An Exit Strategy from Quantitative Easing and the Demand for Monetary Base in the United States

1. An Exit Strategy from Quantitative Easing and the Demand for Monetary Base in the United States Richard G. Anderson Robert H. Rasche Professors Meeting, November 5th2009

2. Disclaimer Opinions expressed are my own and are not necessarily those of the Federal Reserve Bank of St. Louis or the Federal Reserve System. Audio and /or video recording is expressly prohibited without written prior consent from the Federal Reserve Bank of St. Louis. This presentation contains no confidential information. Demand for the Monetary Base

3. Introduction • Discuss Quantitative easing • Discuss Fed’s implementation of Quantitative easing • Discuss “exit strategy” – Exit to where? • Examine the long-run demand for the adjusted monetary base in the United States, 1919 – 2008. • 4 variable SVAR • The “price” of the monetary base is measured by the inverse of the yield on long-term high-quality corporate bonds • Unitary Income elasticity • Inflation is approximately a random walk=> “excess” base does not forecast inflation • a stable function “… of a small number of variables.” Demand for the Monetary Base

4. Unconventional Policy • The Federal Reserve has pursued “unconventional” monetary policy since August 2007 • Reduction in policy target rate • Direct lending and discounting • On balance sheet (TAF, TALF, central bank currency swaps) • Off balance sheet • “Credit easing” • Focus on composition of assets, not quantity • “Quantitative Easing” since early 2009 • large scale asset purchase program • “Agency” (housing GSEs) debt, MBS • Longer-dated Treasuries • Monetary base will be $2.4T 2010 Q1, with reserves balances > $1.4T (vs $10B in 2007 Q1) Demand for the Monetary Base

5. Quantitative Easing: How Does It Work? (1) • New Keynesian models (sticky prices/wages, imperfect competition in product and labor markets, all financial assets perfect substitutes, inflation forecast-targeting monetary policy) • Policy rate at zero bound • Policy effect due to promise to maintain policy rate at zero for an “extended period” • What is an extended period? • When aggregate demand strengthens and forecasts suggest higher inflation, delay increasing policy rate => future higher actual inflation (above policy goal) • Sustaining the nominal rate and increasing future expected inflation => lowering future real rates => shifting spending forward • Balance sheet increases are a commitment mechanism to increase the cost of policymakers reneging on the “extended period” promise QE and Demand for the Monetary Base

6. Quantitative Easing: How Does It Work? (2) • But central bankers pledge no future higher inflation • What channel remains? • Credit channel (Bernanke and others) • In Bernanke’s writing, an amplifier to the interest rate channel, not a substitute or alternative • Bank lending channel • Loans readily available for good credit • Strong bank lending 2008 Q4 • Contraction in 2009 likely a good thing • Balance sheet channel • Massively alter the balance sheet of the private sector (because the elasticities of substitution among high-quality financial assets are small) Demand for the Monetary Base

7. Bank Lending Channel Demand for the Monetary Base

8. Balance Sheet Channel Demand for the Monetary Base

9. Household Balance Sheet (Billions of Dollars) Perfect Substitutes ! Demand for the Monetary Base

10. How to End Quantitative Easing? • Many countries have done QE before (forthcoming FRBSTL Review article) • Best way (?): Cold turkey • How? • Sell assets to the public [potential losses] • RP assets to the public [losses] • Sequester in central bank “time deposits” • Sell central bank securities • Raise remuneration rate (Goodfriend, Woodford, FRBNY Review, 2002) Demand for the Monetary Base

11. Targeted Interest Rate and Monetary Base Growth Demand for the Monetary Base

12. Composition of Federal Reserve Assets and Liabilities Demand for the Monetary Base

13. What Size Should the Monetary Base Be? • The challenge: Does a Stable Demand Relationship Exist? • What does “demand” mean when the quantity demanded always equals the quantity supplied? • Corollary: The private sector cannot change the size of the monetary base. • Short-run demand curves for base money are useless. • John Taylor’s initial exploration of interest rate-based monetary policy rules grew from a frustration with the apparent instability of US money demand. • Friedman and Kuttner asserted that all extant stable money-demand relationships from 1970s are sample specific and disintegrate when the sample extends into the 1980s. • Subsequent research has suggested the existence of stable relationships. Friedman and Kuttner’s criticism is not robust to the use of reasonable, alternative functional forms. • Remuneration rate might be able to control credit expansion by banks => the size of the base is not relevant to monetary policymaking or aggregate demand (Goodfriend, 2002; Woodford, 2002) => We search for an alternative functional form that might be a stable long-run “demand curve”. Demand for the Monetary Base

14. Data Selection 1919-present • Monetary Base: The Federal Reserve Bank of St. Louis’ adjusted monetary Base. • GDP: BEA’S annual GDP series (1929 -2008) is spliced with Balke and Gordon’s GDP series (1919 - 1946) via an index number method (splice using average of the period-by-period growth rates of the two series) • Interest Rates: Moody’s Aaa-rated corporate bond yields • Default rate: Moody’s series on defaults on investment grade corporate bonds. Demand for the Monetary Base

15. Level of Bond Rate (Lucas, 1988) – poor model • Nonlinear • Interest elasticity is an increasing function of the level of the interest rate Demand for the Monetary Base

16. Log Constant Elasticity Model (Cagan, 1956) • Less Nonlinear • Interest elasticity is constant Demand for the Monetary Base

17. Log price model (inverse interest rate) • Almost linear • Interest elasticity is decreasing function of level of interest rate Demand for the Monetary Base

18. Demand for the Monetary Base

19. Default on Investment-Grade Corporate Bonds Demand for the Monetary Base

20. A Forecast of Monetary Base Velocity Quantitative Easing! Demand for the Monetary Base

21. A Forecast of Quarterly Monetary Base Velocity Demand for the Monetary Base

22. Functional Form and Velocity Restriction • We applied Box-Cox transformation to the base money demand function, and the general functional form is: • We also imposed a restriction on monetary base velocity (γ = 1), and set λ0 = λ2 = 0; then the general functional form becomes: Demand for the Monetary Base

23. Box – Cox Transformation on Aaa Rate Variable Demand for the Monetary Base

24. Interest Rate Elasticity Estimates Demand for the Monetary Base

25. Forward and Backward Recursive Estimations Recursive estimations prefer the velocity restriction: • The recursively estimated parameters from the models with velocity restriction are more consistent across different sample sizes. Demand for the Monetary Base

26. Forward and Backward Recursive Estimations Demand for the Monetary Base

27. Forward and Backward Recursive Estimations Recursive estimations prefer the velocity restriction: • The recursively estimated parameters from the models with velocity restriction are consistent across different sample sizes. • The recursively estimated parameters from the models without velocity restriction have bad performance for small sample size. • The β parameters from the models without velocity restriction have significantly different results between forward recursive estimations and backward recursive estimations. Demand for the Monetary Base

28. Forward and Backward Recursive Estimations Demand for the Monetary Base

29. Residual Diagnostics for Log-Inverse Model with Velocity Restriction • The fitted values are very close to the actual values • Most of the standardized residuals and recursive residuals are inside the S.E. bands • Reasonable correlations between residuals • The standardized residuals look normally distributed Demand for the Monetary Base

30. Residual Diagnostics for Log-Inverse Model with Velocity Restriction Demand for the Monetary Base

31. VECM Model • We used a structural VAR to interpret the long-run monetary-base velocity equation as a demand curve. • The Reduced-form VECM is: • After Imposing the restrictions, the VECM becomes: where defines the contemporaneous (simultaneous) relationships. Demand for the Monetary Base

32. The Estimation Strategy • First, we re-order the equations such that the single equation for the base, which contains the transitory shock, is at the bottom; and the other equations, which contain permanent shocks, are above. • After that, we estimated the set of equations with permanent shocks via Sims-like Wold/Cholesky variance decomposition, since this is essentially a VAR system. • Finally, we estimate the coefficients of the final equation via instrument variables, using the residuals from the prior equations as instruments. Demand for the Monetary Base

33. Parameter Estimates of the Identified VECM Demand for the Monetary Base

34. Implicit Distributed Lag Coefficients in Identified VECM Demand for the Monetary Base

35. Impulse response functions, Inverse Interest Rate ShockModel with Velocity Restriction Demand for the Monetary Base

36. Impulse Response Functions, Real Output ShockModel with Velocity Restriction Demand for the Monetary Base

37. Impulse Response Functions, Real Monetary-Base ShockModel with Velocity Restriction Demand for the Monetary Base

38. Concluding Remarks • We find a well-defined stable demand function. • Our analysis suggests that demand for monetary base may be modeled as demand for a zero coupon, default risk – free consol. • The statistically significant cointegrating vector suggests that there is a strong pull from any short-run disequilibrium toward the long-run equilibrium. • Our Results suggests that growth of the monetary base, at least at the relatively low frequency of annual data, can provide guidance for monetary policymakers, particularly when inflation or the level of nominal interest rates is high. Demand for the Monetary Base

39. Any Questions? Demand for the Monetary Base

40. Richard.G.Anderson@stls.frb.orgresearch.stlouisfed.org314 444 8574