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Marco Del Negro, Marc Giannoni, Raiden Hasegawa, and Frank Schorfheide
Since the financial crisis of 2007-08 and the Great Recession, many commentators have been baffled by the “missing deflation” in the face of a large and persistent amount of slack in the economy. Some prominent academics have argued that existing models cannot properly account for the evolution of inflation during and following the crisis. For example, in his American Economic Association presidential address, Robert E. Hall called for a fundamental reconsideration of Phillips curve models and their modern incarnation—so-called dynamic stochastic general equilibrium (DSGE) models—in which inflation depends on a measure of slack in economic activity. The argument is that such theories should have predicted more and more disinflation as long as the unemployment rate remained above a natural rate of, say, 6 percent. Since inflation declined somewhat in 2009, and then remained positive, Hall concludes that such theories based on a concept of slack must be wrong.
In a recently released New York Fed staff report, we present a forward-looking monitoring program to identify and track time-varying sources of systemic risk. Our program distinguishes between shocks, which are difficult to prevent, and the vulnerabilities that amplify shocks, which can be addressed. Drawing on a substantial body of research, we identify leverage, maturity transformation, interconnectedness, complexity, and the pricing of risk as the primary vulnerabilities in the financial system. The monitoring program tracks these vulnerabilities in four sectors of the economy: asset markets, the banking sector, shadow banking, and the nonfinancial sector. The framework also highlights the policy trade-off between reducing systemic risk and raising the cost of financial intermediation by taking pre-emptive actions to reduce vulnerabilities.
Adam Copeland, Isaac Davis, Eric LeSueur, and Antoine Martin
The repurchase agreement (repo), a contract that closely resembles a collateralized loan, is widely used by financial institutions to lend to each other. The repo market is divided into trades that settle on the books of the two large clearing banks (that is, tri-party repo) and trades that do not (that is, bilateral repo). While there are public data about the tri-party repo segment, there is little to no information on the bilateral repo segment. In this post, we update a methodology we developed earlier to estimate the size and composition of collateral posted for bilateral repos, and find that U.S. Treasury securities are the dominant form of collateral for bilateral repos. This new finding implies that the collateral posted for bilateral repos is of higher quality than the collateral posted for tri-party repos.
Currency forwards do include useful information about the future value of the U.S. dollar, but any messages are hard to decipher without tools. Just as the yield curve reflects expected short rates as well as
foreign exchange forwards embed not only anticipated depreciation but also premiums for currency risk. This complicates life for both central bankers, who routinely tease information from asset prices, and portfolio managers, who need to estimate expected returns and beat benchmarks. Most analyses of market quotes suggest that forwards as well as interest rate differentials largely comprise noise rather than information about anticipated currency returns. However, drawing on my recent
a new method, analogous to common arbitrage-free term structure models and based solely on observable prices, suggests that forwards provide lucid clues about the expected path of the U.S. dollar.
One of the lessons from the recent financial crisis is the need for securities dealers to have durable sources of funding. As evidenced by the demise of Bear Stearns and Lehman Brothers, during times of stress, cash lenders may pull away from firms or funding markets more broadly. Lengthening the tenor of secured funding is one way for a dealer to mitigate the risk of losing funding when market conditions are strained. In this post, we use clearing bank tri-party repo data to examine the degree to which dealers are lengthening the maturities of their sources of funding. (Aggregate statistics using these data are available here.) We focus on less liquid securities because it is for these assets that the durability of funding matters the most. We find substantial progress overall, with the weighted-average maturity (WAM) of funding of the less liquid securities more than doubling from January 2011 to May 2014. Nevertheless, there is currently a wide dispersion in dealer-level WAM, raising questions as to whether all dealers have enough durability in their funding of risk assets.
The spot term premium is the extra compensation investors require, today, to own long-term as opposed to short-term risk-free debt. The expected term premium is what they anticipate demanding later. Notably, the two don’t necessarily move in the same direction. Just as near-term expected short rates could decline with surprisingly easy monetary policy, while simultaneously more distant-horizon expected rates could increase if that action boosts expected longer-run inflation or growth, so too could investors require less duration compensation immediately, perhaps as the central bank announces plans to buy assets, yet build in greater risk premiums for later amid allowances for a bumpy withdrawal of the punchbowl. Why is this distinction relevant? Nearly everyone agrees that historically low term premiums coincided with unconventional measures, but we know less about how long investors expected low premiums to prevail. Drawing on my staff report, formal models suggest that expected term premiums did drop along with spot measures, but a survey-based estimate notably increased since 2007. This hardly means the Federal Open Market Committee (FOMC) didn’t provide extraordinary support beyond the standard short rate channel, but perhaps investors weren’t insouciant and instead fathomed a possibly tricky exit from prolonged policy accommodation.
Most gauges of “the” equity risk premium have declined since the financial crisis but remain elevated, even as broad market indexes near record highs. The implication for investors seems simple; they can expect to be rewarded handsomely for bearing equity risk, relative to holding Treasuries. Lessons for central bankers may also appear straightforward. Sizable premiums could imply that aggressive unconventional monetary policy hasn’t necessarily eased financial market conditions satisfactorily. However, my recent New York Fed staff report suggests that such a cursory reading ignores the term structure of equity premiums, which conveys a subtler story about more precisely when over the investment horizon investors get paid to take risk and how monetary policy accommodation may have affected stock prices.
Tobias Adrian, Richard Crump, Benjamin Mills, and Emanuel Moench
Treasury yields can be decomposed into two components: expectations of the future path of short-term Treasury yields and the Treasury term premium. The term premium is the compensation that investors require for bearing the risk that short-term Treasury yields do not evolve as they expected. Studying the term premium over a long time period allows us to investigate what has historically driven changes in Treasury yields. In this blog post, we estimate and analyze the Treasury term premium from 1961 to the present, and make these estimates available for download here.
Decades of research have produced a library on the “momentum” anomaly in markets. Momentum refers to the tendency for financial assets with the best prior returns to continue to produce superior results, at least for a time. Previous findings—regarding individual U.S. stocks as well as foreign shares, broad equity indexes, commodities, and currencies—contradict the common wisdom that markets are efficient. Curiously, even though the market for nominal U.S. Treasury securities is among the deepest and most liquid in the world, no one has rummaged through government bond term structures to find similar strategies that work, no matter what the future general direction of interest rates. Yet my recent staff report describes simple low-cost trading rules that produce positively skewed and sizable excess returns, merely by directing investors to construct portfolios of maturities that have had superior returns. Neither short sales nor exposure to interest rate risk is required.
The recent financial crisis has highlighted the significance of unhedgable, illiquid positions in complex securities for individual financial institutions and for the global financial system as a whole. Indeed, the Basel Committee on Banking Supervision notes that
One of the key lessons of the crisis has been the need to strengthen the risk coverage of the capital framework. Failure to capture major on- and off-balance sheet risks, as well as derivative related exposures, was a key destabilizing factor during the crisis.
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