A Financial Stress Index for a Small Open Economy: The Australian Case
joint with Pedro Gomis-Porqueras (Queensland University of Technology), Xiaoyang Li (Deakin University) and Xuan Zhou (Reserve Bank of Australia)
Accepted at International Journal of Central Banking
We construct a Financial Stress Index (FSI) for a small open economy, which aims to provide clear and timely signals of financial market strains. This can be used in developing appropriate responses to address these adverse events. To do so, we use the principal component framework and apply it to Australian monthly data on interest rates, spreads, exchange rates, house price growth and inflation expectations. Decomposing the index into foreign and domestic components, we find that the foreign factors can explain more than half (57.4%) of our Australian Financial Stress Index (AFSI). To determine the information content of our index, we run a series of Granger causality tests on several economic and financial observables. We also estimate whether including the AFSI can improve the prediction of the different economic and financial outcomes relative to a specification that uses only its own previous data. We find that including the AFSI improves the forecasts for future retail sales growth and bank credit growth. Finally, we show that financial stress can have non-linear effects on bank credit growth. In particular, an increase in financial stress affects credit growth more adversely if AFSI is high. This result further highlights the importance of an accurate and timely measure of financial stress in an economy for researchers and policy makers.
On the Negatives of Negative Interest Rates
joint with Aleksander Berentsen (University of Basel and FRB of St. Louis) and Hugo van Buggenum (ETH Zürich)
R&R at European Economic Review
Major central banks remunerate reserves at negative rates (NIR). To study the long-run effects of NIR, we focus on the role of reserves as intertemporal stores of value that are used to settle interbank liabilities. We construct a dynamic general equilibrium model with commercial banks holding reserves and funding investments with retail deposits. In the long run, NIR distorts investment decisions, lowers welfare, depresses output, and reduces bank profitability. The type of distortion depends on the transmission of NIR to retail deposits. The availability of cash explains the asymmetric effects of policy-rate changes in negative vs positive territory.
Stop Believing in Reserves
joint with Sriya Anbil (Federal Reserve Board), Alyssa Anderson (Federal Reserve Board) and Ethan Cohen (University of Minnesota)
R&R at the Journal of Finance
We present a new channel of quantitative tightening (QT): the supply of money held by non-banks. Calibrating a structural model to the current monetary tightening cycle, we show that this new channel of QT implies a larger Federal Reserve balance sheet with more short-term liquidity provision than a balance sheet that considers only bank reserve demand. We argue that ignoring the supply of money held by non-banks could lead to loss of interest rate control by the Federal Reserve.
The Effects of CBDC on the Federal Reserve's Balance Sheet
joint with Christopher Gust (Federal Reserve Board) and Kyungmin Kim (Federal Reserve Board)
We propose a parsimonious framework to understand how the issuance of central bank digital currency (CBDC) might affect the financial system, the Federal Reserve’s balance sheet, and the implementation of monetary policy. We show that there is a wide range of outcomes on the financial system and the Federal Reserve’s balance sheet that could reasonably occur following CBDC issuance. Our analysis highlights that the potential effects on the financial sector depend critically on how the Fed manages its balance sheet. In particular, CBDC could in principle put substantial upward pressure on the spread of the federal funds rate and other wholesale funding rates over the interest rate on reserves unless the Fed expanded its balance sheet to accommodate CBDC issuance.
Negative Interest Rates and Bank Lending Rates (new draft coming soon)
This paper studies the effects of negative interest rates on bank lending rates in a dynamic general equilibrium model. I find that a decrease in the interest rate on excess reserves leads to a decrease in lending rates for unconstrained banks but to increasing lending rates for constrained banks, leading to a larger dispersion of lending rates. There exists furthermore a compositional channel as a change in the policy rate affects the share of constrained and unconstrained banks in the economy. Lastly, the level of competition in the bank lending sector crucially affects average lending rates and their dispersion. In my numerical analysis I find that a decrease in the interest rate on excess reserves leads to increasing average lending rates.