nep-cba New Economics Papers
on Central Banking
Issue of 2024‒04‒08
twenty-two papers chosen by
Sergey E. Pekarski, Higher School of Economics

  1. Monetary Policy Transmission Through Shadow and Traditional Banks By Yuteng Cheng; Ryuichiro Izumi
  2. Monetary Policy Transmission in Emerging Markets: Proverbial Concerns, Novel Evidence By Ariadne Checo; Francesco Grigoli; Damiano Sandri
  3. An Exchange Rate Policy Rule By Parrado, Eric
  4. Navigating by Falling Stars:Monetary Policy with Fiscally Driven Natural Rates By Rodolfo G. Campos; Jesus Fernandez-Villaverde; Galo Nuno; Peter Paz
  5. Monetary policy under natural disaster shocks By Alessandro Cantelmo; Nikos Fatouros; Giovanni Melina; Chris Papageorgiou
  6. The role of macroprudential policy in the stabilisation of macro-financial fluctuations. Conference on Financial Stability/Banco de Portugal, Lisbon (Portugal), 2 October 2023 By Pablo Hernández de Cos
  7. Taylor rules and the inflation surge: The case of the Fed By Tatar, Balint; Wieland, Volker
  8. Trade Openness and Exchange Rate Management By Parrado, Eric; Heresi, Rodrigo
  9. Risky Firms and Fragile Banks: Implications for Macroprudential Policy By Tommaso Gasparini; Vivien Lewis; Stéphane Moyen; Stefania Villa
  10. Did the Bank of England's quantitative easing programme become fiscally wasteful? By Michael Bleaney
  11. When Should Central Banks Fear Inflation Expectations? By Lucio Gobbi; Ronny Mazzocchi; Roberto Tamborini
  12. Better than Perceived? Correcting Misperceptions about Central Bank Inflation Forecasts By Muhammed Bulutay
  13. Joining up prudential and resolution regulation for systemically important banks By Ebner, André; Westhoff, Christiane
  14. A Stress Test Approach to the Calibration of Borrower-Based Measures: A Case Study of the Czech Republic By Jiri Gregor
  15. The Consequences of Falling Behind the Curve: Inflation Shocks and Policy Delays Under Rational and Behavioral Expectations By Ms. Mai Hakamada; Carl E. Walsh
  16. Buying into new ideas: The ECB’s evolving justification of unlimited liquidity By Lea Steininger; Casimir Hesse
  17. Monetary Policy Reaction to Geopolitical Risks: Some Nonlinear Evidence By William Ginn; Jamel Saadaoui
  18. Households' probabilistic inflation expectations in high-inflation regimes By Becker, Christoph; Dürsch, Peter; Eife, Thomas A.; Glas, Alexander
  19. ECB macroeconometric models for forecasting and policy analysis By Ciccarelli, Matteo; Darracq Pariès, Matthieu; Priftis, Romanos; Angelini, Elena; Bańbura, Marta; Bokan, Nikola; Fagan, Gabriel; Gumiel, José Emilio; Kornprobst, Antoine; Lalik, Magdalena; Montes-Galdón, Carlos; Müller, Georg; Paredes, Joan; Santoro, Sergio; Warne, Anders; Zimic, Srečko; Rigato, Rodolfo Dinis; Kase, Hanno; Koutsoulis, Iason; Brunotte, Stella; Cocchi, Sara; Giammaria, Alessandro; Invernizzi, Marco; Von-Pine, Eliott
  20. A primer on optimal policy projections By Dengler, Thomas; Gerke, Rafael; Giesen, Sebastian; Kienzler, Daniel; Röttger, Joost; Scheer, Alexander; Wacks, Johannes
  21. Jane Haldimand Marcet: Impact of Monetary Policy Shocks in the Peruvian Economy Over Time By Flavio Pérez Rojo; Gabriel Rodríguez
  22. The Fed Takes on Corporate Credit Risk: An Analysis of the Efficacy of the SMCCF By Simon Gilchrist; Bin Wei; Vivian Z. Yue; Egon Zakrajšek

  1. By: Yuteng Cheng; Ryuichiro Izumi
    Abstract: We examine the optimal amount of user anonymity in a central bank digital currency (CBDC) in the context of bank lending. Anonymity, defined as the lender’s inability to discern an entrepreneur’s actions that enable fund diversion, influences the choice of payment instrument due to its impact on a bank’s lending decisions. We show that moderate anonymity in CBDC leads to an inefficient pooling equilibrium. To avoid this, CBDC anonymity should be either low, reducing attractiveness, or high, discouraging bank lending. Specifically, the anonymity should be high when CBDC significantly benefits sales, and low otherwise. However, competition between deposits and CBDC may hinder the implementation of low anonymity.
    Keywords: Digital currencies and fintech
    JEL: E42 E58 G28
    Date: 2024–03
  2. By: Ariadne Checo; Francesco Grigoli; Damiano Sandri
    Abstract: Doubts persist about the effectiveness of monetary transmission in emerging markets, but the empirical evidence is scarce due to challenges in identifying monetary policy shocks. In this paper, we construct new monetary policy shocks using novel analysts' forecasts of policy rate decisions. Crucial for identification, analysts can update forecasts up to the policy meeting, allowing them to incorporate any relevant data release. Using these shocks, we show that monetary transmission in emerging markets operates similarly to advanced economies. Monetary tightening leads to a persistent increase in bond yields, a contraction in real activity, and a delayed reduction in inflation. Furthermore, monetary policy impacts leveraged firms more strongly.
    Keywords: monetary policy shocks, financial markets, emerging markets
    JEL: E50 E52
    Date: 2024–03
  3. By: Parrado, Eric
    Abstract: This paper introduces a novel monetary policy framework where the exchange rate becomes the central instrument. Using Singapore as a case study, it explores the Monetary Authority's adoption of the exchange rate as the primary tool since 1981, diverging from conventional approaches centered on interest rates or monetary aggregates. The estimated exchange rate reaction function aligns well with actual deviations, supporting the hypothesis that Singapore's forward-looking policy rule effectively responds to inflation and output volatility, especially during economic crises. This framework offers a promising alternative for countries with open economies and challenges in implementing traditional interest rate instruments.
    Keywords: exchange rate;Inflation;monetary policy rules;Singapore
    JEL: E31 E52 E58 F41
    Date: 2023–12
  4. By: Rodolfo G. Campos (Banco de Espana); Jesus Fernandez-Villaverde (University of Pennsylvania, NBER, CEPR); Galo Nuno (BIS, Banco de Espana, CEMFI, CEPR); Peter Paz (Banco de Espana)
    Abstract: We study a new type of monetary-fiscal interaction in a heterogeneous-agent New Keynesian model with a fiscal block. Due to household heterogeneity, the stock of public debt affects the natural interest rate, forcing the central bank to adapt its monetary policy rule to the fiscal stance to guarantee that inflation remains at its target. There is, however, a minimum level of debt below which the steady-state inflation deviates from its target due to the zero lower bound on nominal rates. We analyze the response to a debt-financed fiscal expansion and quantify the impact of different timings in the adaptation of the monetary policy rule, as well as the performance of alternative monetary policy rules that do not require an assessment of the natural rates. We validate our findings with a series of empirical estimates.
    Keywords: HANK models, natural rates, fiscal shocks
    JEL: E32 E58 E63
    Date: 2024–08–03
  5. By: Alessandro Cantelmo (Bank of Italy); Nikos Fatouros (University of Birmingham); Giovanni Melina (International Monetary Fund); Chris Papageorgiou (International Monetary Fund)
    Abstract: With climate change increasing the frequency and intensity of natural disasters, how should central banks respond to these catastrophic events? Looking at IMF reports for 34 disaster-years, which occurred in 16 disaster-prone countries from 1999 to 2017, what emerges is a non-negligible heterogeneity in central banks' responses to climate-related disasters. Using a standard small-open-economy New-Keynesian model with disaster shocks, we show that, consistently with textbook theory, inflation targeting remains the welfare-optimal regime. The best strategy for monetary authorities is to resist the impulse to accommodate in the face of catastrophic natural disasters, and rather to continue to focus on price stability.
    Keywords: natural disasters, climate change, DSGE, monetary policy, exchange rate regimes
    JEL: E5 E52 E58 F41 Q54
    Date: 2024–03
  6. By: Pablo Hernández de Cos (Banco de España)
    Abstract: Macroprudential policy emerged after the global financial crisis to increase the resilience of the financial system against systemic risk and to prevent the excessive accumulation of such risk. This paper focuses on the effects of this policy on macroeconomic stability, a goal that it can complement monetary and fiscal policies in helping to achieve. Specifically, the potential role for this purpose of capital buffers and, in particular, the countercyclical capital buffer (CCyB), is examined.
    Keywords: systemic risk, macroprudential policy, countercyclical capital buffer (CCyB), macro-financial stabilisation
    JEL: G21 G28 E50
    Date: 2024–02
  7. By: Tatar, Balint; Wieland, Volker
    Abstract: The Federal Reserve has been publishing federal funds rate prescriptions from Taylor rules in its Monetary Policy Report since 2017. The signals from the rules aligned with Fed action on many occasions, but in some cases the Fed opted for a different route. This paper reviews the implications of the rules during the coronavirus pandemic and the subsequent inflation surge and derives projections for the future. In 2020, the Fed took the negative prescribed rates, which were far below the effective lower bound on the nominal interest rate, as support for extensive and long-lasting quantitative easing. Yet, the calculations overstate the extent of the constraint, because they neglect the supply side effects of the pandemic. The paper proposes a simple model-based adjustment to the resource gap used by the rules for 2020. In 2021, the rules clearly signaled the need for tightening because of the rise of inflation, yet the Fed waited until spring 2022 to raise the federal funds rate. With the decline of inflation over the course of 2023, the rules' prescriptions have also come down. They fall below the actual federal funds rate target range in 2024. Several caveats concerning the projections of the interest rate prescriptions are discussed.
    Keywords: Monetary policy, interest rates, Federal Reserve, Taylor rule, New Keynesian macroepidemic models
    JEL: E42 E43 E52
    Date: 2024
  8. By: Parrado, Eric; Heresi, Rodrigo
    Abstract: Singapore's unique monetary policy consists of a managed exchange rate framework that can be characterized as a Taylor-like reaction function with the nominal devaluation rate instead of the nominal interest rate as the main policy instrument. We build a small open economy New Keynesian model to estimate and characterize such a monetary rule from a welfare perspective. Welfare gains under an exchange rate rule (ERR) relative to the more standard interest rate-based Taylor rule (IRR) are unambiguously increasing in the degree of trade openness (defined as exports plus imports as a share of GDP). For Singapore, where trade openness is 280% of GDP, we estimate welfare gains of 1.48% of permanent consumption under an ERR. In a counterfactual thought experiment, we find that Chile, an established inflation-targeting economy using an IRR, would be better off under an ERR for any degree of openness above 100% (currently at 70%).
    Keywords: Monetary policy;Exchange rate management;Open economy macroeconomics
    JEL: E52 E58 F41
    Date: 2023–12
  9. By: Tommaso Gasparini; Vivien Lewis; Stéphane Moyen; Stefania Villa
    Abstract: Increases in firm default risk raise the default probability of banks while decreasing output and inflation in US data. To rationalize the empirical evidence, we analyse firm risk shocks in a New Keynesian model where entrepreneurs and banks engage in a loan contract and both are subject to default risk. In the model, a wave of corporate defaults leads to losses on banks' balance sheets; banks respond by selling assets and reducing credit provision. A highly leveraged banking sector exacerbates the contractionary effects of firm defaults. We show that high minimum capital requirements jointly implemented with a countercyclical capital buffer are effective in dampening the adverse consequences of firm risk shocks.
    Keywords: Bank Default, Capital Buffer, Firm Risk, Macroprudential Policy
    JEL: E44 E52 E58 E61 G28
    Date: 2024
  10. By: Michael Bleaney
    Abstract: Nearly half of the government bonds purchased under the Bank of England’s Quantitative Easing (QE) programme were bought in 2020-21, when long-term real yields on indexed debt were well below zero and therefore almost bound to entail a sizeable loss to taxpayers. In addition to this expansion of QE, some maturing issues from earlier rounds were rolled over at this time. In so far as QE had the intended effect of raising the prices of the assets bought, the marginal loss per £ increased with the size of the QE programme. There is no evidence that this marginal effect, or the risk that a sizeable QE programme might have a substantial fiscal cost, was taken into account by the Bank’s Monetary Policy Committee or by the Government in its instructions to the Committee.
    Keywords: interest rate, monetary policy, quantitative easing
    Date: 2024
  11. By: Lucio Gobbi; Ronny Mazzocchi; Roberto Tamborini
    Abstract: When inflation picks up, central banks are most concerned that the de-anchoring of inflation expectations and the ignition of wage-price spirals will trigger inflation dynamic instability. However, such scenarios do not materialize in the standard New Keynesian theoretical framework for monetary policy. Using a simulative model, we show that they can materialize upon introducing in particularly strong doses boundedly-rational expectations that de-anchor endogenously, as they are updated according to the actual inflation process, with indexed wages, and persistent inflation shocks. In these cases, a more hawkish central-bank stance on inflation expands the stability region of the system, which however remains bounded. On the other hand, the critical combinations of factors that trigger instability can be regarded as extreme in empirical terms, while in "normal times" the system is resilient to shocks and expectation de-anchoring even with more dovish monetary policy.
    Keywords: cost-push inflation, New Keynesian models for monetary policy, wage-price spiral, de-anchoring of inflation expectations
    JEL: E17 E30 E50
    Date: 2024
  12. By: Muhammed Bulutay
    Abstract: How do households perceive the forecasting performance of the central bank? Using two novel experiments embedded in the Bundesbank's Survey on Consumer Expectations (total N=9500), this article shows that the majority of German households underestimate the ECB's inflation forecasting accuracy. In particular, they believe that the ECB is overly optimistic. Communication that challenges these perceptions improves the anchoring of inflation expectations, reduces inflation uncertainty and discourages consumption of durable goods. Treated households also report higher trust in the ECB, perceive the ECB's inflation target as more credible, the ECB's communication as more honest, and the ECB's policy as more beneficial to them. Finally, the causal effect of central bank trust on inflation expectations is quantified using instruments to deal with endogeneity.
    Keywords: Inflation Expectations, Central Bank Trust, Inflation Forecasts, Central Bank Communication, Information Provision Experiments
    JEL: C83 D91 E71
    Date: 2024–03–13
  13. By: Ebner, André; Westhoff, Christiane
    Abstract: We set out a stylised framework for the policies enacted to address the risks posed by systemically important institutions (SIIs) and to counter the too-big-to-fail (TBTF) problem, examining conceptually how far supervisory and resolution policies are complementary or substitutable. The Financial Stability Board (FSB) TBTF reforms comprise (i) a higher loss-absorbing capacity in the form of regulatory capital buffers for SIIs, (ii) more intensive and effective supervision and (iii) a recovery and resolution regime, including sufficient loss-absorbing and recapitalisation capacity in the form of capital and eligible liabilities, to deal with distressed or failing institutions. These reform strands are part of a fundamentally integrated concept, but were largely developed and implemented independently of each other. Therefore, they may fall short of fully taking interdependencies into account, rendering policies less effective and consistent than an integrated approach, which we outline as an alternative. The analysis discusses the regulatory interplay, its implications for policymaking based on the FSB TBTF reforms for banks and its operationalisation in the Basel framework at the global level and in the European Union. JEL Classification: G01, G28, G38
    Keywords: financial regulation, financial stability, going concern, gone concern, macroprudential policy, resolution framework, systemically important institutions, systemic risk, too big to fail
    Date: 2024–03
  14. By: Jiri Gregor
    Abstract: This paper focuses on the calibration of borrower-based measures using a semi-structural modelling framework and defines two approaches to the setting of these measures. The first approach takes into account the magnitude of losses in the mortgage portfolio and the associated absorption potential of banks, while the second, preferred approach, considers both the benefits of regulation in terms of loss reduction and its costs manifested as foregone profits. This approach thus facilitates the optimization of the macroprudential strategy to minimize Type I error (no regulation) and Type II error (excessive regulation). The case of the Czech Republic serves as an illustrative example, demonstrating that borrower-based regulation appears unnecessary and costly during periods of low credit growth, specifically in the downward phase of the credit cycle. However, if any regulation is preferred with respect to other factors and circumstances that are not captured by the modelling framework, a purely loan-to-value regulation shows the best results in terms of cost-benefit analysis.
    Keywords: Borrower-based measures, macroprudential policy, mortgage lending, stress testing, systematic risk
    JEL: C63 E58 G21 G28 R31
    Date: 2024–03
  15. By: Ms. Mai Hakamada; Carl E. Walsh
    Abstract: Central banks in major industrialized economies were slow to react to the surge in inflation that began in early 2021. The proximate causes of this surge were the supply chain disruptions associated with the easing of COVID restrictions, fiscal policies designed to cushion the economic impact of COVID, and the impact on commodity prices and supply chains of the war in Ukraine. We investigate the consequences of policy delay in responding to inflation shocks. First, using a simple three-period model, we show how policy delay worsens inflation outcomes, but can mitigate or even reverse the output decline that occurs when policy responds without delay. Then, using a calibrated new Keynesian framework and two measures of loss that incorporate a “balanced approach” to weigh inflation and the output gap, we find that loss is monotonically increasing in the length of the delay. Loss is reduced if policy, when it does react, is more aggressive. To investigate whether these results are sensitive to the assumption of rational expectations, we consider cognitive discounting as an alternative assumption about expectations. With cognitive discounting, forward guidance is less powerful and results in a reduction in the costs of delay. Under either assumption about expectations, the costs of a short delay can be eliminated by adopting a less inertial policy rule and a more aggressive response to inflation.
    Keywords: monetary policy; inflation policy delay; behavioral expectations; falling behind the curve
    Date: 2024–03–01
  16. By: Lea Steininger (Department of Economics, Vienna University of Economics and Business; Vienna Institute for International Economic Studies); Casimir Hesse (Rothschild & Co.)
    Abstract: In 2012, Draghi put an end to rising euro area sovereign bond yield spreads by resolving to do 'whatever it takes'. The crisis rhetoric and institutional practices of unlimited liquidity have since become commonplace, as countermeasures to recent market turmoil show. This paper sets out to explain how and why 'unlimited liquidity' ideas moved to the ECB's center of economic analysis during the euro crisis. Previous work fails to decipher that the ideational shift was highly anomalous when viewed against German ordoliberalism or scholarly support for 'expansionary austerity'. Addressing this relative neglect in other accounts, we draw on qualitative text analysis and expert interviews to argue that this shift was due to norm entrepreneurs who capitalized on the uncertainty of the crisis. We employ constructivist arguments to identify four scoping conditions that account for the ascendance of 'unlimited liquidity': an indicative reference, credibility, institutional positioning, and -- as an extension to the literature -- intellectual sensitivity. Our analysis suggests that the euro crisis changed economic ideas, and fundamentally remodels the constructivist framework for studying monetary policy in crisis times.
    Keywords: European Central Bank, euro crisis, monetary policy, unlimited liquidity, economic ideas, constructivism
    JEL: E52 E58 F50
    Date: 2024–03
  17. By: William Ginn; Jamel Saadaoui
    Abstract: How do geopolitical risk shocks impact monetary policy? Based on a panel of 20 economies, we develop and estimate an augmented panel Taylor rule via linear and nonlinear local projections (LP) regression models. First, the linear model suggests that the interest rate remains relatively unchanged in the event of an uncertainty shock. Second, the result turns out to be different in the nonlinear model, where the policy reaction is muted during an expansionary state, which is operating in a manner proportional to the transitory shock. However, geopolitical risks can amplify the policy reaction during a non-expansionary period.
    Keywords: monetary policy, linear and nonlinear local projections, geopolitical risk, economic policy uncertainty
    JEL: E
    Date: 2024
  18. By: Becker, Christoph; Dürsch, Peter; Eife, Thomas A.; Glas, Alexander
    Abstract: Central bank surveys frequently elicit households' probabilistic beliefs about future inflation. However, most household surveys use a response scale that is tailored towards low-inflation regimes. Using data from a randomized controlled trial included in the Bundesbank Online Panel Households, we show (i) that keeping the original scale in high-inflation regimes distorts estimates of histogram moments and forces households to provide probabilistic expectations that are inconsistent with the point forecasts and (ii) how shifting the scale improves the consistency of predictions by allowing respondents to state more detailed beliefs about higher inflation ranges. We also explore potential disadvantages of adjusting the response scale.
    Keywords: Probabilistic expectations, inflation, survey data
    JEL: D84 E58
    Date: 2023
  19. By: Ciccarelli, Matteo; Darracq Pariès, Matthieu; Priftis, Romanos; Angelini, Elena; Bańbura, Marta; Bokan, Nikola; Fagan, Gabriel; Gumiel, José Emilio; Kornprobst, Antoine; Lalik, Magdalena; Montes-Galdón, Carlos; Müller, Georg; Paredes, Joan; Santoro, Sergio; Warne, Anders; Zimic, Srečko; Rigato, Rodolfo Dinis; Kase, Hanno; Koutsoulis, Iason; Brunotte, Stella; Cocchi, Sara; Giammaria, Alessandro; Invernizzi, Marco; Von-Pine, Eliott
    Abstract: This paper takes stock of the ECB’s macroeconometric modelling strategy by focusing on the models and applications used in the Forecasting and Policy Modelling Division. We focus on the guiding principles underpinning the current portfolio of the main macroeconomic models and illustrate how they can in principle be used for economic forecasting, scenario and risk analyses. We also discuss the modelling agenda which is currently under development, focusing notably on heterogeneity, machine learning, expectation formation and climate change. The paper makes it clear that the large macroeconometric models typically developed in central banks remain stylised descriptions of our modern economies and can fail to predict or assess the nature of economic events (especially when big crises arise). But even in highly uncertain economic conditions, they can still provide a meaningful contribution to policy preparation. We conclude the paper with a roadmap which will allow the ECB and the Eurosystem to exploit technological advances and cooperation across institutions as a useful means of ensuring that the modelling framework is not only resilient to disruptive events but also innovative. JEL Classification: C30, C53, C54, E52
    Keywords: economic models, forecasting, macroeconometrics, monetary policy
    Date: 2024–03
  20. By: Dengler, Thomas; Gerke, Rafael; Giesen, Sebastian; Kienzler, Daniel; Röttger, Joost; Scheer, Alexander; Wacks, Johannes
    Abstract: Optimal policy projections (OPPs) offer a flexible way to derive scenario-based policy recommendations. This note describes how to calculate OPPs for a simple textbook New Keynesian model and provides illustrations for various examples. It also demonstrates the versatility of the approach by showing OPP results for simulations conducted using a medium-scale DSGE model and a New Keynesian model with heterogeneous households.
    Keywords: Optimal monetary policy, macroeconomic projections, New Keynesian models, household heterogeneity
    JEL: C63 E20 E31 E47 E52 E58
    Date: 2024
  21. By: Flavio Pérez Rojo (Pontificia Universidad Católica del Perú.); Gabriel Rodríguez (Departamento de Economía de la Pontificia Universidad Católica del Perú.)
    Abstract: We investigate the evolution of the impact of monetary policy (MP) shocks in Peru in 1996Q1-2018Q2 using a set of time-varying parameter vector autoregressive models with stochastic volatility (TVP-VAR- SV), as proposed by Chan and Eisenstat (2018). The main results are: (i) the volatilities, intercepts, and contemporaneous coe cients change more gradually than VAR coe cients over time; (ii) the volatility of MP shocks falls from 4% to 0.3% on average during the In ation Targeting (IT) regime; (iii) in the long run, a contractionary MP shock decreases both gross domestic product (GDP) growth and in ation by 0.28% and 0.1%, respectively; (iv) the interest rate reacts faster to aggregate supply shocks than to both aggregate demand shocks and exchange rate shocks; (v) under the pre-IT regime, MP shocks explain almost 20%, 10%, and 85% of the uncertainty in GDP growth, in ation, and the interest rate, respectively; and under the IT regime, all these percentages shrink to 1-2%. The sensitivity analysis con rms the robustness of the main results across various prior speci cations, measures of external and domestic variables, and recursive identi cations. In general, the results show that MP has contributed to diminishing macroeconomic volatility in Peru. JEL Classification-JE: C32, E32, E51, E52.
    Keywords: Deviance Information Criterion, Peru, Monetary policy, time, Time-Varying Parameter VAR, Marginal Likelihood, Stochastic Volatility.
    Date: 2023
  22. By: Simon Gilchrist; Bin Wei; Vivian Z. Yue; Egon Zakrajšek
    Abstract: This paper evaluates the efficacy of the Secondary Market Corporate Credit Facility, a program designed to stabilize the U.S. corporate bond market during the COVID-19 pandemic. The program announcements on March 23 and April 9, 2020, significantly reduced investment-grade credit spreads across the maturity spectrum—irrespective of the program’s maturity-eligibility criterion—and ultimately restored the normal upward-sloping term structure of credit spreads. The Federal Reserve’s actual purchases reduced credit spreads of eligible bonds 3 basis points more than those of ineligible bonds, a sizable effect given the modest volume of purchases. A calibrated variant of the preferred habit model shows that a “dash for cash”—a selloff of shorter-term lowest-risk investment-grade bonds—combined with a spike in the arbitrageurs’ risk aversion, can account for the inversion of the investment-grade credit curve during the height of turmoil in the market. Consistent with the empirical findings, the Fed’s announcements, by reducing risk aversion and alleviating market segmentation, helped restore the upward-sloping credit curve in the investment-grade segment of the market.
    Keywords: COVID-19; SMCCF; credit spreads; credit market support facilities; event study; purchase effects; preferred habitat
    JEL: E44 E58 G12 G14
    Date: 2024–03–01

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