R* an and t the G Glob obal E Economy y Reuven Glick Federal - - PowerPoint PPT Presentation

Reuven Glick

Federal Reserve Bank of San Francisco

Conference on ” Global Safe Assets, International Reserves, and Capital Flow” City University of Hong Kong and Journal of international Money and Finance May 20-21, 2019

Disclaimer: The views presented are mine alone and do not necessarily represent the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System.

R* an and t the G Glob

• bal E

Economy y

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Navigating by the Stars π*, g*, u*, … r*

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One explanation for declining interest rates

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Other explanations for declining r*

• Supply-side phenomena: lower productivity growth, aging populations
• Demand-side phenomena: insufficient demand, secular stagnation
• Portfolio preference shifts, growing global safe asset demand

4

• Estimates of r* in U.S. and abroad
• Possible Drivers of r *
• Saving-investment balance
• Safe asset supply and demand
• Empirical evidence
• Saving, investment factors
• Asset preferences, foreign demand for U.S. assets
• Implications for U.S. monetary policy

5

Outline

U.S. real rates have been falling

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• 2

2 4 6 8 10 1980 1985 1990 1995 2000 2005 2010 2015

U.S. Real 10-year and 3-month Treasury Yields (%)

10-yr TB - 10-yr infl (SPF) 10-yr TIPS 3-mo TB - 1-yr infl (SPF)

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Estimated r* in U.S. has been falling

• 1

1 2 3 4 5 1980 1985 1990 1995 2000 2005 2010 2015

Estimates of r* for the U.S. (%)

Laubach-Williams Holston-Laubach-Williams Kiley Johanssen-Mertens Del Negro et al Lubik-Matthes AVERAGE zero line

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r* in other countries has fallen as well

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1 2 3 4 5 1980 1985 1990 1995 2000 2005 2010 2015

Estimates of r* in Advanced Countries (%)

Canada Euro Area U.K. U.S. average

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Source: updated figures from Holston et al. (2017) and FRBNY website.

Saving and Investment Balance Approach to Determining r*

A

Global saving, S + Sf Global investment, I + If ro S + Sf I+ If Interest rate, r

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.

ro = r* when y = y*, yf = yf*

Saving increase or investment decline lowers equilibrium interest rate

A B Global saving, S + Sf Global investment, I + If ro

S + Sf I + If

Interest rate, r

. .

r1

Effects of Saving Increase and Investment Decline on Interest Rate

. .

B r1 Global saving, S + Sf Global investment, I + If ro

S + Sf I+ If

I

Interest rate, r A

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Possible drivers of declining r*

Factors increasing saving

• Demographics: Longer lifer

expectancy, lower dependency burdens

• Rising inequality
• Excess foreign saving
• Greater risk aversion, portfolio shift

towards safer assets

Factors decreasing investment

• Demographics: Slower labor force

growth

• Lower productivity growth
• Reduced investment profitability
• Declining competition

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Life expectancy increasing, labor force growth falling in advanced countries

• 0.40
• 0.20

0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 70 72 74 76 78 80 82 84 86 88 90 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

OECD Life Expectancy (years) and Labor Force Growth (%)

Life Expectancy (years, left scale) Labor force growth (%, right scale)

Projections

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Potential output growth falling in advanced countries

1 2 3 4 5 1980 1985 1990 1995 2000 2005 2010 2015

Trend Output Growth in Advanced Countries (%)

Canada Euro Area U.K. U.S. average

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Source: updated figures from Holston et al. (2017) and FRBNY website.

Excess foreign saving decreases domestic interest rate

. .

B Domestic saving, S Domestic investment, I r1

I

Interest rate, r A A’ B’ Foreign saving, Sf Foreign investment, If ro

f

Sf If

Interest rate, r

.

CA deficit CA surplus

.

C ro r1

Global Imbalances and the Interest Rate

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S

. .

C’

Excess saving in developing countries in 2000s

10 15 20 25 30 35 1980 1985 1990 1995 2000 2005 2010 2015

Advanced and Developing Country Saving and Investment (% of GDP)

S advanced I advanced S developing I developing

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Saving & investment factors contributed to decline in r*

• 800
• 600
• 400
• 200

200 400 600 Rachel and Smith (2017), 30+ yrs, 1980s-2015 Rachel and Summers (2019), 40+ yrs, 1970s-2018

Decline in r* Decomposed (bps)

More fiscal spending, debt Unexplained Higher foreign saving Interactions Lower y*, productivity Lower investment Higher inequality Demographics: aging,etc. Net decline

• 4.5pp
• 2.7pp

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Safe Asset Approach to Determining r*

A Global supply of safe assets, S + Sf Global demand for safe assets, D+ Df ro S + Sf D+ Df Safe interest rate, r

.

Equilibrium Safe Interest Rate

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ro = r* when y = y*, yf = yf*

Properties of safe assets

Provide

• Security, i.e. pay close to par in the future
• Liquidity, i.e. money-like in availability and acceptability

Play parallel roles to money:

• Transaction role by serving as collateral in financial transactions and regulatory

capital in meeting liquidity requirements,

• Accessible store of value role by providing a reliable return
• Accounting role by serving as a benchmark for the pricing of other assets

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Who supplies safe assets?

• Governments: e.g. Treasury securities, currency, central bank reserves
• Private financial sector: deposits, commercial paper, asset-backed

securities

Note:

• Governments may enhance the security of privately-created assets by providing

guarantees, e.g. deposit insurance for bank deposits.

• Safe assets are not all perfect substitutes in terms of their liquidity or safety

properties.

• “Frontier” between safe and unsafe assets can be sensitive to changes in

perceptions of security, credit quality (Gourinchas& Jeanne)

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Possible drivers of declining r* for safe assets

Factors increasing demand

• Economic growth
• Greater precautionary demand
• Regulatory reform that increases

demand for high-quality collateral

Factors decreasing supply

• Decreased credit quality of

government or private safe assets

• Fiscal austerity that reduces supply of

government asset issuance

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A B

Global supply of safe assets, S + Sf Global demand for safe assets, D + Df

ro D+ Df S + Sf

I

Safe interest rate, r

. .

r1

Effect on Safe Rate r if Demand Increases More Than Supply

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Caballero et al. view of the world: Global shortage of safe assets lowers interest rate

A B

Global supply of safe assets, S + Sf Global demand for safe assets, D + Df

ro D+ Df S + Sf

I

Safe interest rate, r

. .

r1

Effect on Safe Rate r if Demand Increases More Than Supply

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Caballero et al. view of the world: Global shortage of safe assets lowers interest rate

Financial crisis effect?

Determination of Safe Rate in “General Equilibrium” Caballero, Farhi, Gourinchas, AER, 2016

y = y*

A

Output, y r* = rtarget Taylor rule (TR): r =rtarget + θ(y-y*) Safe asset interest, r

.

Safe Asset equilib. (SA): S = β + αyy + αr == > r = ( S - β - αyy)/α

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y target * * * * r r r

( ) : S = β + α y + αr ( ) : r = r + θ(y - y ) : y = y - δ(r - r ) - δ (r -r ) Safe Asset Equilibrium SA Taylor Rule TR IS curve

_ _ _

Determination of Safe Rate in “General Equilibrium” Caballero, Farhi, Gourinchas, AER, 2016

y = y*

A

Output, y r* = rtarget Taylor rule (TR): r =rtarget + θ(y-y*) Safe asset interest, r

.

Safe Asset equilib. (SA): S = β + αyy + αr == > r = ( S - β - αyy)/α

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y target * * * * r r r

( ) : S = β + α y + αr ( ) : r = r + θ(y - y ) : y = y - δ(r - r ) - δ (r -r ) Safe Asset Equilibrium SA Taylor Rule TR IS curve

r* declines in response to decline in supply S or rise in demand β

_ _ _

Empirical Evidence

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• Price-based evidence:
• Rate spreads
• Risk premia
• Quantity-based evidence:
• Holdings of government and private-provided safe U.S.

assets by domestic and foreign sectors

Are Bond Spreads Rising? Del Negro et al. vs. Rachel and Summers

• 1

1 2 3 4 5 6 1980 1985 1990 1995 2000 2005 2010 2015

U.S. Bond Spreads (%)

AAA - TB20 BAA - TB20

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Are Bond Spreads Rising? Del Negro et al. vs. Rachel and Summers

• 1

1 2 3 4 5 6 1980 1985 1990 1995 2000 2005 2010 2015

U.S. Bond Spreads (%)

AAA - TB20 BAA - TB20 Are spreads rising?

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Equity premium increasing since late 1990s

0% 5% 10% 15% 20% 25% 1980 1985 1990 1995 2000 2005 2010 2015

U.S. 10-year Treasury Bond Rate and Expected Equity Return

10-year Treasury rate Equity premium

Since late 1990s, the expected equity return has been constant, while Treasury rate has continued to decline

Equity return

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Foreign holdings of U.S. Treasuries rising since 1990s

2,000 4,000 6,000 8,000 10,000 12,000 14,000 1990 1995 2000 2005 2010 2015

Holdings of U.S. Treasury Securities (bil$)

All private and foreign held Foreign held Foreign official held

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Source: Treasury Bulletin, Treasury International Capital (TIC) reports

Measuring holdings of U.S. safe assets by U.S. and foreign creditors (Gourinchas and Jeanne, 2012)

• U.S. households&non-financial businesses (“private real sector”)
• Govt. safe assets: U.S. Treasury&municipal securities
• Private financial-sector-provided safe assets: checking, time, and saving deposits, shares
• f money market mutual funds, commercial paper, repos.
• U.S. financial sector
• Govt. safe assets: U.S. Treasury&municipal securities, cash and bank reserves at Federal

Reserve.

• Rest of world
• Govt. safe assets: U.S. Treasury and municipal securities, SDRs, and currency.
• Private financial-sector-provided safe asset holdings: time and saving deposits, shares of

money market mutual funds, commercial paper, and repos, foreign-affiliate-related interbank transaction levels.

Note: safe asset measures do not include direct debt and ABS securities issued by U.S. Agencies or GSEs, nor “private label” ABS issued within financial sector. Examined separately below.

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Holdings of U.S. Safe Assets by Sector (% of GDP)

20 40 60 80 100 1980 1985 1990 1995 2000 2005 2010 2015

• A. U.S. Households and Businesses

All Safe Govt Safe Private Safe

20 40 60 80 100 1980 1985 1990 1995 2000 2005 2010 2015

• B. U.S. Private Financial Institutions

Govt securities Govt securities + reserves&cash

20 40 60 80 100 1980 1985 1990 1995 2000 2005 2010 2015

• C. Rest of World

All Safe Govt safe Private safe

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Source: U.S. Flow of Funds

Holdings of U.S. Safe Assets by Sector (% of GDP)

20 40 60 80 100 1980 1985 1990 1995 2000 2005 2010 2015

• A. U.S. Households and Businesses

All Safe Govt Safe Private Safe

20 40 60 80 100 1980 1985 1990 1995 2000 2005 2010 2015

• B. U.S. Private Financial Institutions

Govt securities Govt securities + reserves&cash

20 40 60 80 100 1980 1985 1990 1995 2000 2005 2010 2015

• C. Rest of World

All Safe Govt safe Private safe

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Source: U.S. Flow of Funds

Safe Asset Holding: Stylized Facts

• U.S. household&business holdings of safe assets rose steadily in late 1990s

through 2000s boom period, and continued to rise after financial crisis to almost 100% of GDP

• Most of increase took form of private safe assets
• Government safe assets continue to constitute a very stable 20% of GDP
• U.S. financial sector holdings of government safe assets stable at roughly

25% of GDP until crisis, when doubled to roughly 50% of GDP.

• Increases took form of both more government securities and bank reserves, with

reserves rising dramatically as result of Fed’s QE program.

• Ongoing trend of foreigners acquiring more U.S. safe assets, increasing from

10% in 1980s to roughly 50% of GDP.

• Share of government safe assets rose, while private asset share fell.

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Foreign holdings of private ABS and Agency&GSE-backed securities rose in leadup to crisis, plummeted after crisis

10 20 30 40 1980 1985 1990 1995 2000 2005 2010 2015

Holdings of U.S. Agency&GSE-backed Securities by Sector (% of GDP)

Dom Financial3 Foreign Federal Reserve Household&Business

Source: U.S. Flow of Funds

34 10 20 30 40 1980 1985 1990 1995 2000 2005 2010 2015

Holdings of Private-Issued ABS (% of GDP)

Domestic&foreign2 Foreign

Safe Asset Holding: More Stylized Facts

• U.S. private-issued ABS
• Domestic and foreign holdings rose steadily before the crisis, then plummeted.
• At their peak, foreign holdings accounted for about 1/3 of the total.
• Agency & GSE-backed securities
• Domestic and foreign holdings increased steadily before the financial crisis.
• At their peak, foreign holdings accounted for about 1/4 of the total.
• After the crisis, demand by U.S. households, non-financial businesses, and the rest
• f the world collapsed.
• In contrast, financial sector holdings were relatively stable, suggesting that the

explicit government guarantees of GSE securities in 2008 maintained some degree

• f confidence in their safety attributes.
• The Fed’s holdings of Agency&GSE assets increased as a result of its QE program.

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Total and Foreign Holdings of U.S. Assets (bil$)

10,000 20,000 30,000 40,000 50,000 60,000

2000 2005 2010 2015

• D. U.S. Equities

36 2,000 4,000 6,000 8,000 10,000 12,000 14,000

2000 2005 2010 2015

• A. U.S. Treasuries

2,000 4,000 6,000 8,000 10,000 12,000 14,000

2000 2005 2010 2015

• C. U.S. LT Corporate Securities

2,000 4,000 6,000 8,000 10,000 12,000 14,000

2000 2005 2010 2015

• B. U.S. Agency Securities

Total Foreign Foreign

• fficial

Foreign holdings of Treasuries and LT corporate securities rising

Source: TIC

Low r* has implications for conduct of monetary policy

• Increases likelihood of running out of policy space,
• by increasing frequency and duration of episodes in which policy rate

constrained at the effective lower bound.

• Limits effectiveness of monetary policy to work through portfolio

rebalancing channel

• since there is less scope for lower rates to stimulate demand for other, riskier

assets, and raise financial wealth.

• Fosters financial stability
• by hurting financial sector profitability and increasing incentives to reach for

yield, contributing to buildup of excessive risk-taking and over-leveraging.

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r* is an anchor for monetary policy and setting the federal funds rate (FFR)

e

FFR r * π a(π-π*) b(y y*) = + + + −

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FOMC has raised funds rate toward the nominal r* target

1 2 3 4 5 2012 2013 2014 2015 2016 2017 2018 2019

FOMC Nominal r* and Federal Funds Rate (%)

Federal funds rate level "Longer-run" Federal funds target (Nominal r*)

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Note: Nominal r* = r* + 2% inflation target

Concluding Thoughts

• The natural rate of interest, r* has fallen over the last several decades
• Many factors play a role
• Foreign demand for U.S. safe assets, particularly government safe

assets, has increased dramatically

• For now, appears r* will remain low for the near future

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