Government debt and the term premium new results from old data

The results claim that supply effects do play a substantial role in driving longer-term interest levels. There are two caveats on these results. First, if debt managers seek to improve the maturity of debt when longer-term interest levels are expected to go up later on, our results could be somewhat upward-biased. But we remember that in the time we study, many changes in the maturity of debt were led by legislation, instead of any short-run response to advertise conditions (e.g. in 1976 and 2001). And, second, if we extend the estimation sample there is some proof structural instability from 2008 onwards, which could very well be hardly surprising, and additional motivates the usage of the pre-crisis period.

The Greenspan Conundrum and the impact of QE

We run two analyses of the model’s capability to explain changes in longer-term interest levels. In February 2005, Alan Greenspan lamented that long-term interest levels had continued to fall despite the fact that the Federal Funds rate have been raised by 150 basis points to 2.5%. In his view, there is no obvious explanation, and he famously called this a ‘conundrum’. In subsequent months, the Federal Reserve continued to improve the Federal Funds rate, which reached 5.25% in July 2006, however the 10-year long-term rate didn’t increase up to it had in previous tightening episodes. Our estimates claim that an important reason behind the amount of the long-term rate may have been the shortening of the maturity of public debt – average maturity reached a peak of over 70 months in late 2001 and it steadily declined to attain a trough of 56 months in March 2005. According to your estimates, a decline in the common maturity of almost 58 months would result in a reduced amount of over 150 basis points. In Figure 1, we show the cumulative change in the forward rate from 2002H1 and the estimated contribution of expected future debt and average maturity with regard to a 95% confidence band, in addition to the point contribution from maturity alone. And we remember that any undershoot in forwards seem reasonably well explained by changes in maturity.

Figure 1 . Net supply, maturity, and the Greenspan Conundrum

QE1 was announced in November 2008. From then to the finish of 2012, marketable debt (including Federal Reserve holdings) rose by 28.5 percentage points of GDP. The Federal Reserve absorbed some 7 percentage points of the increase. Therefore by buying long-dated bonds, the Federal Reserve also lowered the common maturity of debt by around 7 months. Table 1 shows just how much higher the 5-year-ahead 10-year rates and the 10-year term premium could have been if public debt held beyond your central bank have been 7 percentage points of debt higher and average maturity 7 months longer. Specifically, the absorption of 7 percentage points of debt results in a 12-15 basis points lower forward rate and a 0-8 basis points lower term premium, and a 7-month lower maturity results in an 80-100 basis points lower forward rate and 67-89 basis points lower term premium. Combing both of these effects, Fed purchases since November 2008 may have contributed to lowering the 5-year forward 10-year rates by approximately 90-115 basis points and the 10-year term premium by approximately 70-95 basis points.

Table 1 . Potential ramifications of central bank purchases of Treasuries, November 2008 to end-2012

Note: Change in the first column identifies changes in privately held debt that could be related to central bank interventions since November 2008

Portfolio balance effects: Segmentation and the limits to arbitrage

Portfolio balance effects certainly are a convenient catch-all for why both size and maturity of public debt can matter for the determination of interest levels. Preferred habitat theories involve segmented markets where investors demand bonds at a particular maturity, and the price tag on that bond is thus dependant on local demand and offer at that maturity. For instance, pension funds may have a solid preference for longer maturities so that you can match their liabilities. Furthermore, Krishnamurthy and Vissing-Jorgensen (2012) have argued that government bonds, particularly those of the united states, have such a higher amount of liquidity and safety they are close substitutes for the money. So the prices of government debt could be suffering from their relative supply and the demand for money-like debt, instead of simply dependant on the expectations hypothesis (e.g. Bauer and Rudebusch 2013). Work by Greenwood and Vayanos (2013) shows that although inelastic demand and offer for debt at each maturity could possibly be ironed out by arbitrageurs, risk aversion (and liquidity constraints) limit their capability to undertake duration risk, and cause them to demand an increased premium when the relative way to obtain longer-duration government bonds increases. As the cost of risk rises, bond prices at all maturities are affected, albeit by more at longer maturities.

Concluding remarks

That our email address details are estimated in the 30 roughly years before the financial crisis we can exclude the chance that they have already been driven by extraordinary financial market conditions. Our results connect with the market for all of us government debt. How well overall supply and maturity effects explain longer-term interest levels far away remains an open question. However, Iwata and Fueda-Samikawa (2013), applying an extremely similar methodology to yields on Japanese government bonds, also found significant overall supply and maturity effects. It appears reasonably clear, though, that in virtually any exit from extraordinary policies these effects will complicate the decision of path for the policy rate, as key benchmark longer-term rates will be buffeted by announcements and actual debt sales, that may alter the web supply and maturity of public debt held beyond your Federal Reserve. More generally, it could also appear that fiscal policy and its own financing may have significantly more substantive implications for monetary policy than was thought a generation ago. Ultimately, if our findings about the need for maturity are accepted, then your Federal Reserve could also consider making more usage of operations that change the maturity of debt held by the private sector and overseas.

Author’s note: I am grateful for comments and support from my co-authors Philip Turner and Fabrizio Zampolli at the lender for International Settlements.


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[1]Indeed, “monetary policy determines the composition of the federal government portfolio” was the first line in Wallace (1981) that expounded the logic of a Modigliani-Miller theorem for central bank market operations.

[2] Remember that they calculate that QE1 and QE2 lowered the maturity-weighted debt to GDP ratio by simply under 0.7 percentage points. So they claim that the impact of the operations on longer-term yields was some 30 basis points.

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