Liquidity Effects and the New Economy
Working Paper No. 01-W17
Boyan Jovanovic and Peter L. Rousseau
ABSTRACT [article]
U.S. Treasury securities are nominal assets that are subject to two sources
of risk: inflation risk, and bond-supply risk. Inflation risk is well-known,
but supply risk has received little attention. For reasons we shall discuss
in the body of the paper, the amount of securities offered to the public or
withdrawn from circulation is not fully predictable. Because participation
in these markets requires some liquidity, when the supply of T-bills
fluctuates, participants in the market must either accept the changes in the
rates of interest, or else end up with lower rate of return assets as
substitutes.
Our study begins with a look at monthly data over the past eighty years of
Fed history. We find that supply risk has added about a 13 basis-point risk
to the real rate of return on three-month T-bills over the postwar period,
which is down from an average of about 36 basis-points over the 1920-46
period. The effect\ of inflation risk on the T-bill rate, on the other hand,
has declined from nearly five and a half percentage points before the war to
only one percent over the past 20 years as Fed policy has rendered the price
level more and more predictable.
Next, we study how the stock market responds to shocks in the supply of
Treasury securities. An increase in the supply of T-bills should lower their
price and raise their rate of return. One may conjecture, then, that an
increase in the supply of T-bills should also lower the price of stocks (a
substitute asset) and raise \textit{their} rate of return. In one dimension,
this conjecture turns out to be correct: Over the 1920-99 period, stock
returns and T-bill rates are both positively related to surprises in the
growth of T-bills, although the correlation with stock returns is very
small. The conjecture is not entirely correct, though, because stock returns
are negatively correlated with the T-bill rate. This suggests that the bond
market and the stock market are segmented.
Finally, we briefly examine the long-term trends in U.S. Treasury financing.
The share of bonds in the aggregate security portfolio rises sharply until
about the end of the Second World War, and then it declines fairly steadily.
These trends do not seem to be related to the overall levels of interest
rates and asset yields in the various periods. At monthly frequencies,
however, supply risk in the bond market continues to matter in spite of
these shifts in the relative importance of bonds.
To sum up: We find that liquidity effects of bond injections are
substantial, and that they have been with us for as long as we have the data
to measure them. When measured in this way, the liquidity effect seems
larger than what one can infer when one measures liquidity by the supply of
money -- whether money defined as nonborrowed reserves or more broadly. The
Fed seems to be trying to keep the risk associated with these injections to
a minimum, but is not able to push it to zero because the gradual paydown of
the Federal debt has necessitated a less accommodative stance with regard to
unexpectedly large rollover demands for Treasury securities among foreign
financial institutions and international monetary authorities. Further, so
long as the Fed uses the secondary market for Treasury securities as its
primary means of conducting open market operations, shocks to the supply of
these securities that are available to the public will persist. This
suggests that as the supply of outstanding Treasury securities falls, a
policy that seeks to minimize surprises to this supply by increasing the use
of other debt instruments for open market operations will help Treasury
securities to maintain their desirable feature of true "risklessness."