Discussion of Forward Guidance in the Yield Curve by Hanson, Greenwood and Vayanos

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Agatha Marjorie Morgan
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1 Simone Manganelli European Central Bank Discussion of Forward Guidance in the Yield Curve by Hanson, Greenwood and Vayanos 19 th Annual Conference of the Central Bank of Chile Santiago, November 2015

2 Rubric Summary of the paper An arbitrageur maximises a risk-variance expected utility of instantaneous returns on her wealth invested in bonds. Four risk factors, all modelled as stochastic mean processes. Two from Greenwood and Vayanos (RFS 2014): 1. Short interest rate 2. Supply of bonds (by government/central bank) Two more added in this paper: 3. Target short rate Forward guidance on interest rates 4. Target supply of bonds Forward guidance on QE The arbitrageur requires compensation to hold each of these risks, which depend in a non-trivial way on: the supply of bonds the parametrization of the stochastic mean process. 2

3 Rubric In case you want to know Risk premium Risk sensitivity Price of risk 3

4 Rubric Main findings A positive shock to any factor increases all yields and forward rates. But shocks to interest rates do not affect risk premia and operate only through expected future short rates. And shocks to supply affect yields only through risk premia. The effect of shocks is hump-shaped with maturity. Increase in supply raises duration risk: Little effect on short maturities Biggest impact on medium maturities Impact on longer maturities diminished by mean reverting properties of supply Humps for shocks to QE occur at longer maturities than shocks to FG. But only under specific conditions: shocks to FG do not mean revert more slowly than shocks to QE. 4

5 Rubric Comments Definition of forward guidance Interpretation of shocks to forward guidance Accounting for the lower bound 4 Evidence from the euro area 5

6 Rubric Comment 1 Forward guidance Paper s definition of forward guidance. For interest rates: For asset purchases: dr t = κ r (r r t )dt + σ r db r,t dβ t = κ β β t dt + σ β db β,t Shocks to these variables are interpreted as policy announcements that provide forward guidance. Is this really forward guidance? How do you rationalise the fact that shocks to forward guidance occur instantaneously and are idiosyncratic? Forward guidance should rather put interest rates and asset purchases on a predictable path. 6

7 Rubric Simulation of forward guidance using calibration in the paper dr t = κ r (r r t )dt + σ r db r,t dβ t = κ β β t dt + σ β db β,t 7

8 Rubric Comment 2 Interpretation of shocks to forward guidance dβ t = κ β β t dt + σ β db β,t In several parts of the paper you assume σ β = 0 and interpret changes in β as unanticipated and one-off. See for instance Propositions 5, which derives one the main results about the position of the hump of the forward rate curve after QE and FG shocks. But if you set σ β = 0 there is no risk coming from the target supply, and therefore this factor should not be priced at all. There seems to be a contradiction between the assumption σ β = 0 and the definition of shock to β. 8

9 Rubric Comment 3 What happened to the lower bound? Forward guidance goes hand in hand with lower bound. In fact, the paper starts with the sentence Since reaching the zero lower bound Central banks resort to FG and QE because short term interest rates cannot be pushed lower. The impact of FG and QE has been among other things to extend the maturity at which interest rates hit their lower bound. In the paper, however, there is no lower bound constraint for interest rates. How would results be affected by the introduction of such constraint? There is an emerging literature dealing with lower bounds in term structure: Kim and Singleton (JoE 2012) Monfort, Pegoraro, Renne and Roussellet (BdF 2015). 9

10 Rubric Comment 4 What is going on in the euro area? Main events 4 July 2013 Announcement of forward guidance The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time.. 22 January 2015 Announcement of Asset Purchase Programme The Governing Council today announced an expanded asset purchase programme. Combined monthly purchases will amount to 60 billion. They are intended to be carried out until at least September March 2015 Beginning of purchases 10

11 Rubric Forward Guidance vs. QE Impact on euro area term structure 0,2 0,15 0,1 0,05 0-0,05-0,1-0,15-0, Spot FG Forward FG Spot QE Forward QE A negative shock to any factor decreases all yields and forward rates. The effect of shocks is hump-shaped with maturity. Humps for shocks to QE occur at longer maturities than shocks to FG. X?? 11

12 Forward guidance on maturity GC 22 Jan :30 14:40 15: Jan 15 Press Conference starts The combined monthly purchases... will amount to 60bn The maturities range between 2 and 30 years market reaction to a size shock market reaction to a maturity shock Maturity shock Size shock Source: Altavilla, Carboni and Motto (2015), ECB WP No

13 Rubric Impact of QE Announcement vs. implementation 0,05 0-0,05-0,1-0,15-0,2-0,25-0, Spot Announcement Forward Announcement Spot Implementation Forward Implementation 13

14 Rubric Impact of QE Is credit risk also affected? Impact on Italian-German spreads 0-0,05-0,1-0,15-0,2-0,25-0,3-0, FG QE 14

15 Rubric Conclusion As Bernanke put it, we know it works in practice, but not in theory. Central banks need to understand better the mechanism of transmission of QE, not least to explain it to the public. Vayanos s research has been very helpful and influential in this respect. I am not entirely convinced about how forward guidance is introduced in this paper. Still, I commend the authors to address an extremely important topic. I am looking forward to the next extension possibly to euro area! 15

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