1/21 Central Bank Balance Sheets and Long Term Forward Rates Sharon Kozicki Eric Santor Lena Suchanek March 12, 2010 The views expressed in this presentation are those of the authors. No responsibility for them should be attributed to the Bank of Canada.

2/21 Introduction financial crisis dramatic policy response –Fiscal policy –Liquidity policy –Monetary policy With severe liquidity problems and policy rates at the ELB, major central banks (CB) took unconventional and often unprecedented measures Debate with respect to the effectiveness of CBI on interest rates and economic activity

3/21 Were Fed purchases of Treasuries effective?

Rates have stayed lower since announcements of Fed purchases of MBS and agency debt... 4/21

UK yields fell with Bank of England announcement of purchases... 5/21

With large-scale asset purchases, some central bank balance sheets exploded... 6/21

At the same time, public debt levels are rising... 7/21

With net public debt rising even faster... 8/21

9/21 Introduction Central Bank (CB) initiatives have significant implications for their balance sheets –What is the impact of CB balance sheet expansion on neutral interest rates and long- term interest rates? During this crisis, fiscal stimulus plans have led to large increases in debt –What is the impact of increased government indebtedness on neutral interest rates and long-term interest rates?

10/21 Contribution Objective: Examine the impact of the size of CB balance sheets on long-term interest rates for a sample of developed countries Policy questions: –What is the neutral rate of interest (important for planning exit from accommodative policy? –Will higher interest rates (owing to higher fiscal debt) derail the recovery? –Do unconventional policies provide more flexibility at the ELB, allowing a lower inflation target?

11/21 Summary Objective: Examine the impact of the size of CB balance sheets on long-term interest rates for a sample of developed countries Model: –Long-term forward rates –Encompass the analysis by Laubach (2009) including fiscal deficits/debt and expand to also consider CB balance sheet size Result: An increase in CB assets is associated with a decline in long-term forward rates (c.p.)

12/21 Overview CB initiatives and balance sheets Data & empirical model Estimation results: U.S. & panel Implications for monetary policy and future research

13/21 Central Bank Initiatives and Balance Sheets In normal times: –Operational target of central banks in G7: a short-term interest rate –Evolution of the balance sheet = endogenous outcome of meeting this target More recently: balance sheets exploded due to numerous unprecedented initiatives

14/21 Central Bank Initiatives and Balance Sheets (cont.) Liquidity facilities (e.g. TAF) Credit facilities (e.g. CPFF) Purchase programs (quantitative easing) Facilities to deal with insolvency of systemically important financial institutions (e.g. AIG) Dramatic implications for CB balance sheets

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16/21 Empirical Framework Literature focus: impact of debt/deficit on long term interest rates Model as in Laubach (2009): Augment regressions by CB variables

17/21 Data for U.S. regressions Dependent: 5-year-ahead 10-year forward rate

18/21 Data for U.S. regressions (cont.) Dependent: 5-year-ahead 10-year forward rate Independent Variables –Total CB assets and CB claims

19/21 Data for U.S. regressions (cont.) Dependent: 5-year-ahead 10-year forward rate Independent Variables –Total CB assets and CB claims –5-year-ahead projected debt, deficit –Long-horizon inflation expectations Frequency: , semi-annually

20/21 Baseline Results: CB Assets

21/21 Robustness Dependent: current 10-year Treasury yields and 5-year-ahead 5-year forward rates Independent: current fiscal variables Both CB variables remain statistically significant and are relatively robust to alternative specifications

22/21 Data for panel regressions Countries: Australia, Canada, Switzerland, Japan, UK, and US Dependent: 10-year government bond yields Independent: long-term expected inflation, CB assets and claims, actual deficit/debt Frequency: , quarterly

23/21 Panel regressions

24/21 Caveats Innovations in the balance sheet are simply proxies for the short-term policy rate Effect of changes of the CB sheet are over- stated But: forward rates should be immune to changes in short-term policy rates Negative relationship is driven by trends Alternative specification using detrended variables

25/21 Policy implications Recent expansion of CB balance sheets sizeable effects on long-term forward rates But: estimated historical relationship related to changes in the holdings of treasuries Many recent initiatives are short-term Estimated coefficients should be seen as an upper bound.

26/21 Conclusion Examine the impact of the size of CB balance sheets on long-term interest rates Model: Long-term forward rates An increase in CB assets is associated with a decline in long-term forward rates (c.p.)

27/21 Future Research Include risk measures (e.g. VIX) Case studies (Japan, U.S., U.K.)