Michael Feroli

Abstract: Assessments of the risks to financial stability often focus on the degree of leverage in the system. In this report, however, we question whether subdued leverage of financial intermediaries is sufficient grounds to rule out stability concerns. In particular, we highlight unlevered investors as the locus of potential financial instability and consider the monetary policy implications. Our focus is on market “tantrums” (such as that seen during the summer of 2013) in which risk premiums inherent in market interest rates fluctuate widely. Large jumps in risk premiums may arise if non-bank market participants are motivated, in part, by their relative performance ranking. Redemptions by ultimate investors strengthen such a channel. We sketch an example and examine three empirical implications. First, as a product of the performance race, flows into an investment opportunity drive up asset prices so that there is momentum in returns. Second, the model predicts that return chasing can reverse sharply. And third, changes in the stance of monetary policy can trigger heavy fund inflows and outflows.Using inflows and outflows for different types of open-end mutual funds, we find some support for the proposition that market tantrums can arise without any leverage or actions taken by leveraged intermediaries. We also uncover connections between the destabilizing flows and shocks to monetary policy. We draw five principal conclusions from our analysis. First, in contrast with the common presumption, the absence of leverage may not be sufficient to ensure that monetary policy can disregard concerns for financial stability. Second, the usual macroprudential toolkit does not address instability driven by non-leveraged investors. Third, forward guidance encourages risk taking that can lead to risk reversals. In fact, our example suggests that when investors infer that monetary policy will tighten, the instability seen in summer of 2013 is likely to reappear. Fourth, financial instability need not be associated with the insolvency of financial institutions. Fifth, the tradeoffs for monetary policy are more difficult than is sometimes portrayed. The tradeoff is not the contemporaneous one between more versus less policy stimulus today, but is better understood as an intertemporal tradeoff between more stimulus today at the expense of a more challenging and disruptive policy exit in the future.Of course, our analysis neither invalidates nor validates the policy course the Federal Reserve has actually taken. Any such conclusion depends on an assessment of the balance of risks given the particular circumstances, which lies beyond the scope of our paper. Instead, our paper is intended as a contribution to developing the analytical framework for making policy judgments. But our analysis does suggest that unconventional monetary policies (including QE and forward guidance) can build future hazards by encouraging certain types of risk-taking that are not easily reversed in a controlled manner.

Abstract: The standard life-cycle model of consumption behavior predicts that a household's age will influence its saving behavior. Moreover, simple national accounting identities reveal that a country's current account balance reflects its savings-investment imbalance. Thus, differences in national age-profiles should affect the current account. To test this theory's plausibility and significance, I simulate a multi-region overlapping generations model that is calibrated to match the demographic differences among the major industrialized countries over the past 50 years. In the model, it is found that these differences can explain some of the observed long-term capital movements in the G-7. In particular, the model does a good job of predicting the size and timing of American current account deficits as well as Japanese current account surpluses.

Abstract: This report examines the behavior of inflation in the United States since 1984 (updating Cecchetti et al. (2007)). Over this period, the change in inflation is negatively serially correlated, and the change in inflation is best predicted by a statistical model that includes only information from the two most recent quarters. We find that the level of inflation fluctuates around a slowly changing trend that we call the local mean of inflation. Few variables add extra explanatory power for inflation once the local mean is taken into account. This local mean is itself well characterized by a random walk. Labor market slack has a statistically significant, but quantitatively small, effect on the local mean and inflation expectations have no effect. Some financial conditions that are influenced by monetary policy have larger effects on the local mean. Concretely, this means that one-off moves in labor market slack or inflation expectations that are not mirrored in broader indicators of inflation pressures are unlikely to be predictive of changes in trend inflation.

Abstract: The standard life-cycle model of consumption behavior predicts that a household's age will influence its saving behavior. Moreover, simple national accounting identities reveal that a country's current account balance reflects its savings-investment imbalance. Thus, differences in national age-profiles should affect the current account. To test this theory's plausibility and significance, I simulate a multi-region overlapping generations model that is calibrated to match the demographic differences among the major industrialized countries over the past 50 years. In the model, it is found that these differences can explain some of the observed long-term capital movements in the G-7. In particular, the model does a good job of predicting the size and timing of American current account deficits as well as Japanese current account surpluses.

Abstract: This paper examines the Federal Reserve's communication strategy to see how well it has worked and how it can be improved. It argues that Federal Reserve communication when short-term interest rates are no longer constrained by the zero lower bound should be focused on relaying a data-based reaction function which informs market participants how interest rates will adjust as new information arrives. Instead, the Federal Reserve in recent years has relied more heavily than desired on “time-based” forward guidance, focusing on when interest rates are likely to rise rather than under what circumstances. We argue that, except under unusual circumstances, this is an imprudent strategy, as it mutes the effect of macroeconomic news on interest rates and unnecessarily places restrictions on future Federal Reserve action when new information arrives. We argue that the Federal Reserve can improve communication in the current environment by moving away from time-based forward guidance, clarifying how interest rates are likely to change given new information, and providing more information in the Summary of Economic Projections.

Abstract: We present a quantitative analysis of the effects of population aging and pension reform on international capital markets. First, demographic change alters the time path of aggregate savings within each country. Second, this process may be amplified when a pension reform shifts old-age provision towards more pre-funding. Third, while the patterns of population aging are similar in most countries, timing and initial conditions differ substantially. Hence, to the extent that capital is internationally mobile, population aging will induce capital flows between countries. All three effects influence the rate of return to capital and interact with the demand for capital in production and with labor supply. In order to quantify these effects, we develop a computational general equilibrium model. We feed this multi-country overlapping generations model with detailed long-term demographic projections for seven world regions. Our simulations indicate that capital flows from fast-aging regions to the rest of the world will initially be substantial but that trends are reversed when households decumulate savings. We also conclude that closed-economy models of pension reform miss quantitatively important effects of international capital mobility. (This version: 25 August, 2004)

Abstract: Investment in bond mutual funds has grown rapidly in recent years. With it, there is a growing concern that they are a new source of potential fragility. While there is a vast literature on flows in equity mutual funds, relatively little research has been done on bond mutual funds. In this paper, we explore flow patterns in corporate-bond mutual funds. We show that their flows behave quite differently than those of equity mutual funds. While we confirm the well-known convex shape for equity funds’ flow-to-performance over the period of our study (1992-2014), we show that during the same time, corporate bond funds exhibit no convexity. Under some performance benchmarks, corporate bond funds even exhibit a concave shape: their outflows are sensitive to bad performance more than their inflows are sensitive to good performance. Moreover, corporate bond funds tend to have more concave flow-performance relationships when they have more illiquid assets and when the overall market illiquidity is high. These results point to the possibility of fragility: The illiquidity of corporate bonds may generate a first mover advantage (or strategic complementarities) among investors in corporate-bond funds, amplifying their response to bad performance or other bad news.

Abstract: We examine the behavior, determinants, and implications of the equilibrium level of the real federal funds rate, defined as the rate consistent with full employment and stable inflation in the medium term We draw three main conclusions First, the uncertainty around the equilibrium rate is large, and its relationship with trend GDP growth much more tenuous than widely believed Our narrative and econometric analysis using cross-country data and going back to the 19th Century supports a wide range of plausible central estimates for the current level of the equilibrium rate, from a little over 0% to the pre-crisis consensus of 2% Second, despite this uncertainty, we are skeptical of the “secular stagnation” view that the equilibrium rate will remain near zero for many years to come The evidence for secular stagnation before the 2008 crisis is weak, and the disappointing post-2008 recovery is better explained by protracted but ultimately temporary headwinds from the housing supply overhang, household and bank deleveraging, and fiscal retrenchment Once these headwinds had abated by early 2014, US growth did in fact accelerate to a pace well above potential Third, the uncertainty around the equilibrium rate implies that a monetary policy rule with more inertia than implied by standard versions of the Taylor rule could be associated with smaller deviations of output and inflation from the Fed’s objectives Our simulations using the Fed staff’s FRB/US model show that explicit recognition of this uncertainty results in a later but steeper normalization path for the funds rate compared with the median “dot” in the FOMC’s Summary of Economic Projections

Abstract: This article surveys recent research on the usefulness of the term spread (i.e., the difference between the yields on long-term and short-term Treasury securities) for predicting changes in economic activity. Most studies use linear regression techniques to forecast changes in output or dichotomous choice models to forecast recessions. Others use time-varying parameter models, such as Markov-switching models and smooth transition models, to account for structural changes or other nonlinearities. Many studies find that the term spread predicts output growth and recessions up to one year in advance, but several also find its usefulness varies across countries and over time. In particular, many studies find that the ability of the term spread to forecast output growth has diminished in recent years, although it remains a reliable predictor of recessions.

Abstract: In the industrialized world the population is aging over time, reducing the fraction of the population in working age. Consequently labor is expected to be scarce, relative to capital, with an ensuing decline in the real return on capital. This paper uses demographic projections together with a large scale multi-country Overlapping Generations Model with uninsurable idiosyncratic uncertainty to quantify the distributional and welfare consequences of these changes in factor prices induced by the demographic transition. In our model capital can freely flow between different regions in the OECD (the U.S., the EU and the rest of the OECD). Thus international capital flows may in principle mitigate the decline in rates of returns one would expect in the U.S. if it were a closed economy. We find exactly the opposite. In the U.S. as an open economy, rates of return are predicted to decline by 86 basis points between 2005 and 2080. If the U.S. were a closed economy, this decline would amount to only 78 basis points. This result is due to the fact that other regions in the OECD will age even more rapidly; therefore the U.S. is "importing" the more severe aging problem from these regions, especially Europe. A similar conclusion is reached if we let capital flow freely between the OECD and the rest of the world (ROW). While ROW currently has a younger population structure, it is predicted to age even more severely in the next decades, giving rise to an even more pronounced decline in world rates of return to capital. In order to evaluate the welfare consequences of the demographic transition we ask the following hypothetical question: suppose a household economically born in 2005 would live through the economic transition with changing factor prices induced by the demographic change (but keeping her own survival probabilities constant at their 2005 values), how would its welfare have changed, relative to a situation without a demographic transition? We find that households experience significant welfare losses due to the demographic transition, in the order of 2-5 % of consumption, depending on their initial productivity level and the design of the pension system. These losses are mainly due to the fact that lower future returns to capital make it harder for households to save for retirement. On the other hand, if the OECD suddenly opens up to ROW in 2005 and ROW has higher returns to capital before the world capital market integration, then these losses are reduced to 1,5 - 2,5 %.