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Working PaPer SerieS

no 1122 / december 2009

monetary Policy

ShockS and

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W O R K I N G PA P E R S E R I E S

N O 112 2 / D E C E M B E R 2 0 0 9

This paper can be downloaded without charge from

In 2009 all ECB publications

MONETARY POLICY SHOCKS

AND PORTFOLIO CHOICE

1

by Marcel Fratzscher

2

, Christian Saborowski

3

and Roland Straub

2
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© European Central Bank, 2009 Address

Kaiserstrasse 29

60311 Frankfurt am Main, Germany

Postal address

Postfach 16 03 19

60066 Frankfurt am Main, Germany

Telephone +49 69 1344 0 Website http://www.ecb.europa.eu Fax +49 69 1344 6000 All rights reserved.

Any reproduction, publication and reprint in the form of a different publication, whether printed or

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Abstract 4

Non-technical summary 5

1 Introduction 7

2 Decomposing net capital fl ows 10

3 The empirical model 12

3.1 Model specifi cation 12

3.2 Identifi cation of monetary policy shocks 14

4 Estimation results 17

4.1 The response and composition

of capital fl ows 17 4.2 Variance decomposition 22 4.3 Robustness analysis 24 5 Conclusions 26 References 28 Appendix 32

European Central Bank Working Paper Series 47

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Abstract

The paper shows that monetary policy shocks exert a substantial effect on the size and

composition of capital flows and the trade balance for the United States, with a 100

basis point easing raising net capital inflows and lowering the trade balance by 1% of

GDP, and explaining about 20-25% of their time variation. Monetary policy easing

causes positive returns to both equities and bonds. Yet such a monetary policy easing

shock also induces a shift in portfolio composition out of equities and into bonds,

implying a negative conditional correlation between flows in equities and bonds.

Moreover, such shocks induce a negative conditional correlation between equity flows

and equity returns, but a positive conditional correlation between bond flows and

bond returns. The findings thus provide evidence for the presence of a portfolio

rebalancing motive behind investment decisions in equities, but the dominance of

what is akin to a return chasing motive for bonds, conditional on monetary policy

shocks. The results also shed light on the puzzle of the strongly time-varying

equity-bond return correlations found in the literature.

Keywords: monetary policy, trade balance, capital flows, portfolio choice, asset

prices, United States, vector auto regressions, sign restrictions.

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Non-technical summary

The current …nancial crisis has been preceded for several years by substantial global imbalances in trade and capital ‡ows. In particular, the United States has not only been the origin of the …nancial crisis, but it had been among the economies globally relying most heavily on capital in‡ows to …nance a large and growing trade de…cit. At the same time, a number of observers have ar-gued that accommodative monetary policy over the past decade has been a key culprit behind these imbalances by inducing the build-up of excess liquidity, a rise in …nancial leverage and a boom in asset prices. This, in turn, may have contributed to a surge in private consumption, in part due to wealth e¤ects, and ultimately to a rising US current account de…cit (e.g. Taylor 2009).

The role of monetary policy thus warrants closer scrutiny in order to un-derstand how it may have contributed to the dynamics of capital ‡ows, both in terms of their size and their composition. Moreover, the focus on the e¤ect of monetary policy shocks on the direction and composition of capital ‡ows al-lows us to contribute to the debate on the determinants of portfolio choice, and how asset price movements are related to portfolio decisions of investors across countries as well as across …nancial asset classes.

This paper tests empirically the e¤ect of US monetary policy shocks on the composition of US capital ‡ows and the US trade balance, and its channels. It employs a standard structural VAR speci…cation to identify monetary policy shocks, relying on sign restrictions imposed on the impulse response functions of a few macroeconomic variables. The empirical analysis yields two key …nd-ings. First, US monetary policy shocks exert a statistically and economically meaningful e¤ect on US capital ‡ows. An exogenous easing of US monetary policy by 100 basis points (b.p.) induces net capital in‡ows and a worsening of the US trade balance of around 1% of GDP after 8 quarters. The variance decomposition indicates that US monetary policy shocks over the period 1974 to 2007 explain about 20-25% of the variation in both the US trade balance and capital ‡ows at that horizon. As to the channels, it appears that wealth e¤ects play a central role. Equity returns rise on impact by about 6% in response to a 100 b.p. policy easing, while interest rates fall. Both of these responses in turn induce an increase in private consumption for about 8 quarters, and thus a deterioration in the trade balance.

The second main …nding focuses on the e¤ect of monetary policy shocks on the composition of US capital ‡ows. The intriguing …nding is that an exoge-nous US monetary policy easing causes net in‡ows in debt securities, foreign direct investment (FDI) and other investment, while inducing net out‡ows in portfolio equities from the United States. Monetary policy shocks thus entail a conditional negative correlation between ‡ows in portfolio equity and debt. By contrast, monetary policy shocks induce a positive conditional correlation in equity returns and bond returns, as is well known in the literature. More-over, they cause a negative conditional correlation between equity ‡ows and equity returns, but a positive conditional correlation between bond ‡ows and bond returns. The …ndings are robust to a battery of extensions and sensitivity

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1

Introduction

The current …nancial crisis has been preceded for several years by substantial global imbalances in trade and capital ‡ows. In particular, the United States has not only been the origin of the …nancial crisis, but it had been among the economies globally relying most heavily on capital in‡ows to …nance a large and growing trade de…cit. At the same time, a number of observers have ar-gued that accommodative monetary policy over the past decade has been a key culprit behind these imbalances by inducing the build-up of excess liquidity, a rise in …nancial leverage and a boom in asset prices. This, in turn, may have contributed to a surge in private consumption, in part due to wealth e¤ects, and ultimately a rising US current account de…cit (e.g. Taylor 2009).

At the same time, capital ‡ows to the United States have exhibited peculiar dynamics regarding their composition in recent years, with net in‡ows having become characterised by an ever heavier US dependence on in‡ows into US bonds, as opposed to equities. Figure 1 illustrates this point, underlining that in particular since 2001, in an environment of accommodative monetary policy, net in‡ows into US debt securities have surged to close to 6% of US GDP or about USD 800 billion per year, while net in‡ows into equities, FDI and other investment have been modest and even negative at times.

The role of monetary policy thus warrants closer scrutiny in order to under-stand how it may have contributed to the dynamics of capital ‡ows, both in terms of their size and their composition. This is a …rst objective of the paper. More speci…cally, the paper focuses on the e¤ect of monetary policy shocks in the United States on the US trade balance and di¤erent types of capital ‡ows. Our analysis is in part motivated by the build-up of large trade and …nancial imbalances in recent years, which are now unwinding to some extent.

Moreover, the focus on the e¤ect of monetary policy shocks on the direction and composition of capital ‡ows allows us to contribute to the debate on the determinants of portfolio choice, and how asset price movements are related to portfolio decisions of investors across countries as well as across …nancial asset classes. This is the second objective of the paper. An important strand of this literature analyses portfolio rebalancing versus return chasing as motives for investment decisions, in an environment of incomplete …nancial markets and imperfect substitutability of …nancial assets (e.g. Bohn and Tesar 1996, Hau and Rey 2006 and 2008, Albuquerque 2007, Devereux and Sutherland 2006, Tille and van Wincoop 2007). A related literature focuses on understanding asset price comovements, in particular the peculiar stock-bond return correlation, which are hard to explain with empirical models to date (e.g. Shiller and Beltratti 1992, Baele, Bekaert and Inghelbrecht 2008).

The paper tests empirically the e¤ect of US monetary policy shocks on the composition of US capital ‡ows and the US trade balance, and its channels. It employs a standard structural VAR speci…cation to identify monetary policy shocks, relying on sign restrictions imposed on the impulse response functions of a few macroeconomic variables, following closely Canova and De Nicolo (2002), Uhlig (2005) and Fratzscher and Straub (2008). These identifying restrictions

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The literature on asset price comovements may help us rationalise this pat-tern across …nancial assets. This literature stresses that there tend to be strong time variations in the comovements of returns across di¤erent asset classes, such as between equity returns and bond returns. These strong time variations con-stitute a puzzle, as neither present value models (Shiller and Beltratti 1992), nor consumption-based asset pricing models (Bekaert, Engstrom and Grenadier 2005), nor dynamic factor models with a broad set of economic state variables (Baele, Bekaert and Inghelbrecht 2008) are able to explain them well. Andersen et al. (2007) show that the bond-stock return correlation is positive during pe-riods of expansion but negative and large during economic contractions. They conjecture that this strong time variation and switch in sign in the correlation may be explained by the time-variation in the relative importance of cash ‡ow e¤ects and discount rate e¤ects: during expansions, discount e¤ects dominate thus inducing a positive correlation between stock and bond returns; while cash ‡ow e¤ects are dominant in contractions so that returns on bonds - with …xed nominal cash ‡ows have the opposite sign compared to returns on equities -which have stochastic dividends.

The present paper stresses that this positive correlation between stock re-turns and bond rere-turns are present precisely when discount e¤ects (monetary policy shocks) dominate. Of course, it also implies that this correlation may be di¤erent when other shocks dominate. As such, the present paper focuses on un-derstanding the e¤ect of one speci…c shock for portfolio choice and asset prices, while we leave it for future research to condition the analysis on other types of economic shocks. Moreover, the paper’s …ndings emphasise the importance of jointly analysing quantities and prices, i.e. portfolio ‡ows in conjunction with asset price movements, and also across asset classes for understanding the portfolio choices of investors.

The paper proceeds as follows. In Section 2, we examine the determinants of net capital ‡ows in a simple intertemporal capital-asset pricing model as discussed in Bohn and Tesar (1995). Section 3 presents the empirical model and outlines methodology used to identify monetary policy shocks in detail. Section 4 presents the empirical …ndings for the benchmark speci…cation and discusses the interpretation and the implications of the results. Robustness and sensitivity tests are presented in section 5. Section 6 concludes.

2

Decomposing Net Capital Flows

We begin by examining the determinants of net capital ‡ows in an intertem-poral capital-asset-pricing model as discussed in Bohn and Tesar (1995). We use the model to …x language and notation. Although originally constructed for equity investment, the intutition of the model can be applied to most other forms of investment in a similar fashion. The model yields a natural decompo-sition of net purchases of assets into (i) transactions that are necessary to main-tain a balanced portfolio of securities (portfolio-rebalancing e¤ect) and (ii) net

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The …rst component on the right hand side of equation 4 captures what we denote theportfolio-rebalancing e¤ect, namely net purchases of assetkthat are required to maintain constant portfolio weights. The second term captures the extent to which investors adjust portfolio weights as the portfolio is reoptimized over time. Given a …xed level of risk aversion and a constant variance-covariance matrix of returns, an investor adjusts portfolio weights only if his expectations of excess returns are revised over time. We therefore refer to this as the return-chasing e¤ect.

The two e¤ects imply di¤erent correlation structures between the (expected) return on capital and capital ‡ows. If theportfolio rebalancing e¤ect dominates, an increase in the relative return on assets in country k should lead to a net capital out‡ow as indicated by the negative coe¢ cient on the local capital gain

gkt:On the other hand, if thereturn chasinge¤ect dominates then changes in the

investor’s expectation of excess returns in countrykshould dominate portfolio ‡ows. The latter implies a positive correlation between expected excess returns and net capital ‡ows.

We emphasise that the purpose of this section is purely motivational in order to illustrate the implications of changes in returns for portfolio ‡ows, and vice versa. Our empirical exercise in the next sections will investigate which e¤ect dominates empirically when analysing net portfolio ‡ows of debt and equity following a monetary policy shock in the United States.

3

The Empirical Model

In this section, we present our empirical model and explain the implementation of our pure-sign restrictions approach. In Appendix 1 we de…ne further the variables that we use in the analysis and declare the respective data sources.

3.1

Model Speci…cation

We estimate a structural VAR model of the form

yt=c+ p

X

i=1

Aiyt i+B 1"t (5)

whereBis an(n n)matrix of contemporaneous coe¢ cients,Aiis an(n

n) matrix of autoregressive coe¢ cients, "t is an (n 1) vector of structural

disturbances and yt an (n 1) vector of endogenous variables, and p is the

number of lags in the VAR. The model we use is of dimensionn= 8, whereyt

is de…ned as

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listed in the Appendix.

3.2

Identi…cation of Monetary Policy Shocks

We are interested in the e¤ect of a monetary policy shock on the di¤erent types of net capital ‡ows between the United States and the rest of the world. We identify monetary policy shocks using the pure-sign restrictions approach pioneered by Faust (1998), Canova and de Nicoló (2002) and Uhlig (2005). The technique allows us to identify structural error terms from a reduced form version of the VAR model presented in equation (5) by using a minimum of intuitively appealing sign restrictions on the impulse response functions of some of the endogenous variables included in the vector yt. The identi…cation restrictions

we use are well grounded in economic theory and are by now widely used in the academic literature to identify monetary policy shocks.

We present the restrictions we use to identify an expansionary monetary policy shock in Table 1. An upward arrow indicates that the respective variable is required to increase for four quarters following the shock. In particular, we assume that an expansionary monetary policy shock reduces short term interest rates and has a positive e¤ect on consumption, in‡ation and the ratio of non-borrowed to total reserves. In terms of the relative variables in our model, this implies that a monetary policy shock reduces it it and increasesct ct,

cpit cpit and nbt. In Table 1, the upward arrow on ct ct is shown in

parentheses as we will leave out this restriction at a later point in the analysis as a robustness check. Table 1 also presents the restrictions of two additional types of shocks: an aggregate demand shock and an aggregate supply shock. The reason is that it has been shown that increasing the number of identi…ed shocks can help to uncover the correct sign of the impulse response functions (Paustian 2007). We therefore identify these two additional structural shocks as a robustness check but do not report results on the impulse responses to these shocks in what follows. Moreover, the table illustrates that the identifying restriction for monetary policy shocks make this type of shock distinct from supply and demand shocks.

Table 1: Sign restrictions

it it cpit cpit nbt ct ct

monetary policy # " " (")

aggregate demand " " "

aggregate supply # #

We now move to the implementation of the pure-sign restrictions approach. Thereby, we follow Canova and De Nicoló (2002), Uhlig (2005) and Peersman and Straub (2008) in recovering the structural error terms from the estimated reduced form model via the use of sign restrictions on the impulse response functions of some of the endogenous variables. Let us …rst de…ne vt =B 1"t

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min (j) n X p=1 n X q=1 h X k=1 Rpqk (j) med(Rpqk ) std(Rpqk ) 2 (10)

where h is the horizon considered in the impulse response function and

std(Rpqk ) is the standard deviation of Rpqk across all accepted draws. While employing the standard approach of reporting the median response in our bench-mark case, we use the approach of Fry and Pagan (2007) as a robustness check for our results. Similarly, we compute the variance decomposition as the median of the variance decompositions produced by all accepted draws, but report the variance decomposition resulting from (j) as a robustness check.

4

Estimation Results

We now turn to the empirical …ndings. We estimate the Bayesian VAR described in Section 2. Throughout the analysis, we identify monetary shocks using the sign restrictions presented in Table 1. It is important to emphasize that we do not place any restrictions on the capital ‡ow variables (capt) in the de…nition

of the vector of endogenous variablesyt. We therefore allow the data to speak

for itself in terms of the responses of our variables of interest. In addition, the real exchange rate (reert), the trade balance (tbt) and the relative equity

returns (eqt eqt) are left unrestricted in each of the speci…cations we employ.

This is important because we draw inference upon the correlations between the impulse responses of these and the capital ‡ow variables. We …rst present impulse response functions of the endogenous variables in the model and later their variance decomposition.

4.1

The Response and Composition of Capital Flows

In this subsection, we present the results from estimating the Bayesian VAR presented in equation (5). The vector of endogenous variables is de…ned as in (6). The model thus includes seven control variables plus one of the capital ‡ow variables at a time. We estimate the model for each of the four di¤erent types of capital ‡ows as well as the …nancial account as an aggregate. In our benchmark speci…cation, the capital ‡ows are nominal ‡ows denominated in billions of US dollars. Moreover, the capital ‡ow variables are de…ned such that a positive value signals a net capital in‡ow into the United States. The fact that these variables can thus take both positive and negative values is the reason why we use the variables in levels instead of log terms. It is clear that the use of nominal ‡ow variables is subject to the critique that eventual impulse responses to the monetary shock can be distorted by the response of relative price levels and/or the exchange rate to the same shock. We will address this caveat in the robustness section.

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interpretation of the response of debt instruments to a deviation from interest rate parity. In particular, it appears that investment in debt increases quite persistently in the US relative to the rest of the world when US interest rates fall, thus inducing a deviation from interest rate parity. Hence, contrary to portfolio equities, the monetary policy shock induces a positive conditional correlation for bonds between returns and ‡ows as returns rise when interest rates fall -suggesting that return chasing motives play a dominant role for debt ‡ows. A stronger argument in this respect could be made if bilateral nominal exchange rates were included in the model such that deviations from interest rate parity could be observed and a similar analysis as in the case of equity investment could be conducted. However, due to the rest of the world de…nition behind the construction on the real exchange rate, this is not possible such that the evidence must remain suggestive.

The last plot in Figure 3 shows the response of other investment to the monetary easing, showing that other investment ‡ows into the United States increase strongly and signi…cantly during the …rst part of the response horizon and become insigni…cant thereafter. In order to understand the reasons behind this …nding, it is perhaps useful to remember that major categories of these ‡ows are trade credits, loans and currency ‡ows. These types of capital are typically used to directly …nance import expenditure. Hence, one might categorize these ‡ows as borrower rather than investor driven. It is then reasonable to expect that in‡ows of this type of capital should occur prior to the import expenditure actually being made. And this is precisely what we observe.

In summary, the evidence of this section has shown that monetary policy eas-ing shocks causenet in‡ows in debt securities, foreign direct investment (FDI) and other investment, while inducingnet out‡ows in portfolio equities from the United States. Monetary policy shocks thus entail a conditional negative cor-relation between ‡ows in portfolio equity and debt. A key for understanding this conditional correlation is the e¤ect of monetary policy shocks on asset price returns, which induces a positive correlation between equity returns and bond returns. Overall, our evidence suggests that, conditional on monetary policy shocks, a portfolio rebalancing motive dominates for investment decisions in eq-uity securities but a return chasing motive is the main driver for investments in bonds.

4.2

Variance Decomposition

As a complement to the analysis in the previous subsection, we decomposed the variance of the endogenous variables in our model in order to determine the variance share explained by the monetary shock. Notice that the …ndings presented here are based on the benchmark speci…cation but are not sensitive to identifying additional (aggregate supply and demand) shocks.11 Table 2

contains the median results for the capital ‡ow variables of interest and the trade balance. A …rst glance at the numbers suggests that monetary policy

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criterion. The numbers show that the qualitative arguments we made above are not sensitive to a di¤erent summary measure of the distribution of impulse response functions. At the same time, however, it is interesting to note that the precise numbers for each individual variable di¤er quite strongly in some cases. This suggests that caution is in order when interpreting variance decompositions solely based on one summary measure of the distribution of impulse response functions.

4.3

Robustness Analysis

We conduct a battery of robustness checks to ensure that the main …ndings in the previous sections are not sensitive to the speci…cation of the empirical model. In this subsection, we present the results obtained from these tests.

In the previous section, we employed a restriction in the identi…cation scheme of a monetary policy shock, which di¤ers from the analysis of Uhlig(2005). In particular, we assume that an expansionary monetary shock must have a pos-itive e¤ect on consumption. The reasoning behind this assumption is rather obvious and it is well-established in the literature. We believe that it helps to identify monetary shocks with greater precision. However, one might argue that the restriction implies an unnecessary reduction of the degrees of freedom in the empirical model. As a …rst robustness check, we therefore identify the monetary policy shock solely on the basis of the remaining three restrictions, i.e. the restrictions on the response of the interest rate di¤erential, the in‡ation di¤erential and the reserve ratio. The resulting responses of the endogenous variables in the model can be found in Figure 6 for the case in which the …nan-cial account is added to the basic speci…cation. The impulse response functions presented show that the consumption di¤erential still reacts positively to the expansionary shock in the impact period. Following a brief initial apprecia-tion, the real exchange rate depreciates strongly in response to the monetary shock and shows evidence of delayed overshooting. The impulse responses of the remaining control variables and the …nancial account do not change in any important way compared to the benchmark case. Figure 7 shows that the same is true for the responses of the other capital ‡ow variables.

It has frequently been argued that the number of shocks identi…ed in a VAR is positively related to the probability of identifying each individual shock cor-rectly (Paustian, 2007). As a second robustness check, we therefore identify two additional structural shocks simultaneously with the monetary shock. We have chosen simple aggregate supply and demand shocks because the underlying identifying restriction are rather uncontroversial. In particular, Table 1 shows that we require the aggregate supply shock to reduce in‡ation and to have a pos-itive e¤ect on consumption whereas an aggregate demand shock must increase the interest rates, in‡ation and consumption. Formally, we extend the method outlined in Section 2 by requiring that a candidate draw of the decomposition of the variance covariance matrix must, in order to be accepted, uncover one shock that obeys the restrictions of the monetary shock, one that obeys the

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(27)

the same time. In spite of the fact that we are now working with a VAR of dimension eleven, the resulting impuls

References

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