over time, preferring to wait for the opportunity to match with attractive agents who, in turn, become less selective as the deadline approaches. When payoffs accrue after the deadline, or agents do not discount, a sharp characterization is available: at any point in t ime, the market is segmented into a first class of matching agents and a second class of waiting agents. This points to a different interpretation of unraveling observed in some markets and provides a benchmark for other studies of non-stationary matching. A simple intervention -- a small participation cost -- can dramatically improve efficiency.

Keywords: Deadlines, matching, nonstationary dynamics, search

DOI: http://dx.doi.org/10.17016/FEDS.2016.014

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FEDS 2016-013
Fiscal Stimulus and Firms: A Tale of Two Recessions (PDF)

Abstract: In this paper, I examine the effects of a countercyclical fiscal policy that gave firms additional tax refunds--additional liquidity--at the end of the past two recessions. I take advantage of a discontinuity in the slope of the tax refund formula to estimate the policy's impact. I find that after passage of the policy in 2002, firms allocated $0.40 of every tax refund dollar to investment. After passage of the policy in 2009, in contrast, firms used the refunds to increase cash holdings ($0.96 of every refund dollar) before paying down debt in the following year. I provide evidence that differences in macroeconomic conditions across the two periods drove these differences in firm responses, illustrating how the effects of stimulus vary across recessionary states of the world. I also show that while the policy had no discernable effect on investment in the most recent recessionary period, it did reduce firms' bankruptcy risk and the probability of a future credit- rating downgrade.

Keywords: Financing policy, fiscal policy, fixed investment, taxation

DOI: http://dx.doi.org/10.17016/FEDS.2016.013

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FEDS 2016-012
Heterogeneity and Unemployment Dynamics (PDF)

Hie Joo Ahn and James D. Hamilton

Abstract: This paper develops new estimates of flows into and out of unemployment that allow for unobserved heterogeneity across workers as well as direct effects of unemployment duration on unemployment-exit probabilities. Unlike any previous paper in this literature, we develop a complete dynamic statistical model that allows us to measure the contribution of different shocks to the short-run, medium-run, and long-run variance of unemployment as well as to specific historical episodes. We find that changes in the inflows of newly unemployed are the key driver of economic recessions and identify an increase in permanent job loss as the most important factor.

Keywords: Great Recession, business cycles, duration dependence, extended Kalman filter, state space model, unemployment duration, unobserved heterogeneity

DOI: http://dx.doi.org/10.17016/FEDS.2016.012

Accessible materials (.zip)

Original: Full Paper (PDF) | Accessible materials (.zip)

FEDS 2016-011
Measuring the Natural Rate of Interest Redux (PDF)

Thomas Laubach and John C. Williams

Abstract: Persistently low real interest rates have prompted the question whether low interest rates are here to stay. This essay assesses the empirical evidence regarding the natural rate of interest in the United States using the Laubach-Williams model. Since the start of the Great Recession, the estimated natural rate of interest fell sharply and shows no sign of recovering. These results are robust to alternative model specifications. If the natural rate remains low, future episodes of hitting the zero lower bound are likely to be frequent and long-lasting. In addition, uncertainty about the natural rate argues for policy approaches that are more robust to mismeasurement of natural rates.

Keywords: Econometrics, Money and interest rates

DOI: http://dx.doi.org/10.17016/FEDS.2016.011

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FEDS 2016-010
Student Loans and Homeownership (PDF)

Abstract: This paper estimates the effect of student loan debt on subsequent homeownership in a uniquely constructed administrative data set for a nationally representative cohort aged 23 to 31 in 2004 and followed over time, from 1997 to 2010. Our unique data combine anonymized individual credit bureau data with college enrollment histories and school characteristics associated with each enrollment spell, as well as several other data sources. To identify the causal effect of student loans on homeownership, we instrument for the amount of the individual's student loan debt using changes to the in-state tuition rate at public 4-year colleges in the student's home state. We find that a 10 percent increase in student loan debt causes a 1 to 2 percentage point drop in the homeownership rate for student loan borrowers during the first five years after exiting school. Validity tests suggest that the results are not confounded by local economic conditions or non-random selection int o the estimation sample.

Keywords: Credit Constraints, Homeowernship, Student loans

DOI: http://dx.doi.org/10.17016/FEDS.2016.010

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Original: Full Paper (PDF) | Accessible materials (.zip)

FEDS 2016-009
The Risky Steady State and the Interest Rate Lower Bound (PDF)

Timothy S. Hills, Taisuke Nakata, and Sebastian Schmidt

Abstract: Even when the policy rate is currently not constrained by its effective lower bound (ELB), the possibility that the policy rate will become constrained in the future lowers today's inflation by creating tail risk in future inflation and thus reducing expected inflation. In an empirically rich model calibrated to match key features of the U.S. economy, we find that the tail risk induced by the ELB causes inflation to undershoot the target rate of 2 percent by as much as 45 basis points at the economy's risky steady state. Our model suggests that achieving the inflation target may be more difficult now than before the Great Recession, if the recent ELB experience has led households and firms to revise up their estimate of the ELB frequency.

Keywords: Deflationary Bias, Disinflation, Inflation Targeting, Risky Steady State, Tail Risk, Zero Lower Bound

DOI: http://dx.doi.org/10.17016/FEDS.2016.009

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FEDS 2016-008
Policy Externalities and Banking Integration (PDF)

Abstract: Can policies directed at the banking sector in one jurisdiction spill over and affect real economic activity elsewhere? To investigate this question, I exploit changes in tax rates on bank profits across U.S. states. Banks respond by reallocating small-business lending to otherwise unaffected states. Moreover, counties in non-tax-changing states that have more exposure to treated banks experience greater changes in lending, which in turn impacts local employment. The findings demonstrate that policies aimed at the banking sector in one jurisdiction can impose externalities on other regions. Critically, financial linkages between regions serve as the transmission channel for these policy externalities.

Keywords: Banks, Credit Supply, Internal Capital Markets, Policy Arbitrage, Small Business Lending, Taxation

DOI: http://dx.doi.org/10.17016/FEDS.2016.008

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Original paper: PDF | Accessible materials (.zip)

FEDS 2016-007
Interpreting Shocks to the Relative Price of Investment with a Two-Sector Model (PDF)

Luca Guerrieri, Dale Henderson, and Jinill Kim

Abstract: Consumption and investment comove over the business cycle in response to shocks that permanently move the price of investment. The interpretation of these shocks has relied on standard one-sector models or on models with two or more sectors that can be aggregated. However, the same interpretation continues to go through in models that cannot be aggregated into a standard one-sector model. Furthermore, such a two-sector model with distinct factor input shares across production sectors and commingling of sectoral outputs in the assembly of final consumption and investment goods, in line with the U.S. Input-Output Tables, has implications for aggregate variables. It yields a closer match to the empirical evidence of positive comovement for consumption and investment.

Keywords: DSGE Models, Long-Run Restrictions, Multi-Sector Models, Vector Auto-Regressions

DOI: http://dx.doi.org/10.17016/FEDS.2016.007

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FEDS 2016-006
To Cut or Not to Cut? On the Impact of Corporate Taxes on Employment and Income (PDF)

Alexander Ljungqvist and Michael Smolyansky

Abstract: Do corporate tax increases destroy jobs? And do corporate tax cuts boost employment? Answering these questions has proved empirically challenging. We propose an identification strategy that exploits variation in corporate income tax rates across U.S. states. Comparing contiguous counties straddling state borders over the period 1970 to 2010, we find that increases in corporate tax rates lead to significant reductions in employment and income. We find little evidence that corporate tax cuts boost economic activity, unless implemented during recessions when they lead to significant increases in employment and income. Our spatial-discontinuity approach permits a causal interpretation of these findings by both establishing a plausible counterfactual and overcoming biases resulting from the fact that tax changes are often prompted by changes in economic conditions.

Keywords: Corporate taxation, economic growth, economic stimulus, employment, fiscal policy, regional economies

DOI: http://dx.doi.org/10.17016/FEDS.2016.006

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FEDS 2016-005
The Resolution of a Systemically Important Insurance Company during the Great Depression (PDF)

Abstract: This paper explores the economic issues related to systemically important insurance companies, using an example from the Great Depression, the National Surety Company. National Surety was a large and diverse insurance company that experienced a major crisis in 1933 due to losses from its guarantees of mortgage-backed securities. A liquidity crisis ensued, as policyholders staged a massive run on the company, demanding the return of their unearned premiums. The New York State Insurance Commissioner stepped in with a reorganization plan that split the company in two, out of fear that a disorderly liquidation would have systemic consequences given the sheer number of the company's counterparties, scattered all across the United States. A key dynamic of the crisis was that policy holders at an insurance company have a dual role as holders of liabilities and as providers of income.

Keywords: Insurance, great depression, surety, systemic importance

DOI: http://dx.doi.org/10.17016/FEDS.2016.005

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FEDS 2016-004
Is Los Angeles Becoming Transit Oriented? (PDF)

Jenny Schuetz, Genevieve Giuliano, and Eun Jin Shin

Abstract: Over the past 20 years, local and regional governments in the Los Angeles metropolitan area have invested significant resources in building rail transit infrastructure that connects major employment centers. One goal of transit infrastructure is to catalyze the development of high density, mixed-use housing and commercial activity within walking distance of rail stations, referred to as Transit Oriented Development (TOD). This project examines the quantity, type, and mix of economic activity that has occurred around newly built rail stations in Los Angeles over the past 20 years. Specifically, have the number of jobs or housing market characteristics changed near stations? We use establishment-level data on employment and property-level data on housing transactions to analyze changes in several employment and housing outcomes. Results suggest that new rail stations were located in areas that, prior to station opening, had unusually high employment density and mostly multifamily rental housing. There is no evidence of changes in employment density, housing sales volume, or new housing development within five years after station opening. Regressions suggest that a subset of stations saw increased employment density within five to ten years after opening.

Keywords: Economic development, housing markets, public transportation, urban spatial structure

DOI: http://dx.doi.org/10.17016/FEDS.2016.004

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FEDS 2016-003
Can a Bank Run Be Stopped? Government Guarantees and the Run on Continental Illinois (PDF)

Abstract: This paper analyzes the run on Continental Illinois in 1984. We find that the run slowed but did not stop following an extraordinary government intervention, which included the guarantee of all liabilities of the bank and a commitment to provide ongoing liquidity support. Continental's outflows were driven by a broad set of US and foreign financial institutions. These were large, sophisticated creditors with holdings far in excess of the insurance limit. During the initial run, creditors with relatively liquid balance sheets nevertheless withdrew more than other creditors, likely reflecting low tolerance to hold illiquid assets. In addition, smaller and more-distant creditors were more likely to withdraw. In the second and more drawn out phase of the run, institutions with relative large exposures to Continental were more likely to withdraw, reflecting a general unwillingness to have an outsized exposure to a troubled institution even in the absence of credit risk. Finally, we show that the concentration of holdings of Continental's liabilities was a key dynamic in the run and was importantly linked to Continental's systemic importance.

Keywords: Bank runs, deposit guarantee, deposit insurance, financial crisis

DOI: http://dx.doi.org/10.17016/FEDS.2016.003

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FEDS 2016-002
Predicting Operational Loss Exposure Using Past Losses (PDF)

Filippo Curti and Marco Migueis

Abstract: Operational risk models, such as the loss distribution approach, frequently use past internal losses to forecast operational loss exposure. However, the ability of past losses to predict exposure, particularly tail exposure, has not been thoroughly examined in the literature. In this paper, we test whether simple metrics derived from past loss experience are predictive of future tail operational loss exposure using quantile regression. We find evidence that past losses are predictive of future exposure, particularly metrics related to loss frequency.

Keywords: Operational risk, quantile regression, tail risk

DOI: http://dx.doi.org/10.17016/FEDS.2016.002

Revision - Accessible materials (.zip)

Original Version: PDF | Accessible materials (.zip)

FEDS 2016-001
Downward Nominal Wage Rigidity in the United States During and After the Great Recession (PDF)

Bruce C. Fallick, Michael Lettau, and William L. Wascher

Abstract: Rigidity in wages has long been thought to impede the functioning of labor markets. In this paper, we investigate the extent of downward nominal wage rigidity in US labor markets using job-level data from a nationally representative establishment-based compensation survey collected by the Bureau of Labor Statistics. We use several distinct methods to test for downward nominal wage rigidity and to assess whether such rigidity is less or more severe in the presence of negative economic shocks than in more normal economic times. We find a significant amount of downward nominal wage rigidity in the United States and no evidence that the high degree of labor market distress during the Great Recession reduced downward nominal wage rigidity. We further find a lower degree of nominal rigidity at multi-year horizons.

Keywords: labor markets, wage rigidity

DOI: http://dx.doi.org/10.17016/FEDS.2016.001

Original paper: PDF | Accessible materials (.zip)

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Last Update: May 14, 2020