Estimating the Impact of the Fed’s Mortgage Portfolio

Some of the big questions looming about the Fed’s exit strategy are if, when, and at what pace the Fed should draw down its huge portfolio of mortgage backed securities (MBS). At its meeting last week the Federal Open Market Committee announced that it is continuing its MBS purchases at a “gradually slowing pace,” but that will still leave $1,250 billion in MBS on its balance sheet at the end of the first quarter. Another, more long-term, question is whether such price-keeping operations—a term used by Peter Fisher who once ran the trading desk at the New York Fed—should be a regular part of monetary policy in the future. Brian Sack, who now runs the trading desk, concludes in a recent speech that they should be.

The answer to these important questions requires on an empirical assessment of the impact of the MBS purchase program. Unfortunately, publicly available assessments are sorely lacking. For this reason, Johannes Stroebel and I undertook an econometric study of the impact; the study is part of a larger research project by us and our colleagues on central bank exit strategies.

Such an assessment requires that one carefully consider other influences on rates on mortgage backed securities. We focused on two obvious ones: prepayment risk and default risk. If we control for prepayment risk using the swap option-adjusted spread, which is regularly used by MBS traders and investors, and if we control for default risk using spreads on senior or subordinated agency debt, we find that that the program has not had an economically or statistically significant effect on mortgage spreads. If we use other measures to control for prepayment and default risk we can see statistically significant effects, but they are small. Even in these cases it was the announcement or the existence of the program, rather than the size of the portfolio that mattered for spreads. We find that there is no statistically or economically significant effect of the size of the portfolio, a finding which we show is quite robust. If our estimates hold up to scrutiny, they raise doubts about such price-keeping operations and suggest that the Fed could gradually reduce the size of its portfolio without a significant impact on the mortgage market.

The graph illustrates our findings. It shows the swap option adjusted spread (with its prepayment risk adjustment) in red and the predictions of that spread using the agency debt spread (a measure of risk) in blue. The residual between these two, shown in green at the bottom of the graph, indicates that there is little left for the Fed’s MBS portfolio to explain. Details and other cases are in the paper.

About John B. Taylor 117 Articles

Affiliation: Stanford University

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution. He formerly served as the director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow, and he was founding director of Stanford's Introductory Economics Center.

Taylor’s academic fields of expertise are macroeconomics, monetary economics, and international economics. He is known for his research on the foundations of modern monetary theory and policy, which has been applied by central banks and financial market analysts around the world. He has an active interest in public policy. Taylor is currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, as a member of the President's Council of Economic Advisers from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001.

For four years from 2001 to 2005, Taylor served as Under Secretary of Treasury for International Affairs where he was responsible for U.S. policies in international finance, which includes currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank. He was also responsible for coordinating financial policy with the G-7 countries, was chair of the working party on international macroeconomics at the OECD, and was a member of the Board of the Overseas Private Investment Corporation. His book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World chronicles his years as head of the international division at Treasury.

Taylor was awarded the Alexander Hamilton Award for his overall leadership in international finance at the U.S. Treasury. He was also awarded the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq, and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. In 2005, he was awarded the George P. Shultz Distinguished Public Service Award. Taylor has also won many teaching awards; he was awarded the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society; he formerly served as vice president of the American Economic Association.

Before joining the Stanford faculty in 1984, Taylor held positions as professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

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