Warren B. Hrung

Capital constraints, counterparty risk, and deviations from covered interest rate parity

We provide robust evidence of a deviation in the covered interest rate parity (CIP) relation since the onset of the financial crisis in August 2007. The CIP deviation exists with respect to several different dollar-denominated interest rates and exchange rate pairings of the dollar vis-a-vis other currencies. The results show that our proxies for margin conditions and for the cost of capital are significant determinants of the CIP deviations, especially during the crisis period. The supply of dollars by the Federal Reserve to foreign central banks via reciprocal currency arrangements (swap lines) reduced CIP deviations at this time. Following the bankruptcy of Lehman Brothers, uncertainty about counterparty risk became a significant determinant of CIP deviations, and the swap lines program no longer affected the CIP deviations significantly. These results indicate a breakdown of arbitrage transactions in the international capital markets that owes partly to lack of capital and partly to heightened counterparty credit risk. Central bank interventions helped reduce the funding liquidity risk of global institutions.

A Comparison of Measures of Core Inflation

The ability of central banks to differentiate between permanent and transitory price movements is critical for the conduct of monetary policy. The importance of gauging the persistence of price changes in a timely manner has led to the development of measures of underlying, or “core,” inflation that are designed to remove transitory price changes from aggregate inflation data. Given the usefulness of this information to policymakers, there is a surprising lack of consensus on a preferred measure of U.S. core inflation. This article examines several proposed measures of core inflation—the popular ex food and energy series, an ex energy series, a weighted median series, and an exponentially smoothed series—to identify a “best” measure. The authors evaluate the measures’ performance according to criteria such as ease of design and accuracy in tracking trend inflation, as well as explanatory content for within-sample and out-of-sample movements in aggregate CPI and PCE inflation. The study reveals that the candidate series perform very differently across aggregate inflation measures, criteria, and sample periods. The authors therefore find no compelling evidence to focus on one particular measure of core inflation, including the series that excludes food and energy prices. They attribute their results to the design of the individual measures and the measures’ inability to account for variability in the nature and sources of transitory price movements.

Repo market effects of the Term Securities Lending Facility

The Term Securities Lending Facility (TSLF) was introduced by the Federal Reserve to promote liquidity in the financing markets for Treasury and other collateral. We evaluate one aspect of the program--the extent to which it has narrowed repo spreads between Treasury collateral and less liquid collateral. We find that TSLF operations have precipitated a significant narrowing of repo spreads. More refined tests indicate the market conditions and types of operations associated with the programs effectiveness. Various additional tests, including a split-sample test, suggest that our findings are robust.

What Does the Taxable Income Elasticity Say About Dynamic Responses to Tax Changes

The taxable income elasticity is relevant to dynamic scoring because it broadly encompasses many ways taxpayers respond to changes in tax rates. The elasticity includes, for example, changes in labor supply and participation, savings and portfolio allocation, the form of compensation, the timing of income and deductions, and tax evasion and avoidance on the tax base, all subsumed in this one statistic. This one statistic summarizes how the tax base expands or contracts in response to changes in tax rates and, consequently, the extent taxpayer behavior offsets the static revenue loss (gain) of tax rate reductions (increases). In contrast to conventional revenues estimates, which assume that output and other key macroeconomic aggregates remain fixed when considering changes in the tax law, the taxable income elasticity imposes no such constraint. Nevertheless, some macro-dynamic responses, such as investment and savings-related supplyside effects and crowding out, are only partially captured in the taxable income elasticity, and demand effects are generally not reflected at all. Also, the taxable income elasticity generally does not account for shifting between the individual and corporate tax bases and is primarily useful to only evaluate policies that involve changes in tax rates. While large is in the eye of the beholder, the taxable income literature has generally found evidence of at least a modest behavioral response with some of the more recent studies suggesting a taxable income elasticity of about 0.4. This paper uses a 0.4 elasticity to simulate the revenue effect of repealing the recent reduction in the top two tax rates to 35 percent and to motivate a discussion of what the this elasticity can tell us about the dynamic response to changes in tax policy.

Responses to the Financial Crisis, Treasury Debt, and the Impact on Short-Term Money Markets

Several programs have been introduced by U.S. fiscal and monetary authorities in response to the financial crisis. We examine the responses involving Treasury debt - the Term Securities Lending Facility (TSLF), the Supplemental Financing Program, increases in Treasury issuance, and open market operations - and their impacts on the overnight Treasury general collateral repo rate, a key money market rate. Our contribution is to consider each policy in light of the others, both to help guide policy responses to future crises and to emphasize policy interactions. Only the TSLF was designed to directly address stresses in short-term money markets by temporarily changing the supply of Treasury collateral in the marketplace. We find that the TSLF is uniquely effective relative to other policies and that, while changes in Treasury collateral do affect repo rates, the impacts are not equivalent across sources of Treasury collateral.

The US Dollar Funding Premium of Global Banks

Following the financial crisis of 2007, many global financial firms faced difficulties in borrowing U.S. dollars (USD). We estimate the premium global banks paid to obtain USD (the “USD basis”) by the rate banks pay to swap euros into USD in the foreign exchange (FX) market, while fully hedging the FX risk, relative to the interbank rate for borrowing USD. We find that the bank basis is higher the day following increases in CDS prices and in asymmetric information measures. Controlling for fundamental risk, the basis is lower the day after successful borrowing at the Fed’s dollar liquidity facilities and it is higher for European banks following an unanticipated decrease in repo funding amounts, implying that USD funding constraints were binding for European banks during the crisis. Our results show that increased asymmetric information and “repo runs” (through unanticipated withdrawals of repo funding) combined to increase bank funding costs during the crisis.

Dealer financial conditions and lender-of-last-resort facilities

We examine the financial conditions of dealers that participated in two of the Federal Reserves lender-of-last-resort (LOLR) facilities—the Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF)—that provided liquidity against a range of assets during 2008–2009. Dealers with lower equity returns and greater leverage prior to borrowing from the facilities were more likely to participate in the programs, borrow more, and, in the case of the TSLF, at higher bidding rates. Dealers with less liquid collateral on their balance sheets before the facilities were introduced also tended to borrow more. The results suggest that both financial performance and balance sheet liquidity play a role in LOLR utilization.