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Finance and Economics Discussion Series

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Abstract: Factor models are widely used in summarizing large datasets with few underlying latent factors and in building time series forecasting models for economic variables. In these models, the reduction of the predictors and the modeling and forecasting of the response y are carried out in two separate and independent phases. We introduce a potentially more attractive alternative, Sufficient Dimension Reduction (SDR), that summarizes x as it relates to y, so that all the information in the conditional distribution of y|x is preserved. We study the relationship between SDR and popular estimation methods, such as ordinary least squares (OLS), dynamic factor models (DFM), partial least squares (PLS) and RIDGE regression, and establish the connection and fundamental differences between the DFM and SDR frameworks. We show that SDR significantly reduces the dimension of widely used macroeconomic series data with one or two sufficient reductions delivering similar forecasting performance to that of competing methods in macro-forecasting.

Keywords: Diffusion Index, Dimension Reduction, Factor Models, Forecasting, Partial Least Squares, Principal Components

DOI: https://doi.org/10.17016/FEDS.2017.004

Abstract: This paper models the important role that repurchase agreements (repos) play in bond market intermediation. Not only do repos allow dealers to finance their activities, but they also increase dealers' ability to satisfy levered client demands without having to adjust their holdings of risky assets. In effect, the ability to borrow specific assets for delivery allows dealers to source large quantity of assets without taking ownership of them. Larger levered client orders imply larger asset borrowing demands, thus increasing the borrowing cost for the asset (i.e., repo specialness). Dealers pass on the higher intermediation cost to their clients in the form of higher bid-ask spreads. Although this method of intermediation is optimal, the use of repos significantly increases dealers' balance sheets. Limiting one dealer's balance sheet leverage, leaving all else equal, reduces the affected dealer's market making abilities and increases his bid-ask spreads. The equilibrium effect of limiting all dealers' balance sheet leverage on bid-ask spreads is unclear, and depends on the intensity of clients' demand and securities lenders' sensitivity to repo specialness.

Keywords: Market liquidity, Financial services and intermediation, Repo, Specialness, U.S. Treasury market

DOI: https://doi.org/10.17016/FEDS.2017.003

Abstract: Tax return data are increasingly the standard for tracking income statistics in the United States. However, these data have traditionally been limited by their inability to capture non-filers and to identify members of separate tax units living in the same household. We overcome these obstacles and create household records directly in the tax data using mailing address information included on tax forms. We then present the first set of tax-based household income and inequality measures for the entire income distribution. When comparing household income inequality results in the tax data to those using the March CPS, we confirm previous findings that the March CPS understates the inequality of household income. However, we also find that the previous approach of using tax units in the IRS data to proxy for households leads to an overstatement of household income inequality. Finally, using households in the IRS tax records, we illustrate how focusing on tax units rather than households alters the observed distribution of tax programs such as the Earned Income Tax Credit.

Keywords: EITC, Household Income, IRS Data, Income Inequality, Tax Unit Income

DOI: https://doi.org/10.17016/FEDS.2017.002

Abstract: We investigate how the use of a currency transmits monetary policy shocks in the global banking system. We use newly available unique data on the bilateral cross-border lending flows of 27 BIS-reporting lending banking systems to over 50 borrowing countries, broken down by currency denomination (USD, EUR and JPY). We have three main findings. First, monetary shocks in a currency significantly affect cross-border lending flows in that currency, even when neither the lending banking system nor the borrowing country uses that currency as their own. Second, this transmission works mainly through lending to non-banks. Third, this currency dimension of the bank lending channel works similarly across the three currencies suggesting that the cross-border bank lending channel of liquidity shock transmission may not be unique to lending in USD.

Keywords: Bank lending channel, Cross-border bank lending, Currency denomination, Monetary transmission

DOI: https://doi.org/10.17016/FEDS.2017.001

 

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Last update: January 17, 2017