Board of Governors of the Federal Reserve System

Abstract:

We develop an incomplete-markets heterogeneous agent New-Keynesian (HANK) model in which households are allowed to lend and borrow, subject to a borrowing constraint. We show that, in this framework, forward guidance, that is the promise by the central bank to lower future interest rates, can be a powerful policy tool, especially when the economy is in a liquidity trap. In our model, the power of forward guidance is amplified by three redistributive channels, absent in a representative agent new- Keynesian model (RANK) or in a HANK model without private debt. First, expected lower rates imply a future transfer of wealth from savers to borrowers, reducing precautionary motives and stimulating current demand and inflation. Second, higher initial inflation lowers the path of the real rate increasing the wealth of borrowers, who have a higher marginal propensity to consume (MPC). Third, if debt is nominal, debt deflation generates also a wealth transfer towards high-MPC borrowing-constrained agents, further increasing aggregate consumption and inflation. These channels amplify each other in a liquidity trap, and can make forward guidance more powerful in a HANK model than in a RANK framework. These results contrast with previous research on HANK models, which focused on frameworks where agents were not allowed to borrow, and which found negligible effects of forward guidance.

Keywords: HANK model, zero lower bound, forward guidance, household debt

DOI: https://doi.org/10.17016/IFDP.2019.1267

Abstract:

What is the relationship between international trade and business cycle synchronization? Using data from 40 countries, we find that GDP comovement is significantly associated with trade in intermediate inputs but not with trade in final goods. Motivated by this new fact, we build a model of international trade that is able to replicate the empirical trade-comovement slope, offering the first quantitative solution for the Trade Comovement Puzzle. The model relies on (i) global value chains, (ii) price distortions due to monopolistic competition and (iii) fluctuations in the mass of firms serving each country. The combination of these ingredients creates a link between domestic measured productivity and foreign shocks through trade linkages, generating a disconnect between technology and measured productivity. Finally, we provide empirical evidence for the importance of these elements in generating a link between foreign shocks and domestic GDP.

Keywords: International trade, international business cycle comovement, networks, input-output linkages, Solow residual

DOI: https://doi.org/10.17016/IFDP.2019.1266

Abstract:

This paper shows that monetary policy and prudential policies interact. U.S. banks issue more commercial and industrial loans to emerging market borrowers when U.S. monetary policy eases. The effect is less pronounced for banks that are more constrained through the U.S. bank stress tests, reflected in a lower minimum capital ratio in the severely adverse scenario. This suggests that monetary policy spillovers depend on banks’ capital constraints. In particular, during a period of quantitative easing when liquidity is abundant, banks are more flexible, and the scope for adjusting lending is larger when they have a bigger capital buffer. We conjecture that bank lending to emerging markets during the zero-lower bound period would have been even higher had the United States not introduced stress tests for their banks.

Keywords: U.S. bank lending, stress tests, emerging markets, monetary policy spillovers

DOI: https://doi.org/10.17016/IFDP.2019.1265

Abstract:

This paper studies selection into and returns to self-employment in labor markets with stringent employment protection. Using Spanish administrative panel data, we characterize self-employment dynamics in the presence of rigidities that affect workers’ outside options. We document the negative selection into self-employment when workers enter from unemployment, and the pro-cyclicality of the decision. We identify career heterogeneity in the data and estimate a rich life-cycle income process. The self-employed face shocks with smaller variances but lower returns compared to fixed-term workers—the prevalent contract out of unemployment. These facts call for a revision of active labor market policies in place.

Keywords: Self-employment, business cycles, unemployment, employment protection

DOI: https://doi.org/10.17016/IFDP.2019.1264

Abstract:

We study the effects of oil prices on consumption across countries and U.S. states, by exploiting the time-series and cross-sectional variation in oil dependency of these economies. We build two large datasets: one with 55 countries over the years 1975-2018, and another with all U.S. states over the period 1989-2018. We then show that oil price declines generate positive effects on consumption in oil-importing economies, while depressing consumption in oil-exporting economies. We also document that oil price increases do more harm than the good afforded by oil price decreases both in the world and U.S. aggregates.

Keywords: Oil prices, consumption, cross-country, U.S. states, oil dependency

DOI: https://doi.org/10.17016/IFDP.2019.1263

Abstract:

In line with a growing literature on financial intermediary asset pricing, we find that changes in the leverage of primary dealers have predictive power in forecasting exchange rates. Unlike previous studies, we find that primary dealer heterogeneity matters for their role in asset pricing. The leverage of foreign-headquartered dealers in the United States entirely drive the predictive power on exchange rates, while the same measure for domestic U.S.-headquartered dealers is insignificant. The leverage of foreign-headquartered dealers also has more predictive power for some other assets. We argue that this heterogeneity is due to foreign broker-dealers having more balance sheet capacity relative to domestic dealers during the 2000s. This result conflicts with an assumption of homogeneity among intermediaries which is implicit in most modern intermediary asset pricing models. In addition, we find that currency market positions, including derivatives positions, are likely stronger than cross-border lending as the main channel through which leverage manifests itself in exchange rate changes.

Keywords: Exchange rates, intermediaries, international finance, leverage cycles, primary dealers

DOI: https://doi.org/10.17016/IFDP.2019.1262

Abstract:

How does sovereign risk affect investors' behavior? We answer this question using a novel database that combines sovereign default probabilities for 27 developed and emerging markets with monthly data on the portfolios of individual bond mutual funds. We first show that changes in yields do not fully compensate investors for additional sovereign risk, so that bond funds reduce their exposure to a country's assets when its sovereign default risk increases. However, the magnitude of the response varies widely across countries. Fund managers aggressively reduce their exposure to high-debt countries and high-risk countries. By contrast, they are more lenient toward core developed markets. In this sense, these economies appear to receive preferential treatment. Second, we document what determines the destination of reallocation ows. When fund managers reduce their exposure to a country in response to its sovereign risk, they shift their assets to countries outside the immediate geographic region while at the same time avoiding countries with high debt-to-GDP ratios and markets to which they are already heavily exposed. These results are supportive of models of sovereign default that assign a nontrivial role to the preferences of international creditors.

Keywords: Sovereign risk, mutual funds, international capital flows, spillovers

DOI: https://doi.org/10.17016/IFDP.2019.1261

Abstract:

This paper analyzes the potential spillovers of acute financial stress in China, accompanied by a sharp slowdown in Chinese growth, to the rest of the world. We use three methodologies: a structural VAR, an event study, and a DSGE model. We find that severe financial stress in China would have consequential spillovers to the United States and the global economy through both real trade links and financial channels. Other EMEs, particularly commodity exporters, would be hit the hardest. The U.S. economy would be affected to a lesser degree than both EMEs and other advanced economies, and the primary channel of transmission to the U.S. could well be adverse financial spillovers through increased global risk aversion and negative equity market spillovers

Accessible materials (.zip)

Note: On October 22, 2019, a corrected version of this paper was posted because the version published on October 18, 2019, was a draft version that was published in error.

Keywords: China, financial crisis, spillovers, financial system

DOI: https://doi.org/10.17016/IFDP.2019.1260

Abstract:

We show that prior lifetime experiences can "scar" consumers. Consumers who have lived through times of high unemployment exhibit persistent pessimism about their future financial situation and spend significantly less, controlling for the standard life-cycle consumption factors, even though their actual future income is uncorrelated with past experiences. Due to their experience-induced frugality, scarred consumers build up more wealth. We use a stochastic lifecycle model to show that the negative relationship between past experiences and consumption cannot be generated by financial constraints, income scarring, and unemployment scarring, but is consistent with experience-based learning.

Keywords: Household consumption, experience effects, expectation, lifecycle model

DOI: https://doi.org/10.17016/IFDP.2019.1259

Abstract:

This paper shows that dollar appreciations lead to declines in GDP, investment, and credit to the private sector in emerging market economies (EMEs). These results imply that the transmission of dollar movements to EMEs occurs mainly through financial conditions rather than net exports, contrary to what would be expected from the conventional Mundell-Fleming model. Moreover, the central role of the U.S. dollar in global trade invoicing and financing - the dominant currency paradigm - and the increased integration of EMEs into international supply chains weaken the traditional trade channel. Finally, as expected if financial vulnerabilities are prominent, EMEs with higher exposure to credit denominated in dollars and lower monetary policy credibility experience greater contractions during dollar appreciations.

Keywords: Dollar, balance sheet mismatch, dominant currency paradigm, global value chain, monetary policy credibility

DOI: https://doi.org/10.17016/IFDP.2019.1258

Abstract:

The excess procyclicality of fiscal policy is commonly viewed as a central malaise in emerging economies. We document that procyclicality is more pervasive in countries with higher sovereign risk and provide a model of optimal fiscal policy with nominal rigidities and endogenous sovereign default that can account for this empirical pattern. Financing a fiscal stimulus is costly for risky countries and can render countercyclical policies undesirable, even in the presence of large Keynesian stabilization gains. We also show that imposing austerity can backfire by exacerbating the exposure to default, but a well-designed "fiscal forward guidance" can help reduce the excess procyclicality.

Keywords: Fiscal Stabilization Policy, Sovereign Default, Procyclicality

DOI: https://doi.org/10.17016/IFDP.2019.1257

Abstract:

We study the effects of unexpected changes in trade policy uncertainty (TPU) on the U.S. economy. We construct three measures of TPU based on newspaper coverage, firms' earnings conference calls, and aggregate data on tari rates. We document that increases in TPU reduce investment and activity using both firm-level and aggregate macroeconomic data. We interpret the empirical results through the lens of a two-country general equilibrium model with nominal rigidities and firms' export participation decisions. In the model as in the data, news and increased uncertainty about higher future tariffs reduce investment and activity.

Keywords: Trade Policy Uncertainty; Textual Analysis; Tariffs; Investment; Uncertainty Shocks.

DOI: https://doi.org/10.17016/IFDP.2019.1256

Abstract:

This paper examines the connection between deviations in covered interest rate parity and differences in the credit spread of bonds of similar risk but different currency denomination. These two pricing anomalies are highly aligned in both the time series and the cross-section of currencies. The composite of these two pricing deviations – the corporate basis – represents the currency-hedged borrowing cost difference between currency regions and explains up to a third of the variation in the aggregate corporate debt issuance flow. I show that arbitrage aimed at exploiting one type of security anomaly can give rise to the other.

Appendix (PDF)

Keywords: Covered interest rate parity, limits of arbitrage, credit market segmentation, debt issuance, dollar convenience yield, foreign exchange rate hedge

DOI: https://doi.org/10.17016/IFDP.2019.1255

Abstract:

We use a two-country New Keynesian model with financial frictions and dollar debt in balance sheets to investigate the foreign effects of U.S. monetary policy. Financial amplification works through an endogenous deviation from uncovered interest parity (UIP) arising from limits to arbitrage in private intermediation. Combined with dollar trade invoicing, this mechanism leads to large spillovers from U.S. policy, consistent with the evidence. Foreign monetary policies that attempt to stabilize the exchange rate reduce welfare, and may exacerbate exchange rate volatility. We document empirically a link between UIP deviations and measures of credit market frictions, as predicted by the model.

Keywords: Financial Frictions; U.S. Monetary Policy Spillovers; Currency Premium; Uncovered Interest Rate Parity Condition

DOI: https://doi.org/10.17016/IFDP.2019.1254

Abstract:

We find that a US equity tail risk factor constructed from out-of-the-money S&P 500 put option prices explains the cross-sectional variation of currency excess returns. Currencies highly exposed to this factor offer a low currency risk premium because they appreciate when US tail risk increases. In a reduced-form model, we show that country-specific tail risk factors are priced in the cross section of currency returns only if they contain a global risk component. Motivated by the intuition from the model and by our empirical results, we construct a novel proxy for a global tail risk factor by buying currencies with high US equity tail beta and shorting currencies with low US tail beta. This factor, along with the dollar risk factor, explains a large portion of the cross-sectional variation in the currency carry and momentum portfolios and outperforms other models widely used in the literature.

Keywords: Equity tail risk; Global tail risk; Currency returns; Carry trade; Currency momentum

DOI: https://doi.org/10.17016/IFDP.2019.1253

Abstract:

We investigate whether statistical learning models can contribute to supervisors' off-site monitoring of banks' overall condition. We use five statistical learning and two forecast combination models to forecast high-risk composite CAMELS ratings over time (1984-2015), where a high-risk composite CAMELS rating is defined as a CAMELS rating of 3, 4, or 5. Our results indicate that the standard logit model, which is already widely used to forecast CAMELS ratings, comes close enough to be an adequate model for predicting high-risk ratings. We also find that the overall accuracy of the individual forecasts could be modestly improved upon by using forecast combination methods.

Keywords: Bank supervision and regulation, early warning models, CAMELS ratings, machine learning

DOI: https://doi.org/10.17016/IFDP.2019.1252

Abstract:

We study the effects of U.S. interest rates and other factors on risk-taking in the global market for U.S. dollar syndicated term loans. We find that, before the Global Financial Crisis, both U.S. and non-U.S. lenders originated ex ante riskier loans to non-U.S. borrowers in response to a decline in short-term U.S. interest rates and, after the crisis, in response to a decline in longer-term U.S. interest rates. After the crisis, this behavior was more prominent for shadow banks and less prominent for banks with relatively low capital. Separately, before the crisis, lenders originated less risky loans in response to U.S. dollar appreciation. Across the periods, the responses to risk appetite and economic uncertainty varied. To the extent that the Federal Reserve affects U.S. interest rates, we provide evidence of global risk-taking spillovers of U.S. monetary policy, which are important but not dominant factors for risk-taking in the market.

Keywords: Syndicated leveraged loans, risk-taking, global factors, U.S. monetary policy, global spillovers.

DOI: https://doi.org/10.17016/IFDP.2019.1251

Abstract:

Using firm-level data, this paper shows that the Portuguese financial crisis was a period of intensified productivity-enhancing reallocation. Aggregate productivity gains, both in manufacturing and services, came from relatively higher contributions of entering and exiting firms and from reallocation of resources between surviving firms. At the microlevel, the crisis reduced the probability of survival for high- and low-productivity firms, but it hit low-productivity firms disproportionately harder. We also found important heterogeneous effects across economic sectors regarding input reallocation that underline the importance of using data for the entire economy whenever similar studies are conducted.

Keywords: Productivity, firm-level data, entry, exit, survival

DOI: https://doi.org/10.17016/IFDP.2019.1250

Abstract:

This paper proposes a model to jointly explain some of the heterogeneous individual consumption behavior found in the recent empirical literature, such as the existence of a significant size of wealthy hand-to-mouth consumers, and negative marginal propensities to consume associated with housing upgrades. Agents live for a finite horizon, are heterogeneous in initial wealth, and can save in a liquid asset, and in an illiquid housing asset, that also provides housing services. When housing choices are very limited, the model replicates these empirical findings. Moreover, in the presence of unanticipated income shocks and endogenous credit constraints, this richness in marginal propensities to consume has significant implications for aggregate consumption, and helps explain the consumption behavior documented during the Great Recession as well as the consumption responses to recent tax rebates.

Keywords: The Great Recession, housing choices, consumption heterogeneity, wealthy hand-to-mouth consumers

DOI: https://doi.org/10.17016/IFDP.2019.1249

Abstract:

In this paper we study the effect of monetary policy shocks on housing rents. Our main finding is that, in contrast to house prices, housing rents increase in response to contractionary monetary policy shocks. We also find that, after a contractionary monetary policy shock, rental vacancies and the homeownership rate decline. This combination of results suggests that monetary policy may affect housing tenure decisions (own versus rent). In addition, we show that, with the exception of the shelter component, all other main components of the consumer price index (CPI) either decline in response to a contractionary monetary policy shock or are not responsive. These findings motivated us to study the statistical properties of alternative measures of inflation that exclude the shelter component. We find that measures of inflation that exclude shelter have most of the statistical properties of the widely used measures of inflation, such as the CPI and the price index for personal consumption expenditures (PCE), but have higher standard deviations and react more to monetary policy shocks. Finally, we show that the response of housing rents accounts for a large proportion of the "price puzzle" found in the literature.
Accessible materials (.zip)

Keywords: Monetary policy; Housing rents; Inflation dynamics; "Price puzzle"; Housing tenure.

DOI: https://doi.org/10.17016/IFDP.2019.1248

Abstract:

In this paper, we document and explain the distinct behaviors of U.S. downside and upside variance risk premiums (DVP and UVP, respectively) and their international stock return predictability patterns. DVP, the compensation for bearing downside variance risk, is positive, highly correlated with the total variance premium, and countercyclical, whereas UVP is, on average, borderline positive and procyclical with large negative spikes around episodes of market turmoil. We then provide robust evidence that decomposing VP into its downside and upside components significantly improves domestic and international stock return predictability. DVP is a robust predictor at four to six months and exhibits a hump-shaped pattern, whereas UVP performs the best at very short horizons. These stylized facts highlight the importance of acknowledging asymmetry in equity risk premiums. Hence, in the second part of the paper, we rationalize the economic sources of DVP and UVP in an international dynamic asset pricing model featuring asymmetric and time-varying risk aversion and economic uncertainty in a partially integrated world economy. We show that DVP is mostly driven by the upside movements of risk aversion, whereas UVP loads significantly and negatively on downside economic uncertainty. Moreover, we find that DVP (UVP) transmits to international markets mostly through financial integration (real economic integration).

Keywords: Variance risk premium, downside variance risk premium, international stock markets, asymmetric state variables, stock return predictability

DOI: https://doi.org/10.17016/IFDP.2019.1247

Abstract:

This paper documents that an appreciation of the U.S. dollar is associated with a reduction in the supply of commercial and industrial loans by U.S. banks. An increase in the broad dollar index by 2.5 points (one standard deviation) reduces U.S. banks' corporate loan originations by 10 percent. This decline is driven by a reduction in the demand for loans on the secondary market where prices fall and liquidity worsens when the dollar appreciates, with stronger effects for riskier loans. Today, the main buyers of U.S. corporate loans--and, hence, suppliers of funding for these loans--are institutional investors, in particular mutual funds, which experience outflows when the dollar appreciates. A shift of traditional financial intermediation to these relatively unregulated entities, which are more sensitive to global developments, has led to the emergence of this new channel through which the dollar affects the U.S. economy, which we term the secondary market channel.

Keywords: Leveraged loan market, commercial and industrial loans, U.S. dollar exchange rate, credit standards, institutional investors

DOI: https://doi.org/10.17016/IFDP.2019.1246

Abstract:

This study attempts to evaluate the impact of an increase in banks' funding stress and its transmission to the real economy, taking into account different funding sources banks can rely on. Using aggregate data from eight Euro area financial systems, we find that following a liquidity funding shock, both credit and GDP decline in different amounts and lengths. GDP reverts faster than credit. Furthermore, periphery countries experience a more pronounced fall in deposits and credit growth and the negative effects from the shock last longer than in core countries. Banks' funding seems to play a relevant role as periphery countries rely more on wholesale funding during normal times.

Keywords: Liquidity funding shocks, ECB policy, Euro Area

DOI: https://doi.org/10.17016/IFDP.2019.1245

Abstract:

This paper highlights some of the theoretical and practical implications for monetary policy and exchange rates that derive specifically from the presence of a global general equilibrium factor embedded in neutral real policy rates in open economies. Using a standard two country DSGE model, we derive a structural decomposition in which the nominal exchange rate is a function of the expected present value of future neutral real interest rate differentials plus a business cycle factor and a PPP factor. Country specific "r*" shocks in general require optimal monetary policy to pass these through to the policy rate, but such shocks will also have exchange rate implications, with an expected decline in the path of the real neutral policy rate reflected in a depreciation of the nominal exchange rate. We document a novel empirical regularity between the equilibrium error in the VECM representation of the empirical Holston Laubach Williams (2017) four country r* model and the value of the nominal trade weighted dollar. In fact, the correlation between the dollar and the 12 quarter lag of the HLW equilibrium error is estimated to be 0.7. Global shocks to r* under optimal policy require no exchange rate adjustment because passing though r* shocks to policy rates 'does all the work' of maintaining global equilibrium. We also study a richer model with international spill overs so that in theory there can be gains to international policy cooperation. In this richer model we obtain a similar decomposition for the nominal exchange rate, but with the added feature that r* in each country is a function global productivity and business cycle factors even if these factors are themselves independent across countries. We argue that in practice, there could well be significant costs to central bank communication and credibility under a regime of formal policy cooperation, but that gains to policy coordination could be substantial given that r*'s are unobserved but are correlated across countries.
Accessible materials (.zip)

Keywords: Exchange rate, monetary policy, policy coordination

DOI: https://doi.org/10.17016/IFDP.2019.1244

Abstract:

We theoretically explore long-run stagnation at the zero lower bound in a representative agent framework. We analytically compare expectations-driven stagnation to a secular stagnation episode and find contrasting policy implications for changes in government spending, supply shocks and neo-Fisherian policies. On the other hand, a minimum wage policy is expansionary and robust to the source of stagnation. Using Bayesian methods, we estimate a DSGE model that can accommodate two competing hypotheses of long-run stagnation in Japan. We document that equilibrium selection under indeterminacy matters in accounting for model fit.

Keywords: Expectations-driven trap, secular stagnation, inflation expectations, zero lower bound

DOI: https://doi.org/10.17016/IFDP.2019.1243