Collateral and Monetary Policy: A Puzzle

A stylized fact about post-crisis economies is that asset markets have become segmented with “safe assets” trading differently from assets more generally. I have argued elsewhere that the collateralization of financial sector liabilities has played an important role in this segmentation of markets.

I believe that this creates a puzzle for the implementation of monetary policy that provides at least a partial explanation for why we are stuck at the zero lower bound. Consider the consequences of an increase in the policy rate by 25 bps. This has the effect of lowering the price of ultra-short-term Treasury debt, and particularly when combined with a general policy of raising the policy rate over a period of months or years this policy should have the effect of lowering the price of longer term Treasuries as well (due to the fact that long-term yields can be arbitraged by rolling over short-term debt).

A decline in the price of long-term Treasuries will have the effect of reducing the dollar value of the stock of outstanding Treasuries (as long as the Treasury does not have a policy of responding to the price effects of monetary policy by issuing more Treasuries). But now consider what happens in the –segmented — market for Treasury debt. Assuming that demand for Treasuries is downward sloping, then the fact that contractionary monetary policy tends to shrink the stock of Treasuries itself puts upward pressure on the price of Treasuries that, particularly when demand for Treasuries is inelastic, will tend to offset and may even entirely counteract the tendency for the yield on long-term Treasuries to rise. (Presumably in a world where markets aren’t segmented demand for Treasuries is fairly elastic and shifts into other financial assets quash this effect.)

In short, a world where safe assets trade in segmented markets may be one where implementing monetary policy using the interest rate as a policy tool is particularly difficult. Can short-term and long-term safe assets become segmented markets as well? Given arbitrage, it’s hard to imagine how this is possible.

These thoughts are, of course, motivated by the behavior of Treasury yields following the Federal Reserves 25 bp rate hike in December 2015.fredgraph

 

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3 thoughts on “Collateral and Monetary Policy: A Puzzle”

  1. Carolyn,
    I liked your paper and believe your argument on unsecured bank lending and liquidity is compelling.

    However, I find the segmentation thesis to be problematic. Equity risk premia should be highly sensitive to economic growth expectations. They collapsed in the late 90’s, the mid 2000’s and again today. How does this fit with the pessimism needed to create a “shortage of safe assets”? This is indicative of a broader problem with Chart 1 in your paper: the post-’08 fluctuations in spreads are at least as large as the difference in average spreads between the pre and post ’98 periods. In other words, we should see a significant acceleration in growth post-’08 when spreads fall and the “shortage” is alleviated, and a decline when the opposite is true.

    The safe asset thesis has a further problem: issuance. While spreads may be marginally higher than the pre-’98 period, high yield, CMBS, CLO and other issuance has been booming. Is it the price of credit that holds back recovery under the safe asset thesis, or the volume?

    1. Diego,

      With respect to the “equity risk premium” your argument about its connection to economic growth is based on a model without significant liquidity frictions (or equivalently one where the liquidity frictions that exist are effectively eliminated by the financial structure). Back in the day when these models were developed bank regulation was designed to support the liquidity of markets. But we have transitioned to an environment where collateral (or “market-based finance”) is supposed to substitute for the traditional bank-based liquidity upon which the modern economic growth experience is founded — dating back to the late 18th century in Britain. Because “market-based finance” is a very poor substitute for bank-based finance, we now inhabit a world where liquidity frictions — and therefore asset price bubbles — are endemic. In short the historic connection between risk premia and growth has been broken by the destruction of our financial infrastructure and the model you are using to discuss the relationship between the equity risk premium and growth no longer applies. So no, we should not “see a significant acceleration in growth post-’08” because we no longer have the kind of financial system that is capable of delivering such growth.

      Another way of looking at this issue is that underlying the view that relative asset prices reflect growth possibilities is an assumption that asset prices are mostly affected by real phenomena, not mostly affected by financial phenomena. In a world with limited liquidity where asset prices boom and bust, the relationship between relative asset prices is unlikely to be stable or connected to growth of the real economy.

      The underlying model that I work with has economic growth dependent mostly on low-cost and short-term (but generally renewable) bank credit to SMEs. Capital market credit in the form of junk bonds, CMBS and CLOs is a plus — and I generally wouldn’t expect it to hurt growth — but it doesn’t seem to me an important driver of growth. Growth in my model comes from creating a path that makes it possible for people to go from having close to nothing to the opportunity to build up an unsecured reputation-based credit record that makes it possible for “nobodies” to build successful businesses, not from the finance of big business. I use the bond spreads mostly as indicators of how costly it has become to borrow — because while what bank lending evidence there is is consistent with my chart, the bank evidence is fairly thin.

      In short, because modern economic modeling leaves out everything that is important to the process of growth, all of the intuition developed from that modeling is wrong — and in fact dangerous — and the last 30 years of financial deregulation are testimony to the problem.

      1. Interesting and thoughtful response — thanks Carolyn. I am particularly impressed by your SME comments. It’s not so much that we have a “safe asset” shortage, but that certain kinds of risk assets don’t have complete markets (i.e. the unsecured ones issued by “nobodies”).

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