Michelle L. Barnes

Alternative Measures of the Federal Reserve Banks' Cost of Equity Capital

The Monetary Control Act of 1980 requires the Federal Reserve System to provide payment services to depository institutions through the twelve Federal Reserve Banks at prices that fully reflect the costs a private-sector provider would incur, including a cost of equity capital (COE). Although Fama and French (1997) conclude that COE estimates are “woefully” and “unavoidably” imprecise, the Reserve Banks require such an estimate every year. We examine several COE estimates based on the Capital Asset Pricing Model (CAPM) and compare them using econometric and materiality criteria. Our results suggest that the benchmark CAPM applied to a large peer group of competing firms provides a COE estimate that is not clearly improved upon by using a narrow peer group, introducing additional factors into the model, or taking account of additional firm-level data, such as leverage and line-of-business concentration. Thus, a standard implementation of the benchmark CAPM provides a reasonable COE estimate, which is needed to impute costs and set prices for the Reserve Banks’ payments business.

Estimation of Forward-Looking Relationships in Closed Form: An Application to the New Keynesian Phillips Curve

We illustrate the importance of placing model-consistent restrictions on expectations in the estimation of forward-looking Euler equations. In two-stage limited-information settings where first-stage estimates are used to proxy for expectations, parameter estimates can differ substantially, depending on whether these restrictions are imposed or not. This is shown in an application to the New Keynesian Phillips Curve (NKPC), first in a Monte Carlo exercise, and then on actual data. The closed-form (CF) estimates require by construction that expectations of inflation be model-consistent at all points in time, while the difference-equation (DE) estimates impose no model discipline on expectations. Between those two polar extremes there is a wide range of alternative DE specifications based on the same dynamic relationship that explicitly imposes model restrictions on expectations for a finite number of periods. In our application, these last estimates quickly converge to the CF estimates and illustrate that the DE estimates in Cogley and Sbordone (2008) are not robust to imposing modest model requirements on expectations. In particular, our estimates show that the NKPC is not purely forward-looking, and thus that time-varying trend inflation is insufficient to explain inflation persistence.

Closed-form estimates of the New Keynesian Phillips Curve with time-varying trend inflation

We compare estimates of the New Keynesian Phillips Curve (NKPC) when the curve is specified in two different ways. In the standard difference equation (DE) form, current inflation is a function of past inflation, expected future inflation, and real marginal costs. The alternative closed form (CF) specification explicitly solves the DE form to express inflation as a function of past inflation and a present-discounted value of current and expected future marginal costs. The CF specification places model-consistent constraints on expected future inflation that are not imposed in the DE form. In a Monte Carlo exercise, we show that estimating the CF version of the NKPC gives estimates that are much more efficient than the estimates obtained from the DE specification. We then compare DE and CF estimates of the NKPC with time-varying trend inflation on actual data. The data and estimation methodology are the same as in Cogley and Sbordone (2008). We show that DE and CF estimates differ substantially and have very different implications for inflation dynamics. As in Cogley and Sbordone, it is possible to estimate DE specifications of the NKPC where lagged inflation plays no role once trend inflation is taken into account. The CF estimates of the NKPC, however, typically imply as large a role for lagged inflation as for expected future inflation. These estimates thus suggest that trend inflation is not in itself sufficient to explain the persistent dynamics of inflation.

A TIPS Scorecard: Are They Accomplishing Their Objectives?

Treasury Inflation-Protected Securities were developed to provide (1) consumers with assets that permit hedging against real interest rate risk, (2) nominal contract holders a means of hedging against inflation risk, and (3) everyone with an indicator of the term structure of expected inflation. This article evaluates progress toward these objectives. In 1997, the U.S. Treasury introduced Treasury Inflation-Protected Securities (TIPS) to achieve three major policy objectives: (1) to provide consumers with a class of assets that enables them to hedge against real interest rate risk, (2) to provide holders of nominal contracts with a way to hedge against inflation risk, and (3) to provide everyone with a reliable indicator of the term structure of expected inflation. We examined the extent to which these objectives have been achieved and sought to identify ways whereby they can be better achieved in the future. The viability of the TIPS market hinges on whether TIPS provide an effective hedge for most investors against unexpected changes in the real rate of interest that could result from unexpected fluctuations in inflation. Inflation-protected indexed bonds are designed to deliver, to the extent possible, a certain pretax real return to maturity. In the United States, these bonds are indexed to the Consumer Price Index (CPI) for all urban consumers (CPI-U). We focused on two important factors that may limit the ability of this class of securities to offer investors a complete hedge against unexpected changes in the real rate: (1) the possibility that the CPI may not be an appropriate index for all investors and (2) the potential for technical revisions to the measurement of the CPI, such as those recommended by the Boskin Commission just before the initial auctioning of TIPS in January 1997. Either or both of these factors could engender inflation basis risk. We did not address another widely known limiting factor: the fact that the CPI is not continuously measured and published, with the result that the indexation of TIPS’ nominal cash flows occurs with some lag. During the summer of 2008, a spate of popular press articles claimed that the existing methodology of computing the CPI underestimates true inflation. Some authors even asserted that the measure is subject to political influence and has been biased downward over time via methodological changes during several presidential regimes. Because these concerns speak to uncertainties regarding the ability of TIPS to hedge effectively against unexpected changes in the real rate, a few of these articles, not surprisingly, concluded that for many investors, TIPS are not, in fact, good hedges against inflation. We evaluated these criticisms and, to the extent that they are valid, assessed their implications for the efficacy of TIPS as a hedge against unexpected changes in the real rate of interest. We explained the design of TIPS, their tax implications for investors, the demographics of TIPS holders, and other considerations relating to whether TIPS should yield measures of breakeven inflation rates comparable with survey measures of consumers’ inflation expectations. We used both theoretical and empirical analysis to evaluate criticisms of the CPI as an inflation benchmark for adjusting the return on TIPS. We discussed whether the potential mismeasurement of the CPI is relevant to the efficacy of TIPS as a hedging instrument to guarantee the real return, whether the CPI is a good measure for everyone, and whether there might be more appropriate measures for certain heterogeneous groups, as well as the costs and benefits of issuing such securities. We then demonstrated the efficacy of TIPS as a hedge against various ex ante and ex post inflation measures and their efficacy as a short-term versus a long-term hedge. We conclude that the TIPS market provides a good hedge against inflation risk, and from a cost/benefit perspective, little is to be gained from indexing to other inflation measures, be they broader, such as the GDP deflator, or narrower, such as regional inflation measures or the CPI-E (for the elderly). As the proportion of retirees who have defined benefit pensions continues to decrease, the need for individuals to manage lump-sum accounts to provide a steady stream of real income during their retirement becomes more difficult. A “ladder” of TIPS with maturities linked to the dates when the money will be needed for expenses is a safe investment well suited to retirees and those approaching retirement. TIPS have the potential to be the backbone asset underlying inflation-indexed annuities, but the maximum duration of TIPS would need to be extended in order to facilitate such annuities. Note: The views expressed in this article are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Boston or the Federal Reserve System.

The sensitivity of long-term interest rates to economic news: comment

Refet Gurkaynak, Brian Sack, and Eric Swanson (2005) provide empirical evidence that long forward nominal rates are overly sensitive to monetary policy shocks, and that this is consistent with a model where long-term inflation expectations are not anchored because agents must infer the central banks inflation target from noisy interest rate movements. Using the same data, methodology, and model, we show that their empirical results are neither persistent nor robust to small changes in sample period or methodology. In addition, their theoretical results rely mainly on an ad hoc law of motion for the inflation target-imperfect information about the target plays only a small role in un-anchoring expectations in their model.

A Principal Components Approach to Estimating Labor Market Pressure and its Implications for Inflation

We build a summary measure of labor market pressure that captures the common movement among a variety of labor market series. Obtained as the labor market series’ first principal component, this measure explains a large portion of the variability of the underlying series. For this reason, it is a good summary indicator of labor market pressure. We show that the unemployment rate gap has tracked this summary measure closely over the past 35 years. At times, however, the summary measure and the unemployment rate gap have sent somewhat different signals. In terms of relying on the principal components summary measure vis-a-vis the unemployment rate gap for explaining inflation, we argue that the recent evolution of wage inflation is more consistent with the evolution of the summary measure than with the unemployment rate gap. This is because over the past two years the principal components summary measure has been suggesting less labor market pressure than the unemployment rate gap. Over the past 35 years, however, there is little systematic evidence favoring the summary measure of labor market pressure over the unemployment rate gap as a predictor of inflation.