Discussion of Forward Guidance, Quantitative Easing, or both?

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Discussion of Forward Guidance, Quantitative Easing, or both? Han Chen Federal Reserve Board 1 ECB, September 11, 2017 1 The views expressed in this discussion are those of the author and do not necessarily reflect the position of the Federal Reserve Board or the Federal Reserve System. Chen Discussion of De Graeve and Theodoridis 1

Effects of Asset Purchase Programs How do Large Scale Asset Purchase (LSAP) programs affect the economy? Chen Discussion of De Graeve and Theodoridis 2

Effects of Asset Purchase Programs How do Large Scale Asset Purchase (LSAP) programs affect the economy? Effects on financial variables ("Portfolio-Balance" theory reduces long interest rates) Chen Discussion of De Graeve and Theodoridis 2

Effects of Asset Purchase Programs How do Large Scale Asset Purchase (LSAP) programs affect the economy? Effects on financial variables ("Portfolio-Balance" theory reduces long interest rates) Effects on macroeconomic variables (transmission from interest rates to macro variables) Chen Discussion of De Graeve and Theodoridis 2

Effects of Asset Purchase Programs How do Large Scale Asset Purchase (LSAP) programs affect the economy? Effects on financial variables ("Portfolio-Balance" theory reduces long interest rates) Effects on macroeconomic variables (transmission from interest rates to macro variables) How different is the effect of LSAPs when the interest rate is at the zero lower bound? Chen Discussion of De Graeve and Theodoridis 2

Effects of Asset Purchase Programs How do Large Scale Asset Purchase (LSAP) programs affect the economy? Effects on financial variables ("Portfolio-Balance" theory reduces long interest rates) Effects on macroeconomic variables (transmission from interest rates to macro variables) How different is the effect of LSAPs when the interest rate is at the zero lower bound? How do LSAPs compare to interest rate policy? Chen Discussion of De Graeve and Theodoridis 2

Effects of Asset Purchase Programs How do Large Scale Asset Purchase (LSAP) programs affect the economy? Effects on financial variables ("Portfolio-Balance" theory reduces long interest rates) Effects on macroeconomic variables (transmission from interest rates to macro variables) How different is the effect of LSAPs when the interest rate is at the zero lower bound? How do LSAPs compare to interest rate policy? = Perform quantitative analysis using estimated DSGE model Chen Discussion of De Graeve and Theodoridis 2

Model Requirements DSGE that fits macro variables decently well: Smets and Wouters (2007) Del Negro and Schorfheide (2008) Chen Discussion of De Graeve and Theodoridis 3

Model Requirements DSGE that fits macro variables decently well: Smets and Wouters (2007) Del Negro and Schorfheide (2008) Give a chance to LSAP programs Chen Discussion of De Graeve and Theodoridis 3

Model Requirements DSGE that fits macro variables decently well: Smets and Wouters (2007) Del Negro and Schorfheide (2008) Give a chance to LSAP programs Short and long bonds Chen Discussion of De Graeve and Theodoridis 3

Model Requirements DSGE that fits macro variables decently well: Smets and Wouters (2007) Del Negro and Schorfheide (2008) Give a chance to LSAP programs Short and long bonds Friction in financial markets spread between long and short yields Allows LSAPs to affect the risk premium... but not the real economy (by itself) Chen Discussion of De Graeve and Theodoridis 3

Model Requirements DSGE that fits macro variables decently well: Smets and Wouters (2007) Del Negro and Schorfheide (2008) Give a chance to LSAP programs Short and long bonds Friction in financial markets spread between long and short yields Allows LSAPs to affect the risk premium... but not the real economy (by itself) Market segmentation limited arbitrage (Chen, Cúrdia, and Ferrero (CCF), 2012) Allows changes in the risk premium to affect the real economy... breaking the neutrality result Chen Discussion of De Graeve and Theodoridis 3

Model Requirements DSGE that fits macro variables decently well: Smets and Wouters (2007) Del Negro and Schorfheide (2008) Give a chance to LSAP programs Short and long bonds Friction in financial markets spread between long and short yields Allows LSAPs to affect the risk premium... but not the real economy (by itself) Market segmentation limited arbitrage (Chen, Cúrdia, and Ferrero (CCF), 2012) Allows changes in the risk premium to affect the real economy... breaking the neutrality result Harrison (2011): bond-in-utility De Graeve and Theodoridis (2017): financial intermediary with adjustment costs Chen Discussion of De Graeve and Theodoridis 3

Key Results CCF (2012) find that the effects of the LSAPs II are likely to be small Median effect on GDP growth rate is 0.13% and on inflation is 3bp. De Graeve and Theodoridis (2017) Peak effect on GDP growth rate is 0.6% and on inflation is 0.25%. Chen Discussion of De Graeve and Theodoridis 4

Why did CCF (2012) find small effects? Households 2 types: unrestricted: can invest in both short and long bonds, transaction cost when investing in long bonds restricted: can only invest in long bonds, no transaction cost The percentage of restricted household is estimated to be small Transaction cost is assumed to be a function of the market value of long-term bonds However, the elasticity of the transaction cost to the market value of long-term bonds is also estimated small. Chen Discussion of De Graeve and Theodoridis 5

Why did CCF find small effects? Euler Equations for unrestricted household Short-term bond: 1 = E t [mt+1r u t ] ] Long-term bond: 1 = E t [mt+1 u P L,t+1 R L,t+1 1 P L,t 1 + ζ t can arbitrage between the two bonds, subject to transaction cost Chen Discussion of De Graeve and Theodoridis 6

Why did CCF find small effects? Euler Equations for unrestricted household Short-term bond: 1 = E t [mt+1r u t ] ] Long-term bond: 1 = E t [mt+1 u P L,t+1 R L,t+1 1 P L,t 1 + ζ t can arbitrage between the two bonds, subject to transaction cost Chen Discussion of De Graeve and Theodoridis 6

Why did CCF find small effects? Euler Equations for unrestricted household Short-term bond: 1 = E t [mt+1r u t ] ] Long-term bond: 1 = E t [mt+1 u P L,t+1 R L,t+1 1 P L,t 1 + ζ t can arbitrage between the two bonds, subject to transaction cost Chen Discussion of De Graeve and Theodoridis 6

Why did CCF find small effects? Euler Equations for unrestricted household Short-term bond: 1 = E t [mt+1r u t ] ] Long-term bond: 1 = E t [mt+1 u P L,t+1 R L,t+1 1 P L,t 1 + ζ t can arbitrage between the two bonds, subject to transaction cost Euler Equation for restricted household Long-term bond: 1 = E t [m r t+1 cannot arbitrage between the two bonds ] P L,t+1 R L,t+1 P L,t Chen Discussion of De Graeve and Theodoridis 6

Why did CCF find small effects? Euler Equations for unrestricted household Short-term bond: 1 = E t [mt+1r u t ] ] Long-term bond: 1 = E t [mt+1 u P L,t+1 R L,t+1 1 P L,t 1 + ζ t can arbitrage between the two bonds, subject to transaction cost Euler Equation for restricted household Long-term bond: 1 = E t [m r t+1 cannot arbitrage between the two bonds ] P L,t+1 R L,t+1 P L,t Chen Discussion of De Graeve and Theodoridis 6

Why did CCF find small effects? Euler Equations for unrestricted household Short-term bond: 1 = E t [mt+1r u t ] ] Long-term bond: 1 = E t [mt+1 u P L,t+1 R L,t+1 1 P L,t 1 + ζ t can arbitrage between the two bonds, subject to transaction cost Euler Equation for restricted household Long-term bond: 1 = E t [m r t+1 cannot arbitrage between the two bonds ] P L,t+1 R L,t+1 P L,t Transaction cost is function of market value of long-term bond ζ = ζ ( P L,t Bt L ) Chen Discussion of De Graeve and Theodoridis 6

Posterior Estimates Market frictions parameters: Prior Posterior Dist 5% Median 95% 5% Median 95% 100ζ G 0.307 1.285 3.429 0.086 0.327 0.826 ω u B 0.321 0.733 0.965 0.824 0.947 0.993 Data pushes against segmentation Chen Discussion of De Graeve and Theodoridis 7

Simulation of LSAP II (Posterior) Chen Discussion of De Graeve and Theodoridis 8

Why Did De Graeve and Theodoridis Find Big Effects? The authors attribute their findings to Government bond maturity structure Government bond supply rule and tax rule Inflation target in the monetary policy rule Both short-term debt and long-term debt are used as observables Chen Discussion of De Graeve and Theodoridis 9

Why Did De Graeve and Theodoridis Find Big Effects? In De Graeve and Theodoridis (2017), what matters for the real economy is the deposit rate rt h. rt s and rt l do not affect agents saving/consumption decision directly. In CCF (2012), both short rate and long rate affect agents decision directly. Chen Discussion of De Graeve and Theodoridis 10

Why Did De Graeve and Theodoridis Find Big Effects? Chen Discussion of De Graeve and Theodoridis 11

Deposit rate dropped about 3%. LSAPs shock works like a fed funds shock, and a 3% fed funds shock!! This is what drives the macro effects. However this is inconsistent with the LSAPs II experience. This is also inconsistent with ZLB. Chen Discussion of De Graeve and Theodoridis 12

Why Did De Graeve and Theodoridis Find Big Effects? In De Graeve and Theodoridis (2017), the LSAPs II shock is nearly permanent. Authors call a permanent anticipated shock "forward guidance" and they prefer the model with anticipation because of the higher marginal likelihood. We should compare marginal data density The model is estimated through 2015. Given the extended period of extremely low policy rates, it is not surprising the model with anticipation shocks, which also appear in the Taylor rule to, is preferred to the standard model. In CCF (2012), agents have perfect foresight of the entire purchase path. In reality the central bank announces the purchase amount and purchase pace in advance. Standard DSGE models are only adequate to analyze business cycle fluctuations along a stable growth trend. Chen Discussion of De Graeve and Theodoridis 13

LSAPs II shock Chen Discussion of De Graeve and Theodoridis 14

Some Simulation Exercises using CCF IRF of bond supply shock(original parameter)ifr of permanent bond supply shock Chen Discussion of De Graeve and Theodoridis 15

Conclusion Very ambitious paper that makes a significant contribution to the community of studying the unconventional monetary policy. Although the authors find substantial effects of the LSAPs, I suspect this is due to the model specifications that may be inconsistent with some dimensions of the data It is still premature to claim how effective the LSAPs are. Further investigation is necessary. Chen Discussion of De Graeve and Theodoridis 16

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