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Finance and Economics Discussion Series

Other Years Available:
 feds  2016-095
December 2016

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

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

 feds  2016-093
November 2016

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

 feds  2016-092
November 2016

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

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

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

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

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

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

 feds  2016-086
November 2016

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

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

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

 feds  2016-083
October 2016

Simple Estimators for ARCH Models (PDF)

Todd Prono

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 identi?cation (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-de?ned 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 con?dence intervals for the ARCH estimates are also discussed.

Appendix (PDF)

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

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

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

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

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

Accessible materials (.zip)

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

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

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

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

 feds  2016-075
September 2016

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

 feds  2016-074
September 2016

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

 feds  2016-073
September 2016

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

 feds  2016-072
September 2016

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

 feds  2016-071
September 2016

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

 feds  2016-070
August 2016

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

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

 feds  2016-068
August 2016

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

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

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

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 the recent comprehensive 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. 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.2016.065

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

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

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

 feds  2016-061
August 2016

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

 feds  2016-060
August 2016

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

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

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

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

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

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

 feds  2016-054
July 2016

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

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

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

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

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

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

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

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

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

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

 feds  2016-044
May 2016

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

 feds  2016-043
May 2016

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

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

Original paper (PDF)

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

 feds  2016-041
May 2016

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

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

 feds  2016-039
May 2016

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

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

Accessible materials (.zip)

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

Accessible materials (.zip)

 feds  2016-036
April 2016

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

Accessible materials (.zip)

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

Accessible materials (.zip)

 feds  2016-034
April 2016

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

Accessible materials (.zip)

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

Accessible materials (.zip)

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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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

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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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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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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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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

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 feds  2016-026
April 2016

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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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
March 2016

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

Matteo Barigozzi, Marco Lippi, and Matteo Luciani

Abstract: We develop the econometric theory for Non-Stationary Dynamic Factor models for large panels of time series, with a particular focus on building estimators of impulse response functions to unexpected macroeconomic shocks. We derive conditions for consistent estimation of the model as both the cross-sectional size, n, and the time dimension, T, go to infinity, and whether or not cointegration is imposed. We also propose a new estimator for the non-stationary common factors, as well as an information criterion to determine the number of common trends. 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, common trends, impulse response functions, unit root processes

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

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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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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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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
March 2016

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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Abstract: The importance of financial frictions for the business cycle is widely recognized, but it is less recognized that their effects depend heavily on the underlying asset pricing theory. This paper examines the implications of learning-based asset pricing. I construct a model in which firms' ability to access credit depends on their market value, and investors rely on past observation to predict future stock prices. Agents' expectations remain model-consistent conditional on their beliefs about stock prices, which disciplines the expectation formation process. The model matches several asset price properties such as return volatility and predictability and also leads to a powerful feedback loop between asset prices and real activity, substantially amplifying business cycle shocks. Agents' expectational errors on asset prices spill over to forecasts of economic activity, resulting in forecast error predictability that closely matches survey data. A reaction of monetary policy to asset prices is welfare-improving under learning but not under rational expectations.

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

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

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 feds  2016-018
March 2016

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
March 2016

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

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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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
February 2016

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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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
February 2016

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

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 feds  2016-011
February 2016

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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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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 feds  2016-009
February 2016

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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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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 feds  2016-007
February 2016

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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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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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
February 2016

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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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
February 2016

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

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Abstract: Rigidity in wages has long been thought to impede the functioning of labor markets. One recent strand of the research on wage flexibility in the United States and elsewhere has focused on the possibility of downward nominal wage rigidity and what implications such rigidity might have for the macroeconomy at low levels of inflation. The Great Recession of 2008-09, during which the unemployment rate topped 10 percent and price deflation was at times seen as a distinct possibility, along with the subsequent slow recovery and persistently low inflation, has added to the relevance of this line of inquiry. In this paper, we use establishment-level data from a nationally representative establishment-based compensation survey collected by the Bureau of Labor Statistics to investigate the extent to which downward nominal wage rigidity is present in U.S. labor markets. We use several distinct methods proposed in the literature to test for downward nominal wage rigidity, and to as sess whether such rigidity is more severe at low rates of inflation and in the presence of negative economic shocks than in more normal economic times. Like earlier studies, we find evidence of a significant amount of downward nominal wage rigidity in the United States. We find no evidence that the high degree of labor market distress during the Great Recession reduced the amount of downward nominal wage rigidity and some evidence that operative rigidity may have increased during that period.

Keywords: labor markets, wage rigidity

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

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