Sunday, November 2, 2014

"The impact of the maturity of US government debt on forward rates and the term premium: New results from old data"

From VoxEU:
The impact of the stock and maturity of government debt on longer-term bond yields matters for monetary policy. This column assesses the magnitude and relative importance of overall bond supply and maturity effects on longer-term US Treasury interest rates using data from 1976 to 2008. Both factors have a significant impact on both forwards and term premia, but maturity of public debt appears to matter more. The results have implications for exit from unconventional policies, and also for the links between monetary and fiscal policy and debt management.
Revisiting the supply effect
The question of the impact of the stock and maturity of net government debt on longer-term US Treasury yields, and the potential implications for central bank balance sheet policies, matters for monetary policy. For Keynes, Tobin, and Milton Friedman, decisions about the maturity of government debt issuance had major implications for the term structure of interest rates (Turner 2011).1 But earlier empirical studies, arguably starting with Modigliani and Sutch (1967), seemed to find limited support for supply effects, with Ben Friedman ([1981] 1992) a notable exception. In any event, the rise of New Classical Macroeconomics and the mainstream New Keynesian model led many economists to ignore portfolio balance effects. Under this new orthodoxy, that inhabited a world of (near-)perfectly elastic demand for government debt, the relative supply of short- and long-dated government bonds had little effect on longer-term interest rates. The yield curve was in turn determined by the current level and expected path of the policy rate. For Ricardian-type reasons, the method of financing a given level of government expenditure would have no impact on the level of consumption, and hence on the path of interest rates. And so the proper focus of monetary policy became solely the assessment of the correct level for the short-term policy rate.

But in trying to assess the prospective and actual impact of large-scale central bank purchases on government bonds, a number of recent studies have attempted to estimate the impact of debt issuance on interest rates. Kuttner (2006) freely admits that his estimates, on quarterly data from 1964–2004, may be ‘too strong’, as he finds that a 2 percentage-point increase in central bank holdings of debt reduces the term premium by around 200 basis points, but they are certainly indicative of the results emerging from several subsequent studies....MORE 
HT: Economist's View