William R. Nelson

Interpreting the Significance of the Lagged Interest Rate in Estimated Monetary Policy Rules

Many researchers have found that the lagged interest rate enters estimated monetary policy rules with overwhelming significance. However, a recent paper by Rudebusch (2002) argues that the lagged interest rate is not a fundamental component of the U.S. policy rule, and that its significance arises from the omission of serially correlated variables from the policy rule. This paper demonstrates that, contrary to Rudebuschs claims, these two hypotheses can be directly distinguished in the estimation of the policy rule. Our findings indicate that while serially correlated omitted variables may be present, the lagged interest rate enters the policy rule on its own right and plays an important role in describing the behavior of the federal funds rate.

Securitization Markets and Central Banking: An Evaluation of the Term Asset-Backed Securities Loan Facility

In response to the near collapse of US securitization markets in 2008, the Federal Reserve created the Term Asset-Backed Securities Loan Facility, which offered non-recourse loans to finance investors’ purchases of certain highly rated asset-backed securities. We study the effects of this program and find that it lowered interest rate spreads for some categories of asset-backed securities but had little impact on the pricing of individual securities. These findings suggest that the program improved conditions in securitization markets but did not subsidize individual securities. We also find that the risk of loss to the US government was small.

Bank Risk Rating of Business Loan

In recent years many banks have attempted to improve the measurement and management of credit risk by assigning risk ratings to business loans. Virtually all large banks now assign such ratings. However, until recently there has been little information on the use of risk ratings by smaller banks. Recent revisions to the Federal Reserves Survey of Terms of Business Lending and telephone consultations with more than 100 banks on the survey panel provide data on the prevalence and precision of risk rating systems at banks of all sizes. We find that the use of risk rating systems is quite widespread, but that smaller banks generally have less detailed systems than do larger banks. In addition, the new survey data allow us to asses the relationships between loan risk ratings and loan terms. Not surprisingly, riskier loans generally carry higher interest rates, even after taking account of other loan terms. There are more complex relationships between loan risk and other loan terms. Regression results indicate that banks of all sizes price for risk. We do not find a relationship between reported loan risk and delinquency and charge-off rates. However, this may reflect how recently the risk rating data have become available.

Using Policy Intervention to Identify Financial Stress

This paper describes the construction of a financial stress index. This stress index differs from other indexes in that it incorporates the co-movement and volatility of financial series as well as the levels of the series. Our index also uses past experience more than others to guide the assessment about which characteristics of the data suggest financial stress exists. In addition to describing the construction of our financial stress index, we spend some time discussing issues relevant to the general construction of stress indexes.

Why Do We Need Both Liquidity Regulations and a Lender of Last Resort? A Perspective from Federal Reserve Lending During the 2007-09 U.S. Financial Crisis

During the 2007-09 financial crisis, there were severe reductions in the liquidity of financial markets, runs on the shadow banking system, and destabilizing defaults and near-defaults of major financial institutions. In response, the Federal Reserve, in its role as lender of last resort (LOLR), injected extraordinary amounts of liquidity. In the aftermath, lawmakers and regulators have taken steps to reduce the likelihood that such lending would be required in the future, including the introduction of liquidity regulations. These changes were motivated in part by the argument that central bank lending entails extremely high costs and should be made unnecessary by liquidity regulations. By contrast, some have argued that the loss of liquidity was the result of market failures, and that central banks can solve such failures by lending, making liquidity regulations unnecessary. In this paper, we argue that LOLR lending and liquidity regulations are complementary tools. Liquidity shortfalls can arise for two very different reasons: First, sound institutions can face runs or a deterioration in the liquidity of markets they depend on for funding. Second, solvency concerns can cause creditors to pull away from troubled institutions. Using examples from the recent crisis, we argue that central bank lending is the best response in the former situation, while orderly resolution (by the institution as it gets through the problem on its own or via a controlled failure) is the best response in the second situation. We also contend that liquidity regulations are a necessary tool in both situations: They help ensure that the authorities will have time to assess the nature of the shortfall and arrange the appropriate response, and they provide an incentive for banks to internalize the externalities associated with any liquidity risks.

Connecting the Dots: Market Reactions to Forecasts of Policy Rates and Forward Guidance Provided by the Fed

This paper compares market reactions to forecasts of the policy rate path provided by FOMC participants (“dots�?) in the Summary of Economic Projections (SEP) with those to forward guidance provided by the FOMC in its statements. We find that market expectations of the time to lift-off from the zero lower bound are significantly affected in the expected direction by surprises in SEP dots and in forward guidance. We also find a significant impact of macroeconomic news on market participants’ expectations of time to lift-off. These results are consistent with forward guidance about policy rates and SEP forecasts each contributing to the public’s understanding of future Federal Reserve monetary policy, and with the conditionality of both forms of communication about future policy rates being understood. We also present evidence that market expectations concerning the time to lift-off are influenced by the maximum time to lift-off implied by forward guidance, the SEP and the economic outlook. An appendix provides the FOMC’s forward guidance after each meeting from January 2012 to September 2015 and our interpretation of the implied days to lift-off.