Board of Governors of the Federal Reserve System

Abstract:

I study the dynamics of default-free bond yields and term premia using a novel equilibrium term structure model with a New-Keynesian core and imperfect information about productivity. The model generates term premia that are on average positive with sizable countercyclical variation that arises endogenously. Importantly, demand shocks, in addition to supply shocks, play a key role in the dynamics of term premia. This is in sharp contrast to existing DSGE term structure models with perfect information, which tend to rely on large supply shocks to generate timevariation in yields and term premia. With imperfect information, a shock to productivity is a supply shock, while a shock to signals about productivity that do not lead to actual changes in productivity acts as a demand shock. Nevertheless, an increase in economic activity generates more information about productivity, regardless of which type of shock it arises from. Moreover, a decrease in economic uncertainty leads to a decline in term premia as longer-term bonds are risky on average. This feature helps reconcile the empirical evidence that term premia have been on average positive and countercyclical, with numerous studies pointing to demand shocks as being an important driver of business cycles over the last few decades.

Note: On January 12, 2023, the title of the right panel of Figure 2 and the corresponding description in p.9 (lines 3 and 4) were corrected to "Patent Application Growth" from "Patent Issuance Growth."

Keywords: Term Premium, Term Structure of Interest Rates, Yield Curve, DSGE Model, Imperfect Information, Learning

DOI: https://doi.org/10.17016/FEDS.2022.086

Abstract:

The “taper tantrum” of 2013 represents one of the largest monetary policy shocks since the 1980s. During this episode, long-term interest rates spiked 100 basis points—a move unintentionally induced by policymakers. However, this had no observable negative effect on the overall U.S. economy. Output, employment, and other important variables, all performed either in line with or better than consensus forecasts, often improving considerably relative to their earlier trends. We conclude that, from low levels, a 100 basis point increase in long-term interest rates is probably too small to affect overall economic activity and discuss the implications for monetary policy.

DOI: https://doi.org/10.17016/FEDS.2022.085

Abstract:

We develop a dynamic model for digital service firms, which invest in monetization to generate revenues from services provided to customers for free. Our model captures and explains why such firms often build a large customer base and become highly valued while continuing to suffer losses—traditional models would struggle to explain this pattern. Counterfactual analysis reveals that monetization uncertainty slows technological advancement by diverting resources away from innovation. We also show that regulation aimed at protecting user privacy has sizable adverse effect on firm size and the quality of the offered service but, perhaps surprisingly, makes firms less unprofitable. On the other hand, regulation encouraging competition supports innovation.

Keywords: Monetization; Innovation; Digital service firms; Data privacy; Regulation

DOI: https://doi.org/10.17016/FEDS.2022.084

Abstract:

Economic uncertainty is a powerful force in the modern economy. Research shows that surges in uncertainty can trigger business cycles, bank runs and asset price fluctuations. But where do sudden surges in uncertainty come from? This paper provides a data-disciplined theory of belief formation that explains large fluctuations in uncertainty. It argues that people do not know the true distribution of macroeconomic outcomes. Like Bayesian econometricians, they estimate a distribution. Our main contribution is to explain why real-time estimation of distributions with non-normal tails are prone to large uncertainty fluctuations. We use theory and data to show how small changes in estimated skewness whip around probabilities of unobserved tail events (black swans). Our estimates, based on real-time GDP data, reveal that revisions in the estimates of black swan risk explain most of the fluctuations in uncertainty.

Keywords: Bayesian econometrics, expectations formation, forecast bias, model uncertainty, rational expectations

DOI: https://doi.org/10.17016/FEDS.2022.083

Abstract:

As of October 2022, the retired share of the U.S. population was nearly 1-1/2 percentage points above its pre-pandemic level (after adjusting for updated population controls to the Current Population Survey), accounting for nearly all of the shortfall in the labor force participation rate. In this paper, we analyze the pandemic-era rise in retirements using a model that accounts for pre-pandemic trends in retirement, the cyclicality of retirement, and other factors. We show that: more than half of the increase in the retired share are "excess retirements" that would likely not have occurred in the absence of the pandemic; excess retirements have been concentrated among cohorts age 65 and older at the start of the pandemic; excess retirements have been largest among the college-educated and whites; and excess retirements reflect in part that worker transitions from the labor force to retirement remain elevated. We also show that failing to account for updated population controls to the Current Population Survey leads to an underestimate of the rise in the retired share over the last few years. We use a cohort-based framework to argue that looking forward, unless the pandemic has permanently affected retirement behavior, excess retirements should eventually fade as those who retired early during the pandemic reach ages when they would have normally retired. Even as excess retirements fade, the retired share will remain well above its pre-pandemic level, reflecting population aging.

DOI: https://doi.org/10.17016/FEDS.2022.081

Abstract:

This paper builds a micro-founded general equilibrium model of hysteresis in which changing composition of firms with heterogeneous qualities in response to demand shocks alter the total factor productivity of the economy through a process of "creative destruction". Hysteresis fundamentally challenges existing consensus on stabilization policies: the complete stabilization of demand shocks becomes suboptimal as demand creates its own supply; fiscal multiplier can be substantially larger than 1; an opportunistic monetary policymaker, who adopts a lenient policy reaction to positive demand shocks, but provides decisive monetary stimulus in response to negative demand shocks, can bring large welfare gains.

DOI: https://doi.org/10.17016/FEDS.2022.080

Abstract:

This paper examines estimates of, and drivers for, the sacrifice ratio, defined as the cumulative sum of foregone annualized output accruing from a disinflation of one percentage point. Three approaches are employed. The first reviews the literature on what sacrifice ratio might be expected. The second studies a generic disinflation experiment using 40 estimated macro models of the U.S. economy, calculating a distribution of sacrifice ratios. Those sacrifice ratios are high by historical standards and the paper discusses some stories for why this is so. The role of expectations formation and the credibility of policy is emphasized. The third approach gets under the hood of drivers of the output cost of disinflation by carrying out a selection of disinflation experiments using the FRB/US model, varying certain characteristics of the model's expectations formation mechanism. Pinning down a precise measure for the output cost of disinflation is challenging. But the literature and policy experiments do offer some guidance on how the sacrifice ratio can be reduced.

Keywords: Monetary policy, disinflation, sacrifice ratio, expectations formation

DOI: https://doi.org/10.17016/FEDS.2022.079

Abstract:

Despite the growth in the literature on the opioid crisis, questions remain on how to best measure the local supply of prescription opioids. We document that measures based on the number of prescriptions largely track hydrocodone, while measures based on morphine-equivalent amounts largely track oxycodone. This choice matters, given the well-documented link between oxycodone and the rise in use of illicit opioids such as heroin, plus the fact that oxycodone and hydrocodone (the two most common prescription opioids) are only weakly correlated. We recommend local measures of the supply of opioids should take into account morphine-equivalent amounts, to avoid understating the health and economic consequences of opioid abuse.

DOI: https://doi.org/10.17016/FEDS.2022.078

Abstract:

We investigate whether the bank examination process provides useful insight into bank future outcomes. We do this by conducting textual analysis on about 5,500 small to medium-sized commercial bank examination reports from 2004 to 2016. These confidential examination reports provide textual context to the components of supervisory ratings: capital adequacy, asset quality, management, earnings, and liquidity. Each component is given a categorical rating, and each bank is assigned an overall composite rating, which are used to determine the safety and soundness of banks. We find that, controlling for a variety of factors, including the ratings themselves, the sentiment supervisors express in describing most of the components predict relevant future bank outcomes. The sentiment conveyed in the asset quality, management, and earnings sections provides significant information in predicting future outcomes for problem loans, supervisory actions, and profitability, respectively, for all banks. Sentiment conveyed in the capital adequacy section appears to be predictive of future capital ratios for weak banks. These relationships suggest that bank supervisors play a meaningful role in the surveillance of the banking system.

Note: This paper was updated on December 22, 2022 to include corrected images for figures 3, A5, A6, A7, A8, and A9.

Keywords: CAMELS, bank examination reports, natural language processing, private supervisory information

DOI: https://doi.org/10.17016/FEDS.2022.077

Abstract:

This paper provides an overview of the literature examining how the introduction of a CBDC would affect the banking sector, financial stability, and the implementation and transmission of monetary policy in a developed economy such as the United States. A CBDC has the potential to improve welfare by reducing financial frictions in deposit markets, by boosting financial inclusion, and by improving the transmission of monetary policy. However, a CBDC also entails noteworthy risks, including the possibility of bank disintermediation and associated contraction in bank credit, as well as potential adverse effects on financial stability. A CBDC also raise important questions regarding monetary policy implementation and the footprint of central banks in the financial system. Ultimately, the effects of a CBDC depend critically on its design features, particularly remuneration.

Keywords: Financial stability, Monetary policy, banking, central bank digital currency, central banking

DOI: https://doi.org/10.17016/FEDS.2022.076

Abstract:

When available financial securities allow investors to optimally diversify risk across countries, standard theory implies that exchange rates should reflect this behavior. However, exchange rates observed in the data deviate from these predictions. In this paper, we develop a framework to value the welfare costs of these exchange rate wedges, as disciplined by asset returns. This framework applies to a general class of asset pricing and exchange rate models. We further decompose the value of these wedges into components, showing that the ability of goods markets to respond to financial markets through exchange rate adjustment has significant implications for welfare.

DOI: https://doi.org/10.17016/FEDS.2022.075

Abstract:

The design of US unemployment insurance (UI) policy--which features benefits assigned as a percentage of past wages up to a cap--engenders tests for spillovers from policy variation to workers who are not directly treated. We test for and find a pattern of spillovers from state-level UI policy changes that cannot be neatly reconciled with workhorse or cutting-edge models of UI spillovers. Instead, we show that the documented pattern conforms with the predictions of a canonical model of information frictions: wage posting with random search. Taken together, our results provide novel evidence of quantitatively- and policy-relevant information frictions in this market. Moreover, our estimates suggest that aggregate unemployment of insured individuals would decrease if the replacement rate were increased while holding the cap constant.

DOI: https://doi.org/10.17016/FEDS.2022.074

Abstract:

It is difficult to assess the effectiveness of investment strategies that screen companies based on environmental criteria to hedge climate change risk because physical risks have not yet fully materialized and policies to combat climate change are usually widely anticipated. This paper sidesteps these limitations by analyzing the stock market response to plausibly exogenous changes in expectations about the level of a carbon tax in Germany. The risk-adjusted return on two sustainable investment approaches—screening companies based on environmental scores and on firms’ carbon footprint—around the carbon tax news reveals that firms with a high environmental score did not perform any better than those with a low environmental score. In contrast, the stock price of firms with low carbon emissions increased in value relative to those with a high carbon footprint. Carbon intensity explains the cross-sectional reaction to the carbon tax news because it predicts revisions in expected profitability.

DOI: https://doi.org/10.17016/FEDS.2022.073

Abstract:

The stringency of bank liquidity and capital requirements should depend on their social costs and benefits. This paper investigates their welfare effects and quantifies their welfare costs using sufficient statistics. The special role of banks as liquidity providers is embedded in an otherwise standard general equilibrium growth model. Capital and liquidity requirements mitigate moral hazard from deposit insurance, which, if unchecked, can lead to excessive credit and liquidity risk at banks. However, these regulations are also costly because they reduce the ability of banks to create net liquidity and can distort investment. Equilibrium asset returns reveal the strength of demand for liquidity, yielding two simple sufficient statistics that express the welfare cost of each requirement as a function of observable variables only. Based on U.S. data, the welfare cost of a 10 percent liquidity requirement is equivalent to a permanent loss in consumption of about 0.02%, a modest impact. Even using a conservative estimate, the cost of a similarly-sized increase in the capital requirement is roughly ten times as large. Even so, optimal policy relies on both requirements, as the financial stability benefits of capital requirements are found to be broader.

DOI: https://doi.org/10.17016/FEDS.2022.072

Abstract:

This paper outlines a model of demand segmentation in the federal funds market with two types of borrowers - the "interest on reserves (IOR) arbitrage" type and the "regulatory" type - which have different reservation prices and cannot always be separated. When fed funds trade above IOR, the "regulatory" type is revealed and consequently pays an interest rate closer to its real reservation price, pushing the fed funds rate further up. When fed funds trade below IOR, a decrease in the fed funds rate encourages entry in the market for IOR arbitrage purposes thus counteracting the downward pressure on the fed funds rate. We use probit regression models and daily data for the period April 2018 to February 2020 to provide empirical support for this model. We find the following: 1) When fed funds trade above IOR, there is, on average, a 10 percentage points increase in the probability that the fed funds rate increases the following period. Furthermore, analysis using confidential bank-level data shows that this increase in the probability is higher for banks that report their liquidity profile daily and that were present all trading days during this period. 2) When the fed funds trade below IOR, the probability of a decrease in the fed funds rate decreases with the widening of the spread between the fed funds rate and IOR.

DOI: https://doi.org/10.17016/FEDS.2022.071

Abstract:

This paper considers the use of the Federal Reserve’s ability to provide loans to depository institutions under its discount window lending authority in support of achieving its monetary policy objectives through a funding for lending program. Broadly, a funding for lending program could be structured as one in which the Federal Reserve makes ample low-cost funding available to banks or a program in which the Federal Reserve only provides low-cost funding conditional on the banks meeting certain lending targets. We provide a general description of how a funding for lending program could be structured along each of these lines and review important considerations, costs, and benefits of any such program. We also review the literature regarding various lending programs implemented previously in the United States by a variety of agencies and abroad by foreign central banks that shed light on the potential effectiveness of funding for lending programs.

Keywords: funding for lending, discount window, Federal Reserve, monetary policy tools

DOI: https://doi.org/10.17016/FEDS.2022.070

Abstract:

We study the effect of losing insurance on psychiatric – mental health disorder (MHD) and substance use disorder (SUD) – hospital-based care. Psychiatric disorders cost the U.S. over $1T each year and hospitalizations provide important and valuable care for patients with these disorders. We use variation in public insurance coverage (Medicaid) eligibility offered by a large-scale and unexpected disenrollment in the state of Tennessee in 2005 that lead to 190,000 individuals losing their insurance. Medicaid enrollees are at elevated risk for psychiatric disorders. Following the disenrollment, hospitalizations for SUDs declined by 15.4 percent. Findings suggest that MHD hospitalizations declined by 4.2 percent, but the coefficient estimate is imprecise. The expected financing of hospital care received also changed, with the probability that Medicaid was listed as the expected payer for MHD and SUD hospitalizations declining by 27.5 percent and 30.8 percent respectively post-disenrollment. We provide suggestive evidence that psychiatric health declined post-disenrollment.

Keywords: healthcare; insurance, mental health disorders, substance use disorders

DOI: https://doi.org/10.17016/FEDS.2022.069

Abstract:

This paper presents a stylized, non-country-specific framework to assess conceptually how the financial risks of climate change could interact with a regulatory capital regime. We summarize core features of a capital regime such as expected and unexpected losses, regulatory ratios and risk-weighted assets, and minimum requirements and buffers, and then consider where climate-related risk drivers may be relevant. We show that when considering policy implications, it is critically important to be precise about how climate change may impact the loss-generating process for banks and to be clear about the specific policy objective. While climate change could potentially impact the regulatory capital regime in several ways, an internally coherent approach requires a strong link between specific assumptions and beliefs about how these financial risks may manifest as bank losses and what objectives regulators are pursuing. We conclude by identifying several potential research opportunities to better understand these complex issues and inform policy development.

Keywords: climate change, regulatory capital

DOI: https://doi.org/10.17016/FEDS.2022.068

Abstract:

We assess racial discrimination in mortgage approvals using new data on mortgage applications. Minority applicants tend to have significantly lower credit scores, higher leverage, and are less likely than white applicants to receive algorithmic approval from race-blind government automated underwriting systems (AUS). Observable applicant- risk factors explain most of the racial disparities in lender denials. Further, we exploit the AUS data to show there are risk factors we do not directly observe, and our analysis indicates that these factors explain at least some of the residual 1-2 percentage point denial gaps. Overall, we find that differential treatment has played a limited role in generating denial disparities in recent years.

Keywords: Discrimination, Fair lending, automated underwriting, credit score, mortgage lending

DOI: https://doi.org/10.17016/FEDS.2022.067

Abstract:

This paper presents a stylized framework of bank risk‐taking to help clarify the concept of “double materiality,” the idea that supervisory authorities should consider both the risks that banks face from climate change and the impact of a bank’s actions on climate change. The paper shows that the concept of double materiality can be coherently embedded in a microprudential framework, but the practical implications could be quite similar to the implications of a single materiality perspective. The importance of a double materiality perspective becomes larger when one considers macroprudential objectives driven by financial sector externalities. The framework illustrates the critical importance of being clear on the supervisory mandate and objectives when assessing policy alternatives.

Keywords: Bank risk, Risk management, climate change

DOI: https://doi.org/10.17016/FEDS.2022.066

Abstract:

We study the role of homeownership in the effectiveness of monetary policy on households' expectations. Empirically, we find that homeowners revise down their near-term inflation expectations and their optimism about future labor market conditions in response to a rise in mortgage rates, while renters are less likely to do so. We further show that the monetary-policy component of mortgage-rate changes creates the difference in expectation revisions between homeowners and renters. This result suggests that homeowners are attentive to news on interest rates and adjust their expectations accordingly in a manner consistent with the intended effect of monetary policy. We characterize these findings using a rational inattention model with two types of households---homeowners and renters.

Keywords: Inflation expectations, homeownership, rational inattention

DOI: https://doi.org/10.17016/FEDS.2022.065

Abstract:

Homeowners’ insurance, a $15 trillion market by coverage, provides households financial protection from climate losses. Insurance premiums (rates) are subject to significant regulations at a state level in the United States. Using novel data on filings made by insurers to regulators, we propose a metric to quantify the extent of regulation in individual states. We provide evidence of decoupling of insurance rates from their underlying risks and identify regulation as a driving force behind this pattern. Rates are least reflective of risk in states we classify as "high friction", i.e. states where regulations appear most restrictive. We identify two sources behind the decoupling. First, in high friction states, rates have not adequately adjusted in response to the growth in losses. Second, insurers have cross-subsidized high friction states by raising rates in low friction states. Our results imply that households in low friction states are disproportionately bearing the risks of households in high friction states. More broadly, our findings question whether insurance rates can play a useful role in steering climate adaptation and whether households will have continued access to insurance.

Keywords: Climate Risk, Cross-subsidies, Homeowners' Insurance, Insurance Availability, Rate Regulation

DOI: https://doi.org/10.17016/FEDS.2022.064

Abstract:

On October 6, 1979, Chairman Volcker announced that the Federal Reserve was embarking on a new, forceful, and ultimately successful campaign to lower the rampant inflation of that time. At the center of this campaign were new operating procedures for conducting monetary policy—procedures that focused daily open market operations on controlling the quantity of monetary reserves and on the quantity of nonborrowed reserves in particular. This was a dramatic shift from the prior focus on targeting the federal funds rate.

These new operating procedures were preceded by well over a decade of work that was directed by the Federal Open Market Committee (FOMC) and was carried out by its Committee on the Directive (COD). Prior to 1979, the COD had recommended operating procedures based on controlling nonborrowed reserves but subsequently rejected them. It was the Volcker Fed that accepted and implemented these reserves-based operating procedures, and it did so with the goal of targeting the monetary aggregates to have restrained and stable growth rates.

DOI: https://doi.org/10.17016/FEDS.2022.063

Abstract:

Guaranteed Asset Protection (GAP) shields purchasers from financial risks of losses exceeding insured collateral values if vehicles become total losses. Yet surprisingly little is known about the sales of this product or consumers’ attitudes toward it. In this study, we report the results of a representative national survey conducted by the Survey Research Center (SRC) of the University of Michigan. The SRC interviewed 1,206 individuals in the fall of 2020. This survey shows that consumers purchased GAP in about 39 percent of financed vehicle transactions. Consumers purchase GAP more often when there is a heightened financial risk: larger credit amounts, longer loan maturities, and lower income levels. More than 90 percent of GAP purchasers report that buying GAP is a good idea and that they would buy it again. Only about 1 percent of surveyed purchasers indicate dissatisfaction with their choice. A multivariate model of GAP purchase suggests that consumers’ financial situation and terms of the transaction are more important than risk aversion by itself.

DOI: https://doi.org/10.17016/FEDS.2022.062

Abstract:

Endogenously optimistic beliefs about future house prices can account for the path and standard deviation of house prices in the U.S. housing boom of the 2000s. In a general equilibrium model with incomplete markets and aggregate risk, agents form beliefs about future house prices in response to shocks to fundamentals. In an income expansion with looser credit conditions, agents are more likely to underpredict house prices and revise up their beliefs. Matching the standard deviation and steady rise in house prices results in homeownership becoming less affordable later in the boom as well as consumption dynamics that match the data.

DOI: https://doi.org/10.17016/FEDS.2022.061

Abstract:

Using the historical experience from past monetary tightening cycles and the market-expected path of the federal funds rate for the current tightening cycle, we project that the flows from bank deposits to money market funds (MMFs) would be relatively small, at about $600 billion through the end of 2024, or about 3 percent of current bank deposits. Of these potential inflows to MMFs, about $100 billion are projected to flow into the overnight reverse repo (ON RRP) facility, or about 7 percent of MMFs’ recent take-up. Other factors such as the private demand for repo funding and the net supply of Treasury bills are expected to have more substantial effects on MMFs’ take-up at the ON RRP facility than the inflows from bank deposits.

DOI: https://doi.org/10.17016/FEDS.2022.060

Abstract:

We show that as nonbanks' market share increases in a local residential mortgage market, the quality of mortgage services in the market improves. Two instrumental variable analyses exploiting (1) stress tests conducted by the Federal Reserve, and (2) mortgage industry surety bonds required by each state confirm this finding. We find evidence that as nonbanks grow their market share, they develop a specialty in servicing lower-income borrowers and increase investment in technology, leading to improved service quality. This improvement in service quality is more salient in counties with a higher percentage of minority populations.

DOI: https://doi.org/10.17016/FEDS.2022.059

Abstract:

The value of assets in the digital ecosystem has grown rapidly, amid periods of high volatility. Does the digital financial system create new potential challenges to financial stability? This paper explores this question using the Federal Reserve’s framework for analyzing vulnerabilities in the traditional financial system. The digital asset ecosystem has recently proven itself highly fragile. However adverse digital asset markets shocks have had limited spillovers to the traditional financial system. Currently, the digital asset ecosystem does not provide significant financial services outside the ecosystem, and it exhibits limited interconnections with the traditional financial system. The paper describes emerging vulnerabilities that could present risks to financial stability in the future if the digital asset ecosystem becomes more systemic, including: run risks among large stablecoins, valuation pressures in crypto-assets, fragilities of DeFi platforms, growing interconnectedness, and a general lack of regulation.

Keywords: DeFi, Digital assets, financial stability, financial vulnerabilities, stablecoins, systemic risk

DOI: https://doi.org/10.17016/FEDS.2022.058

Abstract:

Decentralized finance (DeFi) refers to a set of newly emerging financial products and services that operate on decentralized platforms using blockchains to record and share data. DeFi products and services are conducted without a trusted central intermediary such as a bank, and they include payments, lending and borrowing, trading and investments, capital raising (crowdfunding), and insurance. An important innovation that allowed for the development of DeFi was the growth of programming capability on blockchains. This innovation allows for the creation of computer code called smart contracts that can be invoked by users without going through a centralized intermediary. DeFi may pose financial stability risks, that are exacerbated by the fact that both are currently largely outside the prudential regulatory perimeter, which we discuss.

Keywords: Blockchain, Crypto, DeFi, Financial stability and risk

DOI: https://doi.org/10.17016/FEDS.2022.057

Abstract:

This paper examines how physical climate risks affect firms' financial performance and operational risk management in global supply-chains. We document that weather shocks at supplier locations reduce the operating performance of suppliers and their customers. Further, customers respond to perceived changes in suppliers' climate-risk exposure: When realized shocks exceed ex-ante expectations, customers are 6-11% more likely to terminate existing supplier-relationships. Consistent with models of experience-based learning, this effect increases with signal strength and repetition, is insensitive to long-term climate projections, and increases with industry competitiveness and decreases with supply-chain integration. Customers subsequently choose replacement suppliers with lower expected climate-risk exposure.

Keywords: Adaptation, Climate Change, Firm Performance, Production Networks

DOI: https://doi.org/10.17016/FEDS.2022.056

Abstract:

Corporate cash piles vary across companies and over time. A firm's cash holding is an implicit position in a low-return asset that is correlated across firms. Cash generates variation in beta estimates. We show how investors can hedge out the cash on firms' balance sheets when making portfolio choices. We decompose stock betas into components that depend on the firm's cash holding, return on cash, and cash-hedged return. Common asset pricing premia — size, value, and momentum — have large implicit cash positions. Portfolios of cash-hedged premia often have higher Sharpe ratios because firms' cash returns are correlated.

Keywords: cash, cross-section of expected returns, momentum, risk factor, size, value

DOI: https://doi.org/10.17016/FEDS.2022.055

Abstract:

Temporal aggregation biases estimates of monetary policy effects. We hypothesize that information mismatches between private agents and the econometrician—the source of temporal aggregation bias—are as important as the more studied mismatch between private agents and the central bank (the “Fed information effect”) in the study of monetary policy transmission. In impulse responses from both local projections and an unobserved components model, we find that the response of daily inflation to high-frequency monetary shocks confirms theoretical predictions. If there is an adverse-signed response such that inflation increases in response to a contractionary monetary shock, it is much less prominent than previously thought and explained by frequency mismatches of shocks and dependent variables.

DOI: https://doi.org/10.17016/FEDS.2022.054r1

Abstract:

FRB/US, a large-scale, nonlinear macroeconomic model of the U.S., has been in use at the Federal Reserve Board for 25 years. For nearly as long, the FRB/US “project” has included a linear version of the model known as LINVER. A key reason that LINVER exists is the vast reduction in the computational costs that linearity confers when running experiments requiring large numbers of simulations under the assumption that expectations are model-consistent (MC). The public has been able to download FRB/US simulation code, documentation, and data from the Federal Reserve Board’s website since 2014. To further expand access to and understanding of the FRB/US project, a package devoted to LINVER is now available on the website. In this paper, we provide both a general introduction to LINVER and an overview of the contents and capabilities of its package. We review the ways that LINVER has been used in past research to study key policy issues; describe the package’s comprehensive set of programs for running simulations with MC expectations, with or without imposing the effective lower bound (ELB) on the federal funds rate and other nonlinear constraints; and illustrate how LINVER deterministic and stochastic simulations can be used to gauge the implications of the ELB for macroeconomic performance and to assess different strategies for mitigating its adverse effects.

LINVER package

DOI: https://doi.org/10.17016/FEDS.2022.053

Abstract:

We develop a theory of learning in a model of fire sales and collateralized debt to study how beliefs about fundamentals are shaped by market conditions. Agents exchange short-term debt contracts to invest in a long-term risky asset, and receive shocks to the opportunity cost of funds (cost shocks) and news about the fundamental of the asset, both of which are private information. Asset prices play a dual role of clearing markets and conveying agents' private information, but markets are informationally inefficient: Agents can partially, but never fully, infer their counterparties' private information from asset prices. The informational inefficiency of markets is more acute when liquidity conditions are especially tight or loose, as this impairs ability of prices to reveal private information about fundamentals. As a result, beliefs about fundamentals are shaped endogenously by cost shocks which are orthogonal to fundamentals, leading to socially costly booms and busts in asset prices. The equilibrium is constrained inefficient due to an information externality in which agents do not internalize how their choices affect the information set of other agents. Interventions in funding markets can stabilize asset prices by altering perceptions of risk.

DOI: https://doi.org/10.17016/FEDS.2022.052

Abstract:

The benefits of cross-border financial activity are wide-ranging, from greater competition and more efficient markets to broader and more stable access to capital. During normal economic times, the official sector and private sector share an incentive to foster such cross-border financial activities. During a financial crisis, however, the short-term alignment of official- and private-sector incentives can diverge—sometimes significantly. We present a game-theoretic model of the underlying trade-offs and discuss lessons for international financial regulators, placing them in the context of the 2008 financial crisis, when challenges in cross-border cooperation both channeled and amplified financial stress. We also discuss the critical unfinished business of post-crisis regulatory measures to improve oversight of internationally active financial institutions.

Keywords: Bank Capital, Bank Liquidity, Cross-Border Finance, Market Fragmentation, Pre-Positioning

DOI: https://doi.org/10.17016/FEDS.2022.051

Abstract:

Banks modify more CRE loans than CMBS, contributing to better loan performance when property incomes decline. However, banks have higher delinquency rates for less-stressed loans, consistent with modification policies encouraging strategic default. Motivated by these facts, we develop a tradeoff theory model in which lenders vary in their modification technologies. Modification frictions discourage strategic renegotiation, enabling CMBS to offer higher LTV loans and attract borrowers seeking higher leverage. The model produces cross-lender differences in LTVs and spreads consistent with the data. Reducing modification frictions at CMBS decreases welfare by restricting debt capacity for the borrowers that value it most.

Keywords: commercial real estate, modifications, LTV

DOI: https://doi.org/10.17016/FEDS.2022.050

Abstract:

The U.S. economy entered the 1920s with a robust job market and high inflation but fell into a recession following the Federal Reserve's discount rate hikes to tame inflation. Using a newly constructed data set, we study labor market dynamics during this period. We find that labor markets were tight when the Federal Reserve began tightening monetary policy, but they became loose following the tightening as the recession deepened. The demand-supply imbalance in the labor market was driven by a sharp decline in the number of job openings. We also show that the recession had an uneven effect on labor markets across sectors and by gender.

Accessible materials (.zip)

Keywords: Inflation, Recession of 1920-1921, Vacancies, Unemployment, Labor Market Dynamics

DOI: https://doi.org/10.17016/FEDS.2022.049

Abstract:

This article reviews the rapidly proliferating economic literature on climate change and financial policy. We find: (1) enduring challenges in estimating the statistical properties of a changed climate; (2) emerging evidence of financial markets pricing in climate-related risks; and (3) a range of significant institutional distortions preventing such pricing from being complete. Finally, we argue that geographic regions may be an especially fruitful unit of analysis for understanding the financial impact of climate change.

Accessible materials (.zip)

Keywords: Climate change, Climate-finance, Climate-related risk

DOI: https://doi.org/10.17016/FEDS.2022.048

Abstract:

Under the Community Reinvestment Act (CRA) banks can fulfill their affirmative obligation to meet local credit needs by lending in low-to-moderate-income (LMI) communities or by purchasing loans made by others. This paper evaluates whether giving CRA credit for purchases has had its intended effect of increasing LMI credit availability by making LMI loans more liquid. Analyses using a regression discontinuity design show that CRA increases loan purchases without affecting LMI originations. Instead, banks purchase loans that are temporarily diverted from the Government Sponsored Enterprises, which provides little benefit to the communities the CRA is meant to help.

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DOI: https://doi.org/10.17016/FEDS.2022.047

Abstract:

Banks are vital suppliers of money-like safe assets, which they produce by issuing short-term liabilities and pledging collateral. But their ability to create safe assets varies over time as leverage constraints fluctuate. I present a model to describe private safe-asset production when intermediaries face leverage constraints. I measure bank leverage constraints using bank-intermediated basis trades. The collateral premium—a strategy long Treasuries used more often as repo collateral and short Treasuries used less often—has a positive expected return of 22 basis points per year because the collateral premium compensates for bank leverage risk.
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DOI: https://doi.org/10.17016/FEDS.2022.046

Abstract:

We develop a dynamic general equilibrium integrated assessment model that incorporates costs due to new technology adoption in renewable energy as well as externalities associated with carbon emissions and renewable technology spillovers. We use world economy data to calibrate our model and investigate the effects of the technology adoption channel on renewable energy adoption and on the optimal energy transition. Our calibrated model implies several interesting connections between technology adoption costs, the two externalities, policy, and welfare. We investigate the relative effectiveness of two policy instruments- Pigouvian carbon taxes and policies that internalize spillover effects-in isolation as well as in tandem. Our findings suggest that renewable technology adoption costs are of quantitative importance for the energy transition. We find that the two policy instruments are better thought of as complements rather than substitutes.
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Keywords: Technology adoption, scrapping, energy transition, climate, dynamic taxation

DOI: https://doi.org/10.17016/FEDS.2022.045

Abstract:

After an unprecedented number of banks suspended operations in the during Panic of 1893, the head regulator of banks chartered by the United States government allowed about 100 banks to reopen after certifying their solvency. We evaluate whether actions by bank owners to change management, contract with depositors to extend liability maturity structure, write off bad assets, and/or inject capital affected bank survival and deposit retention. This historical episode is particularly informative because there was no expectation of government intervention. We find that contracting with depositors provided short-term benefits while dealing with bad assets was key for long-run viability.
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Keywords: banking panics, bank resolution, market discipline, National Banking Era

DOI: https://doi.org/10.17016/FEDS.2022.044

Abstract:

This report has two objectives: 1. Review the available literature on Climate-Related Financial Stability Risks (CRFSRs) as it pertains to the United States. Specifically, the literature review considers several modeling approaches and aims to 1.1 Identify financial market vulnerabilities (e.g., bank leverage), 1.2 Provide an assessment of those vulnerabilities (high/medium/low) as identified by the current literature, and 1.3 Evaluate the uncertainty surrounding these assessments based on interpretation of the findings and coverage of existing literature (high/low). 2. Identify methodologies to link climate risks to financial stability and possible research paths to assess U.S. CRFSRs. The report is structured in three parts. First, it characterizes the potential financial system vulnerabilities of climate change. Second, it describes the major methodologies adopted in studying the implications of climate change and provides an assessment of financial system vulnerabilities identified by the current literature. Third, it discusses how different methodologies can be further developed or combined to assess U.S. CRFSRs.
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DOI: https://doi.org/10.17016/FEDS.2022.043

Abstract:

Recent modeling developments have created tradeoffs between attribution-based models, models that rely on causal relationships, and "pure prediction models" such as neural networks. While forecasters have historically favored one technology or the other based on comfort or loyalty to a particular paradigm, in domains with many observations and predictors such as textual analysis, the tradeoffs between attribution and prediction have become too large to ignore. We document these tradeoffs in the context of relabeling 27 million Thomson Reuters news articles published between 1996 and 2021 as debt-related or non-debt related. Articles in our dataset were labeled by journalists at the time of publication, but these labels may be inconsistent as labeling standards and the relation between text and label has changed over time. We propose a method for identifying and correcting inconsistent labeling that combines attribution and pure prediction methods and is applicable to any domain with human-labeled data. Implementing our proposed labeling solution returns a debt-related news dataset with 54% more observations than if the original journalist labels had been used and 31% more observation than if our solution had been implemented using attribution-based methods only.

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Keywords: News, Text Analysis, Debt, Labeling, Supervised Learning, DMR

DOI: https://doi.org/10.17016/FEDS.2022.042

Abstract:

We use a housing search model and data on individual home listings to decompose fluctuations in home sales and price growth into supply or demand factors. Simulations of the estimated model show that housing demand drives short-run fluctuations in home sales and prices, while variation in supply plays only a limited role. We consider two implications of these results. First, we show that reduction of supply was a minor factor relative to increased demand in the tightening of housing markets during COVID-19. New for-sale listings would have had to expand 30 percent to keep the rate of price growth at prepandemic levels given the pandemic-era surge in demand. Second, we estimate that housing demand is very sensitive to changes in mortgage rates, even more so than comparable estimates for home sales. This suggests that policies that affect housing demand through mortgage rates can influence housing market dynamics.

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DOI: https://doi.org/10.17016/FEDS.2022.041

Abstract:

Bank accounts are critical for participation in the modern economy. However, these accounts frequently require maintenance fees and incur overdraft charges. We assess whether minimum account balances to avoid fees, account maintenance fee amounts, and non-sufficient funds charges are systematically different in LMI and majority-minority communities, and find that they are generally higher. For example, the minimum account balance to avoid fees in a non-interest checking account is about $50 higher in LMI Census tracts than in higher income tracts, and $75 higher in majority-minority tracts. Differences in bank fees between LMI, majority-minority, and other communities result from various factors, including bank lending income, bank operating costs, and bank size.

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Keywords: Bank fees; deposit accounts; LMI; majority-minority

DOI: https://doi.org/10.17016/FEDS.2022.040

Abstract:

The liquidity strains that contributed to the meltdown of the mortgage market in the Global Financial Crisis (GFC) re-emerged in the Coronavirus 2019 (COVID-19) Crisis. Some of these strains were acute. For example, the dependence of mortgage real estate investment trusts (REITs) on short-term funding amplified market disruption in March 2020. However, other liquidity pressures had only minor repercussions for the overall mortgage market because of reforms since the GFC, a heavy government presence, and strong house prices. The lackluster performance of the private-label mortgage-backed securities market provides a glimpse of how the market might have performed in the absence of the heavy government presence.

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Keywords: COVID-19, REIT, Term Asset-Backed Securities Loan Facility (TALF), mortgage market, mortgage servicers, mortgage-backed securities (MBS)

DOI: https://doi.org/10.17016/FEDS.2022.039

Abstract:

After reviewing the state of digitalization—the use of digital information technology (IT) throughout the economy—we consider the slippery concept of a distinct digital economy and efforts to record it in national accounts. We then anchor the digital economy in a growth accounting framework, augmenting the conventional measure of the IT contribution to productivity—innovation in the production of IT capital plus labor-saving use of IT throughout the economy—with the contribution from the digital platforms that help users navigate the sprawling information landscape. We discuss the difficult measurement issues that thwart full accounting of the scope and productivity of the digital economy. These include quantifying the intangible assets created by platforms and their users, measuring the consumption of intangible services provided by platforms—often for free—and identifying platforms within the existing statistical system, which does not treat their activity as a distinct industry.
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DOI: https://doi.org/10.17016/FEDS.2022.038

Abstract:

The pickup in the U.S. inflation rate to its highest rates in forty years has led to renewed attention being given to the Great Inflation of the 1970s. This paper asks with regard to the Great Inflation: "How did it happen?" The answer offered is the fact that, in both the United Kingdom and the United States, monetary policy and other policy instruments were guided by a faulty doctrine—a nonmonetary view of inflation that perceived the concerted restraint of aggregate demand as both ineffective and unnecessary for inflation control. In the paper's analysis, the difference in the economic policy doctrine in the 1970s from that prevailing in more recent decades is represented algebraically, with this representation backed up by documentation of policymakers' views. A key conclusion implied by the analysis is that the fact that a nonmonetary perspective on inflation is no longer prevalent in policy circles provides grounds for believing that monetary policy in the modern era is well positioned to prevent the recurrence of entrenched high inflation rates of the kind seen in the 1970s.
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Keywords: Great Inflation, Phillips curve, monetary policy doctrine, monetary policy strategy

DOI: https://doi.org/10.17016/FEDS.2022.037

Abstract:

This paper investigates how bank supervisors’ enforcement decisions and orders (EDOs) influence the allocation of mortgage lending across demographic groups underlying a banks’ borrower base. Specifically, we investigate how banks’ mortgage lending to minority borrowers relative to white borrowers changes following the resolution of severe EDOs. We hypothesize that improvements in management control systems imposed by EDOs serve as channels through which EDOs affect a bank’s borrower base generally, and minority lending specifically. We empirically examine how changes in loan policies and internal governance mechanisms specified in EDOs influence banks’ mortgage lending decisions. We find that relative to white borrowers, mortgage lending to minority borrowers significantly increases following the resolution of EDOs, where this positive effect increases with the strictness of bank supervisors and severity of the EDO. Consistent with management controls serving as channels for this change, there is a more pronounced effect on minority lending when an EDO mandates improvements in lending policies and stronger internal governance over lending decisions.

Keywords: Banking, Bank supervision, Discrimination, Enforcement actions, Internal controls, Internal audit, Loan policy, Mortgage lending

DOI: https://doi.org/10.17016/FEDS.2022.036r1

Abstract:

This paper investigates the impact of vaccine administration on three main dimensions of activity: spending, mobility, and employment. Our investigation combines two parts. First, we exploit the variation in vaccine administration across states. In panel regressions that include a large set of controls, we find that the rollout has a significant impact on spending, while the results on mobility and employment are mixed. Second, to address concerns of endogeneity, we look at the impact of vaccine lotteries on spending. Using a dynamic event design setting, we find that lotteries have significantly boosted vaccination rates about a week after announcement, with an effect that lasts over the next several days and increases new vaccinations between 3.5 and 5 percent. This boost in vaccination rates, in turn, translates into a significant increase in retail spending, which is larger and somewhat more persistent than what we document in our state-level panel regressions. All told, our findings imply that the vaccine rollout added, on average, 0.5 percentage point to GDP growth in 2021.
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Keywords: COVID-19 Vaccine Rollout, Economic Activity

DOI: https://doi.org/10.17016/FEDS.2022.035

Abstract:

We conduct a novel empirical analysis of the role of leverage of financial institutions for the transmission of financial shocks to the macroeconomy. For that purpose we develop an endogenous regime-switching structural vector autoregressive model with time-varying transition probabilities that depend on the state of the economy. We propose new identification techniques for regime switching models.

Recently developed theoretical models emphasize the role of bank balance sheets for the build-up of financial instabilities and the amplification of financial shocks. We build a market-based measure of leverage of financial institutions employing institution-level data and find empirical evidence that real effects of financial shocks are amplified by the leverage of financial institutions in the financial-constraint regime. We also find evidence of heterogeneity in how financial institutions, including depository financial institutions, global systemically important banks and selected nonbank financial institutions, affect the transmission of shocks to the macroeconomy. Our results confirm the leverage ratio as a useful indicator from a policy perspective.
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Keywords: Regime switching models, time-varying transition probabilities, financial shocks, leverage, bank and nonbank financial institutions, heterogeneity

DOI: https://doi.org/10.17016/FEDS.2022.034

Abstract:

This paper studies the consequences of asset bubbles for economies that are vulnerable to persistent stagnation. Stagnation is the result of a shortage of assets that creates an oversupply of savings and puts downward pressure on the level of interest rates. Once the zero lower bound on the nominal interest rate binds, the real rate cannot fully adjust downward, forcing output to fall instead. In such context, bubbles are useful as they expand the supply of assets, absorb excess savings and raise the natural interest rate - the real rate that is compatible with full employment - crowding in consumption and raising welfare. While safe bubbles are more likely to expand economic activity, riskier bubbles command a risk premium that, in equilibrium, lowers the real interest rate. A lower rate loosens borrowing constraints, potentially improving welfare when financing conditions are especially tight. Finally, fiscal policy that promises a bail-out transfer in case of a bubble collapse can support an existing bubble and improve welfare.
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Keywords: bubbles, secular stagnation, liquidity traps

DOI: https://doi.org/10.17016/FEDS.2022.033

Abstract:

This paper discusses how a Federal Reserve issued retail central bank digital currency (CBDC) could affect U.S. monetary policy implementation. Using a stylized balance sheet analysis, we analyze the effect a retail CBDC could have on the balance sheets of the Federal Reserve, commercial banks, and U.S. households. Then we consider how these balance sheet changes could affect monetary policy implementation for the Federal Reserve. We illustrate that the potential effects on monetary policy implementation from a retail CBDC are highly dependent on the initial conditions of the Federal Reserve’s balance sheet. Moreover, the analysis demonstrates how the Federal Reserve may use its existing tools to manage the effects of a retail CBDC on monetary policy implementation.
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Keywords: Bank behavior, Central banking, Households, Monetary policy implementation, Retail CBDC

DOI: https://doi.org/10.17016/FEDS.2022.032

Abstract:

This paper applies natural language processing to a large corpus of central bank speeches to identify those related to climate change. We analyze these speeches to better understand how central banks communicate about climate change. By all accounts, communication about climate change has accelerated sharply in recent years. The breadth of topics covered is wide, ranging from the impact of climate change on the economy to financial innovation, sustainable finance, monetary policy, and the central bank mandate. Financial stability concerns are touched upon, but macroprudential policy is rarely mentioned. Direct central bank action largely revolves around identifying and monitoring potential risks to the financial system. Finally, we find that central banks tend to use speculative language more frequently when talking about climate change relative to other topics.
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Keywords: Financial stability; Transparency; Central bank mandate; Green finance; Natural language processing; Central bank speeches

DOI: https://doi.org/10.17016/FEDS.2022.031

Abstract:

This paper considers the credit response of individuals after the implementation of new work requirements for Supplemental Nutrition Assistance (SNAP) benefits using a large nationally representative sample of credit records. It does so by exploiting county-level variation in the implementation of work requirements after the Great Recession in a difference-in-differences design. We find that the implementation of new SNAP work requirements leads more people to seek out new credit and leads to an increase in credit account openings. New work requirements also result in an increase in total outstanding balances on bank and retail card accounts and increase the number of borrowers that are past due on these accounts. These findings suggest that some individuals are turning to credit and debt products to cover expenses after losing eligibility for SNAP benefits.
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DOI: https://doi.org/10.17016/FEDS.2022.030

Abstract:

Recently, the experience of the 1960s—when the U.S. inflation rate rose rapidly and persistently over a comparatively short period—has been invoked as a cautionary tale for the present. An analysis of this period indicates that the inflation regime that prevailed in the 1960s was different in several key regards from the one that prevailed on the eve of the pandemic. Hence, there are few useable lessons to be drawn from this experience, save that monetary policymaking remains a difficult undertaking.
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DOI: https://doi.org/10.17016/FEDS.2022.029

Abstract:

Is the Phillips curve dead? If so, who killed it? Conventional wisdom has it that the sound monetary policy since the 1980s not only conquered the Great Inflation, but also buried the Phillips curve itself. This paper provides an alternative explanation: labor market policies that have eroded worker bargaining power might have been the source of the demise of the Phillips curve. We develop what we call the "Kaleckian Phillips curve", the slope of which is determined by the bargaining power of trade unions. We show that a nearly 90 percent reduction in inflation volatility is possible even without any changes in monetary policy when the economy transitions from equal shares of power between workers and firms to a new balance in which firms dominate. In addition, we show that the decline of trade union power reduces the share of monopoly rents appropriated by workers, and thus helps explain the secular decline of labor share, and the rise of profit share. We provide time series and cross sectional evidence.

DOI: https://doi.org/10.17016/FEDS.2022.028

Abstract:

We study aggregate, distributional, and welfare effects of a permanent reduction in the capital tax rate in a quantitative model with capital-skill complementarity and household heterogeneity. Such a tax reform leads to expansionary long-run aggregate output and investment effects, but those are coupled with increases in wage, consumption, and income inequality. The tax reform is not self-financing and its effects depend crucially on whether the government cuts lump-sum transfers or raises distortionary labor or consumption tax rates for financing. The former results in a larger aggregate expansion, but at the expense of a greater rise in inequality. As a result, the latter is relatively more beneficial for unskilled households. We find that the tax reform, when the consumption tax rate adjusts, leads to a Pareto improvement in terms of life-time welfare. For transition dynamics, monetary policy, in addition to the fiscal adjustments, matters. In particular, if monetary policy inflates away a portion of the public debt, the economy can avoid the short-run contraction that would arise otherwise.

DOI: https://doi.org/10.17016/FEDS.2022.027

Abstract:

The standard model of permanent and transitory income is known to be misspecified. Estimates of income volatility in the model differ depending on the type of data moments used—levels or differences—and how these moments are weighted in the estimation. We propose two changes to the standard model. First, we account for the time-aggregated nature of observed income data. Second, we allow transitory shocks to persist for varying lengths of time. With only one additional parameter, our proposed model consistently recover the parameters of the income process irrespective of the estimation method. To the extent that researchers employ the standard model, we advise special caution with the use of first-difference moments.

DOI: https://doi.org/10.17016/FEDS.2022.026

Abstract:

This paper studies the effects of a unique multi-day cyberattack on a technology service provider (TSP). Using several confidential daily datasets, we identify and quantify first- and second-round effects of the event. For banks using relevant services of the TSP, the attack impaired their ability to send payments over Fedwire, even though the Federal Reserve extended the time they had to submit payments. This impairment (first-round effect) caused other banks to receive fewer payments (second-round effect), leaving them at risk of having too few reserves to send their own payments (a potential third-round effect). These innocent-bystander banks responded differently depending on their size and reserve holdings. Those with sufficient reserves drew down their reserves. Of the others, smaller banks borrowed from the discount window, while larger banks borrowed in the federal funds market. These significant adjustments to operations and funding prevented the second-round effect from spilling over into third-round effect and broader financial instability. These findings highlight the important role for bank contingency planning, liquidity buffers, and the Federal Reserve in supporting the financial system’s recovery from a cyberattack.

DOI: https://doi.org/10.17016/FEDS.2022.025

Abstract:

Our paper studies the role of the collateral channel for bank credit using confidential bank-firm-loan data. We estimate that for a 1 percent increase in collateral values, firms pledging real estate collateral experience a 12 basis point higher growth in bank lending with higher sensitivities for more credit constrained firms. Higher real estate values boost firm capital expenditures and lead to lower unemployment and higher employment growth and business creation. Our estimates imply that as much as 37 percent of employment growth over the period from 2013 to 2019 can be attributed to the relaxation of borrowing constraints.

Keywords: bank credit, collateral channel, corporate investment, firm borrowing constraints, macro-finance mechanisms

DOI: https://doi.org/10.17016/FEDS.2022.024

Abstract:

Credit default swaps (CDS) are the most common type of credit derivative. This paper provides a brief history of the CDS market and discusses its main characteristics. After describing the basic mechanics of a CDS, I present a simple valuation framework that focuses on the relationship between conditions in the cash and CDS markets as well as an approach to mark to market existing CDS positions. The discussion highlights how the 2008 global financial crisis helped shape current practices and conventions in the CDS market, including the widespread adoption of standardized coupons and upfront premiums and the increased reliance on centralized counterparties. I also address CDS indexes--focusing on their growing role as key indicators of investors’ attitudes toward credit risk--and briefly examine their behavior during periods of acute financial or economic dislocations, including those associated with the COVID-19 pandemic.

Keywords: credit derivatives, credit default swaps, credit risk, CDX, credit curves, CDS-cash basis, CDS valuation

DOI: https://doi.org/10.17016/FEDS.2022.023

Abstract:

The use of stress testing for macroprudential objectives is advanced by modeling spillovers within the financial sector or between the real and financial sectors. In this chapter, we discuss several macroprudential elements that capture these spillovers and how they might be added to stress test frameworks. We show how funding spillovers can be modeled as an add-on, using a reduced-form relation between banks’ funding cost, bank capital and economic activity. Using a calibration to US data, we project very modest funding spillovers conditional on the DFAST 2018 severely adverse scenario. We describe the pros and cons of modeling different types of spillovers using this approach.

Keywords: Bank capital, Funding shocks, Macroprudential policy, Stress testing

DOI: https://doi.org/10.17016/FEDS.2022.022

Abstract:

In response to immense strains in the asset-backed securities market in 2008 and 2020, the Federal Reserve and the U.S. Treasury twice launched the Term Asset-Backed Securities Loan Facility (TALF). TALF was an unusual crisis facility because it provided loans to a wide range of nonbank financial institutions. Using detailed loan-level data unexplored by previous researchers, we study the behavior of nonbank borrowers in TALF. We find the extent to which the actions of these borrowers supported key program goals--stabilizing markets quickly, winding down the program when it was no longer needed, providing liquidity to a wide range of assets, and having borrowers internalize credit risk rather than shift it to the government--were related to institutional differences across nonbanks. Since all TALF borrowers faced the same program terms and conditions, our study is able to highlight the role of these institutional constraints.

DOI: https://doi.org/10.17016/FEDS.2022.021

Abstract:

What are the implications of information technology (IT) in banking for financial stability? Data on US banks' IT equipment and the background of their executives reveals that higher pre-crisis IT adoption led to fewer non-performing loans and more lending during the global financial crisis. Empirical evidence indicates a direct role of IT adoption in strengthening bank resilience; this includes instrumental variable estimates exploiting the historical location of technical schools. Loan-level analysis shows that high-IT banks originated mortgages with better performance, indicating better borrower screening. No evidence points to offloading of low-quality loans, differences in business models, or enhanced monitoring.

DOI: https://doi.org/10.17016/FEDS.2022.020

Abstract:

Borrowing for education has increased rapidly in the past several decades, such that the majority of non-housing debt on US households' balance sheets is now student loan debt. This chapter analyzes the implications of student loan borrowing for later-life economic well-being, with a focus on retirement preparation. We demonstrate that families holding student loan debt later in life have less savings than their similarly educated peers without such debt. However, these comparisons are misleading if the goal is to characterize the experience of the typical student borrower, as they fail to account for student borrowers who already paid off their debt. We develop strategies to locate families that ever financed their education with student loans in two large datasets which enables us to draw more meaningful comparisons. We find that student loan borrowers roughly follow the earnings, saving, and wealth trajectories of other college-educated families into late-career ages and are much better off financially than those that did not attend college.

DOI: https://doi.org/10.17016/FEDS.2022.019

Abstract:

I study the business cycle properties of wage posting models with random search, for which the distributions of employment and wages play a nontrivial role for the equilibrium path. In fact, the main result of this paper is that the distribution of firms is one of the most important elements to understand business cycle fluctuations in the labor market. The distribution of firms (1) determines which shocks are relevant for the labor market, (2) implies that wage rigidity does not significantly amplify shocks, and (3) puts discipline on the relative value of the flow opportunity cost of employment. To assess these type of models quantitatively, I propose a new algorithm that finds the steady state and computes transitional dynamics rapidly. Hence, integrating wage posting models with random search to larger models becomes possible (and easy) with this new algorithm.
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Keywords: Wage Posting, Search and Matching, Stochastic Simulations

DOI: https://doi.org/10.17016/FEDS.2022.018

Abstract:

We study the role of mortgage servicers in implementing the CARES Act mortgage forbearance program during the COVID-19 pandemic. Despite universal eligibility, around one-third of the nonperforming federally-backed loans in our sample fail to enter into forbearance. The relative frequency of these "missing" forbearances varies significantly across servicers for observably similar loans, with small servicers and nonbanks, and especially nonbanks with small liquidity buffers, having a lower propensity to provide forbearance. The incidence of forbearance-related complaints by borrowers is also higher for these servicers. We also use servicer-level variation to estimate the causal effect of forbearance on borrower outcomes. Assignment to a "high-forbearance" servicer translates to a significant increase in the probability of nonpayment, which moves essentially 1:1 with the forbearance probability. Part of this additional household liquidity is used to pay down high-cost credit card debt.
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Keywords: mortgage, forbearance, debt relief, CARES Act, COVID-19, liquidity

DOI: https://doi.org/10.17016/FEDS.2022.017

Abstract:

Inflation was low and stable in the United States during the first two decades of the 21st century and broke out of its stable range in 2021. Experience in the early 21st century differed from that of the second half of the 20th century, when inflation showed persistent movements including the "Great Inflation" of the 1970s. This analysis examines the extent to which the experience from 2000-2019 should lead a Bayesian decisionmaker to update their assessment of inflation dynamics. Given a prior for inflation dynamics consistent with 1960-1999 data, a Bayesian decisionmaker would not update their view of inflation persistence in light of 2000-2019 data unless they placed very low weight on their prior information. In other words, 21st century data contains very little information to dissuade a Bayesian decisionmaker of the view that inflation fluctuations are persistent, or "unanchored". The intuition for, and implications of, this finding are discussed.
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Keywords: Inflation; Phillips Curve; Econometric Modeling.

DOI: https://doi.org/10.17016/FEDS.2022.016

Abstract:

Hurricane Harvey brought more than four feet of rainfall to the Houston area in August 2017, leading to substantial flooding in many areas. Using regulatory data with detailed information on borrowing terms, we compare the borrowing response to Hurricane Harvey in parts of Houston that were more and less affected by flooding. We find that hurricane-affected households borrowed in a price-sensitive and time-limited manner, relying almost exclusively on promotional-rate credit cards and mortgage forbearance for new credit and repaying balances quickly. We find that conditional on flooding, households in FEMA-designated floodplains borrowed less. Within the floodplain, building code changes that required homes to be elevated above the floodplain dramatically reduced households’ storm-related liquidity use. Flooded borrowers in homes subject to this type of physical hardening used forbearance at the same rate as borrowers who did not experience flooding, suggesting that for natural disasters, ex ante physical hardening is a substitute for ex post credit.
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DOI: https://doi.org/10.17016/FEDS.2022.015

Abstract:

We propose a method to decompose stock returns period by period. First, we argue that one can directly estimate expected stock returns from securities available in modern financial markets (using the real yield curve and the Martin (2017) equity risk premium). Second, we derive a return decomposition which is based on stock price elasticities with respect to expected returns and expected dividends. We calculate elasticities from dividend futures. Our decomposition is an alternative to the Campbell-Shiller log-linearization which relies on an assumption about the log-linearization constant. An application to the COVID crisis in 2020 reveals that risk premium changes drove much of the crash and rebound in the S&P500 while a fall in long-term real yields drove a strong positive return for 2020 as a whole.

DOI: https://doi.org/10.17016/FEDS.2022.014

Abstract:

This paper studies competitive market shutdowns due to adverse selection, where sellers post nonexclusive menus of contracts. We first show that the presence of the worst type of agents (moldy lemons) causes markets to fail only if their mass is sufficiently large. We then show that a small mass of moldy lemons can lead to a large cascade of exits when buyers possess outside options. Finally, we show that more precise information about agents' types makes markets more prone to exit cascades. The model is general and does not rely on institution details or structure, and thus can be applied to many different markets and context.

Note: The title of this paper was updated after initial publication.

DOI: https://doi.org/10.17016/FEDS.2022.013

Abstract:

Money market funds (MMFs) are popular around the world, with over $9 trillion in assets under management globally. From their origins in the 1970s, MMFs have operated in a niche between the capital markets and the banking system, as investment funds that offer private money‐like assets with features similar to those of bank deposits. Hence, they are vulnerable to runs that arise from liquidity transformation and from sudden changes in investor perceptions of the funds’ ability to serve as money‐like assets. Since 2000, MMF runs have occurred in many countries and under many regulatory regimes. The global pattern of runs and crises shows that MMF vulnerabilities are not unique to a particular set of governing arrangements, and that mitigating these vulnerabilities requires fundamental reforms that either place MMFs more clearly within the investment‐fund sector or establish protections for MMFs similar to those for deposits.

DOI: https://doi.org/10.17016/FEDS.2022.012

Abstract:

This paper explores the factors behind differences in wages between manufacturing and other sectors. Using data from the Current Population Survey, we find that the manufacturing wage premium—the additional pay a manufacturing worker earns relative to a comparable nonmanufacturing worker—disappeared in recent years and that the erosion of the premium has primarily affected workers employed in production occupations, who experienced a wage decline of 2.5 percentage points since the 1990s relative to other workers in production occupations. While the demographic composition and other worker observables introduce level differences in manufacturing premia, our analysis suggests that they are not responsible for the declining trends. A decomposition of the premium by union membership status reveals that declines have been substantially larger across union members. To quantify the role of unionization membership on wage premia, we exploit the heterogeneity in membership status across industries within manufacturing. We find that the decline in union membership explains more than 70 percent of the decline in premia since the 1990s for union members, but the declines in unionization rates have not significantly affected non-union premia, which have instead responded to other factors, such as capital intensity. Our findings suggest that the erosion of “good” manufacturing jobs has contributed to the increase in overall wage inequality and could accelerate the decline of the manufacturing sector.

DOI: https://doi.org/10.17016/FEDS.2022.011

Abstract:

Prevailing explanations of persistently low interest rates appeal to a secular decline in the natural interest rate, or r-star, due to factors outside monetary policy's control. We propose informational feedback via learning as an alternative explanation for persistently low rates, where monetary policy plays a crucial role. We extend the canonical New Keynesian model to an incomplete information setting where the central bank and the private sector learn about r-star and infer each other's information from observed macroeconomic outcomes. An informational feedback loop emerges when each side underestimates the effect of its own action on the other's inference, possibly leading to large and persistent changes in perceived r-star disconnected from fundamentals. Monetary policy, through its influence on the private sector's beliefs, endogenously determines r-star as a result. We simulate a calibrated model and show that this `hall-of-mirrors' effect can explain much of the decline in real interest rates since 2008.

Keywords: Dispersed information, Learning, Long-term rates, Misperception, Monetary policy shocks, Natural rate of interest, Overreaction

DOI: https://doi.org/10.17016/FEDS.2022.010

Abstract:

While the bank stress test exercise conducted by the Federal Reserve System is a critical policy tool for assessing the health of large banks, the Federal Reserve has worked to build additional tools to assess the resiliency of the banking system as a whole and to address macroprudential goals. The Forward-Looking Analysis of Risk Events (FLARE) model is one such tool. This technical note describes the FLARE model, which is a top-down model that helps assess how well the banking system is positioned to weather exogenous macroeconomic shocks. FLARE estimates banking system capital under varying macroeconomic scenarios, time horizons, and other systemic shocks.

DOI: https://doi.org/10.17016/FEDS.2022.009

Abstract:

This paper studies the impact of unanticipated monetary policy news around FOMC announcements on secondary market corporate loan spreads. I find that the reaction of loan spreads to monetary policy news is weaker than that of bond spreads: following an unanticipated monetary policy tightening (easing) shock, loan spreads do not increase (decrease) as much as bond spreads do. Decomposition of the spreads into compensations for expected defaults and risk premiums shows that differential reactions of loan and bond risk premiums are the main driver of the differential spread reactions. This paper further finds that the weaker loan spread reactions to monetary policy shocks are more pronounced for riskier loans. Lastly, reactions of primary market loan spreads to monetary policy shocks are also muted. These findings highlight heterogeneous impacts of monetary policy across different types of corporate credit markets, possibly reflecting heterogeneous investor demand responses to monetary policy in those markets.

DOI: https://doi.org/10.17016/FEDS.2022.008

Abstract:

We provide new evidence on the effect of education on later life health. Using variation in state compulsory schooling laws, we examine education's effect on a range of outcomes encompassing physical health, decision-making, and life expectancy. We employ under-utilized Health and Retirement Study data linked to restricted geographic identifiers, allowing us to match individuals more accurately to compulsory schooling laws. While positively related to educational attainment, compulsory schooling laws have no significant effect on later life health outcomes. Our results suggest that increased educational attainment has no significant causal effect on health.

DOI: https://doi.org/10.17016/FEDS.2022.007

Abstract:

This paper reviews literature on the empirical relationship between vulnerabilities in the financial system and the macroeconomy, and how monetary policy affects that connection. Financial vulnerabilities build up over time, with both risk appetite and risk taking rising during economic expansions. To some extent, financial crises are predictable and have severe real economic consequences when they occur. Empirically it is difficult to link monetary policy to financial vulnerabilities, in part because financial cycles have long durations, making it difficult to separate effects of changes in monetary policy from other business cycle effects.

DOI: https://doi.org/10.17016/FEDS.2022.006

Abstract:

This paper reviews the theoretical literature at the intersection of macroeconomics and finance to draw lessons on the connection between vulnerabilities in the financial system and the macroeconomy, and on how monetary policy affects that connection. This literature finds that financial vulnerabilities are inherent to financial systems and tend to be procyclical. Moreover, financial vulnerabilities amplify the effects of adverse shocks to the economy, so that even a small shock to fundamentals or a small revision of beliefs can create a self-reinforcing feedback loop that impairs credit provision, lowers asset prices, and depresses economic activity and inflation. Finally, monetary policy may affect the buildup of vulnerabilities, but the sign of the impact along some of its transmission channels is theoretically ambiguous and may vary with the state of the economy.

DOI: https://doi.org/10.17016/FEDS.2022.005

Abstract:

This paper develops a simple framework that helps to draw out some of the potential connections between ex-ante liquidity risk management tools such as liquidity requirements or mandatory fees and ex-post liquidity tools such as a lender of last resort. A central message of this analysis is that policy actions that expand the lender of last resort function so as to better address periods of financial distress are likely to be most effective when accompanied by regulations or other mechanisms that encourage socially-responsible ex-ante liquidity risk management on the part of financial firms. Regulation in the form of a liquidity coverage requirement can be helpful in moving private sector outcomes toward a social optimum. A mandatory fee schedule also emerges as a potentially very useful tool. The structure of the optimal fee schedule depends on both the scale of volatile liabilities and the extent of “liquidity coverage” maintained to cover potential funding shortfalls. Both liquidity requirements and mandatory fees can help to address a form of time consistency problem in connection with the provision of ex-post liquidity support through a lender of last resort. The framework also provides some potentially useful benchmarks in evaluating the distribution of liquidity risks across different classes of financial firms.

Keywords: Lender of Last Resort, Liquidity Regulation, Treasury Market

DOI: https://doi.org/10.17016/FEDS.2022.004

Abstract:

We review developments in research on within-country migration, focusing on internal migration in the U.S. We begin by describing approaches to modelling individuals' migration decisions and equilibrium outcomes across local areas. Next, we summarize evidence regarding the impact of migration on individuals' outcomes, implications of migration for local labor market adjustment, and interactions between migration and housing markets. Finally, we discuss evidence on the efficacy of policies aimed at encouraging migration and conclude by highlighting important unanswered questions that are critical for informing migration-related policy.

Keywords: Internal migration, migration, mobility

DOI: https://doi.org/10.17016/FEDS.2022.003

Abstract:

This paper uses data from the Financial Accounts of the United States to map out the regulatory boundaries of assets held by U.S. financial institutions from a macroprudential perspective. We provide a quantitative measure of the regulatory perimeter—the boundary between the part of the financial sector that is subject to some form of prudential regulatory oversight and that which is not—and show how it has evolved over the past forty years. Additionally, we measure the boundaries between different regulatory agencies and financial institutions that operate within the regulatory perimeter and illustrate how these boundaries potentially become blurred in the face of regulatory overlap. Quantifying the regulatory perimeter and the boundaries for macroprudential regulators within the perimeter is informative for assessing financial stability risks over the credit cycle.

Keywords: Regulation; Regulatory reach; Boundary problem; Financial institutions

DOI: https://doi.org/10.17016/FEDS.2022.002

Abstract:

This paper discusses the Federal Reserve's new framework and highlights some important policy implications that flow from the revised consensus statement and the new strategy. In particular, it first discusses the factors that motivated the Federal Reserve in November 2018 to announce it would undertake in 2019 the first-ever public review of its monetary policy strategy, tools, and communication practices. It then considers the major findings of the review as codified in our new Statement on Longer-Run Goals and Monetary Policy Strategy and highlights some important policy implications that flow from them.

Keywords: FOMC, Monetary policy

DOI: https://doi.org/10.17016/FEDS.2022.001