Liquidity Effects in the Bond Market

Abstract

Introduction and summary Is money neutral? Most economists would now say that it is not, at least not in the short run. This belief derives partly from the results of studies done decades ago. In their book on monetary history, Friedman and Schwartz (1963) argued that the Federal Reserve may have caused or prolonged the Great Depression by a policy of tight money. And in another study, Phillips (1958) found a negative relation between wage inflation and unemployment. In the two decades that followed, other studies confirmed the view that money growth raises output in the short run. Since the 1970s, however, the Phillips-curve relation seems to have broken down, and money seems to have no clear effect on real interest rates either. Only if we assume that some part of money responds to real variables can we conclude that the exogenous part of money does move interest rates. Evans and Marshall (1998), for example, describe several scenarios--identifying assumptions--under which some part of the money supply can plausibly be said to move real interest rates. In other words, what we infer about a liquidity effect on interest rates depends on what we believe the Fed reacts to when it sets the money supply. But, if we wish to estimate the liquidity effect on interest rates, or even if we wish to study the interest rate channel of monetary policy, is money the right measure of policy? The rate of interest is the return on bonds, which depends most directly not on the supply of money but on the supply of bonds. Using bonds, one can find a liquidity effect without introducing a host of other variables. Whether we measure money by nonborrowed reserves or more broadly, injections of money are not the same as withdrawals of, say, Treasury bills (T-bills). This is because the Fed sometimes injects money by buying long-term bonds, and this will affect short-term rates less than would a purchase of T-bills. Indeed, table 1 shows that, since 1961, the correlation between the real per capita supply of outstanding Treasury securities (T-secs) and nonborrowed reserves (NBR), which one might expect to be negative, has been slightly positive at .048. (1) The table also shows that, at least since 1980, growth in nonborrowed reserves has reduced short-term rates, but not as strongly as a contraction of T-secs. Over the whole period, however, growth in both nonborrowed reserves and T-secs is positively correlated with short-term rates--which, for nonborrowed reserves, is the wrong sign. These conclusions do not change if we look instead at surprises, as implied in models like Lucas (1990) and Christiano and Eichenbaum (1995). Table 2 presents the correlations of interest rates with surprises in the growth of NBR and T-secs. (2) For the 1980-99 period, surprises to nonborrowed reserves come in with the wrong sign, whereas T-sec surprises have the positive correlation that a liquidity effect implies. Both correlations have the wrong sign for the 1961-99 period, but the correlation between surprises to growth in the bond supply and real rates is tiny. Tables 1 and 2 suggest that, at least in recent decades, bonds have been the better measure of policy. The remainder of our analysis uses this measure more systematically to estimate the degree of risk that unpredictability in their supply imposes on the investor. A nominal bond carries two kinds of risk. First, its real return erodes with inflation, which may be uncertain. Second, unexpected changes in the supply of bonds may cause the value of a bond to change. If a large bond issue causes bond prices to fall, then the return on existing bonds is reduced and the cost of purchase is lowered for investors who are about to buy bonds. The bond issue therefore transfers wealth from existing bondholders to future bondholders. If such issues are not foreseen, they give rise to what we call bond-supply risk. Supply risk can lead to an uncertain price, or (when prices do not clear markets) an uncertain availability. …