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Central Bank Balance Sheets and Long Term Forward Rates

Sharon Kozicki

Eric Santor

Lena Suchanek

March 12, 2010

The views expressed in this presentation are those of the authors. No responsibility for them should be attributed to the Bank of Canada.

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Introduction• 2007-2009 financial crisis → dramatic policy response

– Fiscal policy

– Liquidity policy

– Monetary policy

• With severe liquidity problems and policy rates at the ELB, major central banks (CB) took unconventional and often unprecedented measures

• Debate with respect to the effectiveness of CBI on interest rates and economic activity

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Were Fed purchases of Treasuries effective?

US 10 Year Treasury Yield

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US 10 Year TreasuryYield

Announcement of Treasury Purchases

Rates have stayed lower since announcements of Fed purchases of

MBS and agency debt...

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UK yields fell with Bank of England announcement of purchases...

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With large-scale asset purchases, some central bank balance sheets

exploded...

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At the same time, public debt levels are rising...

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With net public debt rising even faster...

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Introduction• Central Bank (CB) initiatives have significant

implications for their balance sheets

– What is the impact of CB balance sheet expansion on neutral interest rates and long-term interest rates?

• During this crisis, fiscal stimulus plans have led to large increases in debt

– What is the impact of increased government indebtedness on neutral interest rates and long-term interest rates?

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Contribution• Objective: Examine the impact of the size of CB

balance sheets on long-term interest rates for a sample of developed countries

• Policy questions:

– What is the neutral rate of interest (important for planning exit from accommodative policy?

– Will higher interest rates (owing to higher fiscal debt) derail the recovery?

– Do unconventional policies provide more flexibility at the ELB, allowing a lower inflation target?

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Summary

• Objective: Examine the impact of the size of CB balance sheets on long-term interest rates for a sample of developed countries

• Model:

– Long-term forward rates

– Encompass the analysis by Laubach (2009) including fiscal deficits/debt and expand to also consider CB balance sheet size

• Result: An increase in CB assets is associated with a decline in long-term forward rates (c.p.)

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Overview

• CB initiatives and balance sheets

• Data & empirical model

• Estimation results: U.S. & panel

• Implications for monetary policy and future research

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Central Bank Initiatives and Balance Sheets

• In “normal” times:

– Operational target of central banks in G7: a short-term interest rate

– Evolution of the balance sheet = endogenous outcome of meeting this target

• More recently: balance sheets exploded due to numerous unprecedented initiatives

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Central Bank Initiatives and Balance Sheets (cont.)

• Liquidity facilities (e.g. TAF)

• Credit facilities (e.g. CPFF)

• Purchase programs (quantitative easing)

• Facilities to deal with insolvency of systemically important financial institutions (e.g. AIG)

Dramatic implications for CB balance sheets

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Empirical Framework

• Literature focus: impact of debt/deficit on long term interest rates

• Model as in Laubach (2009):

• Augment regressions by CB variables

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Data for U.S. regressions

• Dependent: 5-year-ahead 10-year forward rate

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1980 1985 1990 1995 2000 2005

FW514CY10

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Data for U.S. regressions (cont.)

• Dependent: 5-year-ahead 10-year forward rate

• Independent Variables

– Total CB assets and CB claims

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1980 1985 1990 1995 2000 2005 2010

CLAIMSCBASSETS

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Data for U.S. regressions (cont.)

• Dependent: 5-year-ahead 10-year forward rate

• Independent Variables

– Total CB assets and CB claims

– 5-year-ahead projected debt, deficit

– Long-horizon inflation expectations

• Frequency: 1980-2007, semi-annually

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Baseline Results: CB AssetsOLS OLS IV GMM

Inflation Expectations 1.171*** 0.950*** 0.905***

(0.111) (0.211) (0.196)

Projected Deficit 0.068 0.139** 0.098*(0.047) (0.061) (0.055)

Projected Growth 0.717* 0.632**(0.417) (0.286)

Central Bank Assets -0.736** -1.200*** -1.167***(0.278) (0.431) (0.419)

R2 0.904 0.913 0.993DW 0.682 0.857Hansen-J 0.865

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Robustness

• Dependent: current 10-year Treasury yields and 5-year-ahead 5-year forward rates

• Independent: current fiscal variables

• Both CB variables remain statistically significant and are relatively robust to alternative specifications

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Data for panel regressions

• Countries: Australia, Canada, Switzerland, Japan, UK, and US

• Dependent: 10-year government bond yields

• Independent: long-term expected inflation, CB assets and claims, actual deficit/debt

• Frequency: 1996-2007, quarterly

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Panel regressions

Inflation expectations 2.356*** 1.819*** 1.841*** 1.712***(0.027) (0.095) (0.104) (0.096)

Debt 0.042*** .005***(0.004) (0.005)

Deficit 0.094*** 0.039*(0.025) (0.021)

Growth 0.022 0.088** 0.011 0.038**(0.034) (0.035) (0.038) (0.042)

Claims -0.336*** -0.120***(0.027) (0.020)

CB assets -0.073** -0.074***(0.009) (0.010)

Instruments: inflation, debt (or deficit), Instrumented: claims or cbassets

GDP, claims(-1) or cbassets(-1), Inflation(-1)

CB Claims CB Assets

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Caveats

• Innovations in the balance sheet are simply proxies for the short-term policy rate

Effect of changes of the CB sheet are over-stated

But: forward rates should be immune to changes in short-term policy rates

• Negative relationship is driven by trends

Alternative specification using detrended variables

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Policy implications

• Recent expansion of CB balance sheets → sizeable effects on long-term forward rates

• But: estimated historical relationship related to changes in the holdings of treasuries

Many recent initiatives are short-term

Estimated coefficients should be seen as an upper bound.

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Conclusion

• Examine the impact of the size of CB balance sheets on long-term interest rates

• Model: Long-term forward rates

• An increase in CB assets is associated with a decline in long-term forward rates (c.p.)

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Future Research

• Include risk measures (e.g. VIX)

• Case studies (Japan, U.S., U.K.)