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41. The ET Interview: Professor David F. Hendry

Author:
Neil R. Ericsson
Publication Date:
07-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This interview for Econometric Theory explores David Hendry's research. Issues discussed include estimation and inference for nonstationary time series; econometric methodology; strategies, concepts, and criteria for empirical modeling; the general-to-specific approach, as implemented in the computer packages PcGive and PcGets; computer-automated model selection procedures; David's textbook Dynamic Econometrics; Monte Carlo techniques (PcNaive); evaluation of these developments in simulation studies and in empirical investigations of consumer expenditure, money demand, inflation, and the housing and mortgage markets; economic forecasting and policy analysis; the history of econometric thought; and the use of computers for live empirical and Monte Carlo econometrics.
Topic:
Economics, Government, and International Trade and Finance
Political Geography:
United States

42. Good News Is No News? The Impact of Credit Rating Changes on the Pricing of Asset-Backed Securities

Author:
John Ammer and Nathanael Clinton
Publication Date:
07-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We assess the impact of credit ratings on the pricing of structured financial products, using a sample of more than 1300 changes in Moody's or Standard and Poor's (S) ratings of U.S. asset-backed securities (ABS). We find that rating downgrades tend to be accompanied by negative returns and widening spreads, with the average effects stronger than those that have been reported in prior research on corporate and sovereign bond ratings. A portion of the negative implications of ABS downgrades are anticipated by price movements ahead of the rating action, although to a lesser degree than has been found for bond ratings. Accordingly, ABS market participants appear to rely somewhat more on rating agencies as a source of negative news about credit risk. Nevertheless, because ABS rating downgrades are relatively rare events, their effects account for only a small fraction of the variance of returns. In contrast to our results on downgrades, market reactions to ABS rating upgrades are virtually zero, on average. Together, the results imply even greater asymmetry in the value-relevance of ABS rating changes than has been found in event studies of changes in bond ratings.
Topic:
Security, Economics, and International Trade and Finance
Political Geography:
United States

43. The Information Content of Forward and Futures Prices: Market Expectations and the Price of Risk

Author:
Jonathan H. Wright, Sergey V. Chernenko, and Krista B. Schwarz
Publication Date:
06-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Forward and futures rates are frequently used as measures of market expectations. In this paper we apply standard forecast efficiency tests, and some newer exact sign and rank tests, to a wide range of forward and futures rates, and in this way test whether these are in fact rational expectations of future actual prices. The forward and futures rates that we study under a common methodology include foreign exchange forward rates, U.S. and foreign interest rate futures and forward rates, oil futures and natural gas futures. For most, but not all, of these instruments, we find that we can reject the hypothesis that the forward or futures rates are rational expectations of actual future prices. It is well known that foreign exchange forward rates give less accurate forecasts than a random walk, but we show that this is also true for some interest rate futures and forward rates. We conclude that forward and futures prices are not generally pure measures of market expectations: they are also heavily affected by the market price of risk.
Topic:
Security, Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

44. The Decline of Activist Stabilization Policy: Natural Rate Misperceptions, Learning, and Expectations

Author:
Athanasios Orphanides and John C. Williams
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We develop an estimated model of the U.S. economy in which agents form expectations by continually updating their beliefs regarding the behavior of the economy and monetary policy. We explore the effects of policymakers' misperceptions of the natural rate of unemployment during the late 1960s and 1970s on the formation of expectations and macroeconomic outcomes. We find that the combination of monetary policy directed at tight stabilization of unemployment near its perceived natural rate and large real-time errors in estimates of the natural rate uprooted heretofore quiescent inflation expectations and destabilized the economy. Had monetary policy reacted less aggressively to perceived unemployment gaps, inflation expectations would have remained anchored and the stagflation of the 1970s would have been avoided. Indeed, we find that less activist policies would have been more effective at stabilizing both inflation and unemployment. We argue that policymakers, learning from the experience of the 1970s, eschewed activist policies in favor of policies that concentrated on the achievement of price stability, contributing to the subsequent improvements in macroeconomic performance of the U.S. economy.
Topic:
Economics, Government, and International Trade and Finance
Political Geography:
United States

45. Equal Size, Equal Role? Interest Rate Interdependence Between the Euro Area and the United States

Author:
Michael Ehrmann and Marcel Fratzscher
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper investigates whether the degree and the nature of economic and monetary policy interdependence between the United States and the euro area have changed with the advent of EMU. Using real-time data, it addresses this issue from the perspective of financial markets by analysing the effects of monetary policy announcements and macroeconomic news on daily interest rates in the United States and the euro area. First, the paper finds that the interdependence of money markets has increased strongly around EMU. Although spillover effects from the United States to the euro area remain stronger than in the opposite direction, we present evidence that US markets have started reacting also to euro area developments since the onset of EMU. Second, beyond these general linkages, the paper finds that certain macroeconomic news about the US economy has a large and significant effect on euro area money markets, and that these effects have become stronger in recent years. Finally, we show that US macroeconomic news has become good leading indicators for economic developments in the euro area. This indicates that the higher money market interdependence between the United States and the euro area is at least partly explained by the increased real integration of the two economies in recent years.
Topic:
Economics, Government, and International Trade and Finance
Political Geography:
United States

46. The Great Inflation of the 1970s

Author:
Fabrice Collard and Harris Dellas
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Was the high inflation of the 1970s mostly due to incomplete information about the structure of the economy (an unavoidable mistake as suggested by Orphanides, 2000)? Or, to weak reaction to expected inflation and/or excessive policy activism that led to indeterminacies (a policy mistake, a scenario suggested by Clarida, Gali and Gertler, 2000)? We study this question within the NNS model with policy commitment and imperfect information, requiring that the model have satisfactory overall empirical performance. We find that both explanations do a good job in accounting for the great inflation. Even with the commonly used specification of the interest policy rule, high and persistent inflation can occur following a significant productivity slowdown if policymakers significantly and persistently underestimate ”core” inflation.
Topic:
Economics, International Trade and Finance, and Political Economy
Political Geography:
United States

47. Ramsey Monetary Policy and International Relative Prices

Author:
Ester Faia and Tommaso Monacelli
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We analyze welfare maximizing monetary policy in a dynamic two-country model with price stickiness and imperfect competition. In this context, a typical terms of trade externality affects policy interaction between independent monetary authorities. Unlike the existing literature, we remain consistent to a public finance approach by an explicit consideration of all the distortions that are relevant to the Ramsey planner. This strategy entails two main advantages. First, it allows an accurate characterization of optimal policy in an economy that evolves around a steady-state which is not necessarily efficient. Second, it allows to describe a full range of alternative dynamic equilibria when price setters in both countries are completely forward looking and households' preferences are not restricted. In this context, we study optimal policy both in the long-run and along a dynamic path, and we compare optimal commitment policy under Nash competition and under cooperation. By deriving a second order accurate solution to the policy functions, we also characterize the welfare gains from international policy cooperation.
Topic:
International Relations, Economics, and International Trade and Finance
Political Geography:
United States

48. Indeterminacy with Inflation-Forecast-Based Rules in a Two-Bloc Model

Author:
Nicoletta Batini, Paul Levine, and Joseph Pearlman
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We examine the performance of forward-looking inflation-forecast-based rules in open economies. In a New Keynesian two-bloc model, a methodology first employed by Batini and Pearlman (2002) is used to obtain analytically the feedback parameters/horizon pairs associated with unique and stable equi-libria. Three key findings emerge: first, indeterminacy occurs for any value of the feedback parameter on inflation if the forecast horizon lies too far into the future. Second, the problem of indeterminacy is intrinsically more serious in the open economy. Third, the problem is compounded further in the open economy when central banks respond to expected consumer, rather than pro-ducer price inflation.
Topic:
International Relations, Economics, and International Trade and Finance
Political Geography:
United States

49. Price-level Determinacy, Lower Bounds on the Nominal Interest Rate, and Liquidity Traps

Author:
Dale W. Henderson and Ragna Alstadheim
Publication Date:
04-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We consider monetary-policy rules with inflation-rate targets and interest-rate or money-growth instruments using a flexible-price, perfect-foresight model. There is always a locally-unique target equilibrium. There may also be below-target equilibria (BTE) with inflation always below target and constant, asymptotically approaching or eventually reaching a below-target value, or oscillating. Liquidity traps are neither necessary nor sufficient for BTE which can arise if monetary policy keeps the interest rate above a lower bound. We construct monetary rules that preclude BTE when fiscal policy does not. Plausible fiscal policies preclude BTE for any monetary policy; those policies exclude surpluses and, possibly, balanced budgets.
Topic:
International Relations, Economics, and International Trade and Finance
Political Geography:
United States

50. Foreign Participation in Local-Currency Bond Markets

Author:
Francis E. Warnock and John D. Burger
Publication Date:
02-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We analyze the development of, and foreign participation in, 49 local bond markets. Countries with stable inflation rates and strong creditor rights have more developed local bond markets and rely less on foreign-currency-denominated bonds. Less developed bond markets have returns characterized by high variance and negative skewness, factors eschewed by U.S. investors. Results based on a three-moment CAPM indicate, however, that it is diversifiable idiosyncratic risk that U.S. investors appear to shun. Taken as a whole our results hint at a virtuous cycle of bond market development: Creditor friendly policies and laws can spark local bond market development that enables the development of derivatives markets and, in turn, attracts foreign participation.
Topic:
Development, Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States