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July 1997

The Research and Market Analysis Group is pleased to introduce Research Update, a new
publication designed to keep you informed about the Group's current work. A companion to
Publications & Other Research, an annual brochure listing our publications and papers—
Research Update will offer detailed summaries of selected studies. It will also contain a
listing of all articles and papers that appeared in recent issues of our four research series—the
Economic Policy Review, Current Issues in Economics and Finance, Staff Reports,and
Research Papers. You can obtain many of the materials featured in Research Update directly
from our publications page (www.ny.frb.org/rmaghome).
Research Update will
Research Update will also report on news within the Research
keep you informed about and Market Analysis Group, beginning with the appointment of
Stephen Cecchetti as the Group's new research director,
our current work.
effective in August.

We hope you'll find our publications and papers of interest; we also hope you'll enjoy
Research Update.

Frederic S. Mishkin
Executive Vice President
and Director of Research

Table of Contents
EPR Summaries
Current Issues Summaries
Staff Report Summaries
Also Available

Paul B. Bennett
Senior Vice President
and Deputy Director of Research

July 1997

Overseas Price Changes in U.S. Treasury Securities
Can Predict Overnight Price Changes in New York
The U.S. Treasury securities market is one of the world's largest and most liquid financial
markets. But how much do we really know about its intraday functioning? In "The Roundthe-Clock Market for U.S. Treasury Securities" (Economic Policy Review, vol. 3, no. 2),
Michael Fleming offers the first detailed intraday analysis of the secondary market for U.S.
Treasury securities.
Using comprehensive data on primary government securities dealers' trading activity,
Fleming examines trading volume, price volatility, and bid-ask spreads for the three major
trading locations—New York, London, and Tokyo&#151and for each half-hour interval of
the global trading day. He finds relatively little trading activity in the overseas locations, as
well as less price discovery and higher bid-ask spreads. Nevertheless, the price changes in
London and Tokyo can accurately predict overnight price changes in New York, he says.
Specifically, the author's analysis reveals that although the U.S. Treasury market operates
around the clock, more than 94 percent of trading occurs in New York, with less than 4
percent in London and less than 2 percent in Tokyo. Lower liquidity notwithstanding, the
overseas trading locations provide important information on the path of U.S. Treasury
security prices. Price volatility is also found to be highly concentrated in New York trading
hours and to peak at the same times each day as trading activity. Although prices have at
times moved significantly during the overseas hours, price volatility tends to be significantly
lower overseas than in New York. Fleming also concludes that bid-ask spreads are higher
overseas than in New York, and higher in Tokyo than in London. Fleming argues that his
intraday analysis of trading volume and bid-ask spreads can be used to ascertain how market
liquidity changes throughout the day. Such information is important to hedgers and other
market participants who may need to trade at any moment and to investors who rely on a
liquid Treasury market for the pricing of other instruments. The price volatility analysis,
Fleming says, reveals when new information gets incorporated into prices and can lead to a
better understanding of the determinants of Treasury prices.
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Publications and Papers
The Research and Market Analysis Group produces various publications and discussion
papers: the Economic Policy Review—a policy-oriented research journal focusing on
macroeconomic, banking, and financial market topics.
Current Issues in Economics and Finance—a newsletter-style publication offering concise
and timely analyses of economic, financial, and regional topics.
Staff Reports—technical papers presenting research findings, designed to stimulate
discussion and elicit comments. These papers meet rigorous academic standards and are
intended for publication in leading economic and finance journals.
Research Papers—discussion papers reporting preliminary research findings.
A New Measure Incorporates Manufacturers' Use of

Imported Inputs. No single measure can capture the importance of international shocks—such
as exchange rate changes and trade policy shifts—to a country's manufacturing industries.
The growing internationalization of the production process and trade means that even small
events abroad can affect producer profitability and output. Recognizing the need for broad
assessment tools, "The Evolving External Orientation of Manufacturing: A Profile of Four
Countries," by José Campa and Linda Goldberg (Economic Policy Review, vol. 3, no. 2),
presents four measures of the "external orientation" of manufacturing industries in the United
States, Canada, the United Kingdom, and Japan. For each major manufacturing industry, the
authors provide histories of the share of total revenues earned in foreign markets, the role of
imports in domestic consumption, and the costs of imported inputs in total production. In
addition, they construct a measure of net external orientation, which is intended to capture
how much an industry's use of imported inputs (a cost factor) can potentially offset exposure
to the international economy through exports (a revenue factor). The authors show that in
Canada, the United Kingdom, and the United States all four external orientation measures
have increased considerably in the past two decades, although the United States trails the
other countries in the degree of its industries' external orientation. In Japan, only export share
has increased significantly. Four industries—electrical machinery, nonelectrical machinery,
transportation equipment, and instruments and related products—rely heavily on export
markets in all the countries. By contrast, the importance of imports and imported inputs by
industry varies widely across countries. The authors suggest that such measures can help
clarify how particular international shocks will influence industry movements in revenues and
costs within countries.
View entire article in Adobe Acrobat.
New Director of Research Named
In August, Stephen G. Cecchetti, a professor of economics at Ohio State University, will
succeed Frederic S. Mishkin as director of research at the Federal Reserve Bank of New York.
Mr. Cecchetti has been a professor of economics at Ohio State since 1992 and a member of
the economics faculty since 1987. From 1982 to 1987, he was on the faculty of New York
University's Graduate School of Business. Mr. Cecchetti has also served as a visiting
professor of economics at such institutions as the University of Melbourne, Boston College,
and Princeton University. In addition to publishing extensively, Mr. Cecchetti has been editor
of the Journal of Money, Credit, and Banking and on the editorial boards of the
American Economic Review, the Journal of Economic Literature, and Ohio State University
Press.
Mr. Mishkin, who served as director of research for three years, will return in September to
Columbia University's Graduate School of Business, where he is the A. Barton Hepburn
Professor of Economics.
Table of Contents
Current Issues Summaries
Staff Report Summaries
Also Available

July 1997

Increasing Demand for Credit Is Forcing up
Debt Burdens and Credit Card Charge-offs
Two demand factors—rising net worth and an increasing share of heavy borrowers in the
population—can explain the rise in debt burdens and credit card charge-offs since the early
1980s, according to Donald Morgan and Ian Toll in "Bad Debt Rising"(Current Issues in
Economics and Finance, vol. 3, no. 4).
The rise in credit card charge-offs—the loans that banks write off as uncollectible—has
paralleled the trend in households' overall debt burden, Morgan and Toll report. These two
parallel trends are no mere coincidence; a mounting debt burden causes higher charge-offs
because heavily indebted borrowers are more exposed to income shocks.
The authors look at both supply and demand explanations for the rise in the debt burden and
bad debt. Most analysts, they report, tend to blame lenders, arguing that banks are granting
credit cards to riskier borrowers without raising rates to compensate. Their review of credit
card pricing and the rate of charge-offs on other loans, however, turns up no evidence that a
supply shift is the cause.
Morgan and Toll then look for changes in two demand factors that drive household
borrowing: wealth, measured as net worth per capita, and the share of the population at peak
borrowing age, measured as borrowers between the ages of twenty-five and fifty-four. They
find that these two factors generally moved in opposite directions before the early 1980s,
which helped to keep demand stable. Since the early 1980s, however, both net worth and the
share of the population at peakborrowing age have risen together. This convergence has
caused debt burdens to grow, making borrowers riskier and forcing up charge-offs across the
board.
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Recently Published
Leonardo Bartolini. "Capital Account Liberalization as a Signal," with A. Drazen.
American Economic Review 87, no. 1.
Rebecca S. Demsetz and Philip E. Strahan. "Diversification, Size, and Risk at Bank
Holding Companies," Journal of Money, Credit, and Banking 29, no. 2.
Robert Rich. "Oil and the Macroeconomy: A Markov State-Switching Approach," with
Jennie E. Raymond. Journal of Money, Credit, and Banking 29, no. 2.
Joseph Tracy. "The Best Business Schools: A Market-Based Approach," with Joel
Waldfogel. Journal of Business 70, no. 1.

Despite U.S. Gains, U.S.-China Trade Gap
Is Expected to Widen
In 1987, the United States benefited from a small trade surplus with China. Today, the U.S.China merchandise trade deficit is about $40 billion, and it is likely to expand further,
according to "The Growing Trade Imbalance with China," by Thomas Klitgaard and Karen
Schiele (Current Issues in Economics and Finance, vol. 3, no. 7).
Not surprisingly, China's high trade barriers have played a major role in the growth of the
trade imbalance. Despite recent efforts at liberalization, China's average tariff rate on foreign
goods remains high at 23 percent, and quota systems, licensing requirements, and other
regulations still apply to many products.
Nevertheless, the United States has made some headway in penetrating the huge Chinese
market. Even with a pause in growth last year, U.S. exports to China grew at an average
annual rate of 16 percent from 1991 to 1996. This modest success, however, is no match for
China's striking gains in U.S. markets in the 1980s. From 1985 to 1990, imports from China
jumped 32 percent per year. Low wages, a relatively skilled labor force, heavy government
subsidies, and economies of scale created by focusing on less expensive consumer goods
have driven China's advances in world markets, report Klitgaard and Schiele.
What is the outlook for the U.S. -- China trade imbalance in the near term? U.S. exports
should continue to grow rapidly. Although sales to China stalled in 1996, growth in the range
of 15 to 20 percent is plausible over the rest of the decade. As for U.S. imports, growth in
demand for Chinese goods should hold its recent pace of about 10 to 15 percent, down from
the near 30 percent rate recorded in the 1980s and early 1990s.
This shift, however, will not be enough to reverse the trade imbalance. To reduce the deficit,
U.S. exports to China would need to grow at an extraordinary rate. Despite recent U.S. gains
and China's efforts at trade liberalization, the trade gap can be expected to widen in the near
term.
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Table of Contents EPR Summaries Staff Report Summaries Also Available

July 1997

In Economic Forecasting, Accuracy May Not Be the Sole Concern
Economic forecasters may not always strive to be as accurate as possible, according to
"Rational Bias in Economic Forecasts," by David Laster, Paul Bennett, and In Sun Geoum
(Staff Reports, no. 21). The paper argues that another factor appears to play a role in
economic forecasting—the desire for publicity.
Laster, Bennett, and Geoum develop a model in which
Independent forecasters, who forecasters are paid according to two criteria: long-term
accuracy and the ability to generate publicity for their
stand to benefit most from firms. Accuracy is defined in the usual sense of
minimizing average forecast error; publicity is the media
favorable publicity, tend to coverage that a forecaster attracts by being more accurate
than everyone else in a given year. Ultimately, the authors
produce outlying forecasts. say, the two goals can conflict.
Because forecasters have access to similar information, the pure pursuit of accuracy would
lead most of them to similar conclusions. A forecaster seeking publicity, however, is likely to
predict an outcome that has a good chance of occurring but that is distinct from what others
are predicting. Thus, forecasters will express a variety of views even though their
expectations are in fact quite similar. Laster, Bennett, and Geoum present evidence
supporting their model from a twenty-year panel of real GDP predictions from Blue Chip
Economic Indicators.
How forecasters position their projections depends on the weight individual employers give
to publicity and accuracy when setting the pay of forecasters. Laster, Bennett, and Geoum
hypothesize that nonfinancial corporations—which use forecasts mainly for internal planning
purposes&#151are likely to emphasize accuracy. Consulting firms and advisory services, by
contrast, are more likely to seek recognition and therefore reward their forecasters for
generating publicity.
Consistent with these hypotheses and the model, nonfinancial corporations as a group deviate
the least from the consensus, while independent forecasters deviate the most. The contrast is
striking: nonfinancial corporations make GDP forecasts that deviate from the consensus by
an average of 0.4 percent; independent forecasts deviate by twice as much.
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Bank Performance Rises as Entry Restrictions Fall
Bank efficiency improves significantly after restrictions on expansion are lifted, contend Jith
Jayaratne and Philip Strahan in "Entry Restrictions, Industry Evolution, and Dynamic
Efficiency: Evidence from Commercial Banking" (Staff Reports, no. 22).

Jayaratne and Strahan reach this conclusion by observing changes in the performance of
states' banking systems after geographic restrictions were removed in the 1970s and 1980s.
Bank operating costs decreased about 8 percent after deregulation of branching restrictions,
and non-performing loans dropped at least 11 percent.
Earlier research had shown that geographic restrictions limit banks' ability to diversify
portfolio risks and to increase their market power but had revealed little about the restrictions'
effects on bank efficiency. Jayaratne and Strahan's study is the first to draw specific
conclusions about these effects. Their findings are especially timely now that full interstate
banking has gone into effect. Early in the industry's development, banks were subject to
severe entry barriers in the form of branching restrictions. Over the last two decades,
however, states have gradually lifted these restrictions.
Much of the efficiency improvement, note the authors,
Bank's efficiency improves
appears to have occurred because branching deregulation
triggered a process of selection whereby better
sharply once restrictions on
performing banks expanded at the expense of high-cost,
low-profit banks. Although the better performers were
found to grow faster than underachievers before intrastate instrastate branching are lifted
branching was allowed, the differences in the growth
and, to a lesser extent, after
rates of low- and high-cost banks rose significantly after
branching restrictions were lifted. Once the restrictions
interstate banking is permitted.
were removed, the better-managed institutions grew at
the expense of their poorly managed rivals, thereby
improving the efficiency of the average bank asset.
In addition, most of the reduced banking costs after branch deregulation appear to have been
passed along to customers in the form of lower loan rates. As a result, the authors find only
small, generally statistically insignificant increases in bank profitability after deregulation.
Borrowers, however, saved approximately $6 billion in 1992 as a result of lower loan rates.
Order Staff Report, no. 22.

Understanding Open Market Operations
by M. A. Akhtar
The formulation and conduct of monetary policy have undergone significant changes in the
past two decades. In assessing the state of the economy, the Federal Reserve has shifted its
focus from the monetary aggregates to a much wider array of economic indicators.
Similarly, in implementing policy, the Fed has changed its strategy from targeting a
particular quantity of reserves to achieving reserve and money market conditions that are
conducive to price stability and other broad policy goals.
In Understanding Open Market Operations, M. A. Akhtar reviews the changes in
formulating monetary policy and describes the Federal Reserve's approaches to
implementation in the 1990s. Focusing on open market operations, he provides a detailed
overview of how monetary policy is carried out and a sense of the uncertainties and
challenges involved in the process. More broadly, the book offers a well-informed
perspective on the linkages between monetary policy and the economy.
View contents.

Table of Contents EPR Summaries Current Issues Summaries Also Available

July 1997

Also Available: January - June 1997
To obtain any of these articles or papers, visit our publications page.

Economic Policy Review
Volume 3, Number 1
This special issue presents the proceedings of a conference—held at the Federal Reserve
Bank of New York in November 1996—on the New York metropolitan region's economy in
the national and world arenas.
Volume 3, Number 2
Creating an Integrated Payment System: The Evolution of Fedwire, by Adam M. Gilbert,
Dara Hunt, and Kenneth C. Winch
Market Returns and Mutual Fund Flows, by Eli M. Remolona, Paul Kleiman, and Debbie
Gruenstein
Credit, Equity, and Mortgage Refinancings, by Stavros Peristiani, Paul Bennett, Gordon
Monsen, Richard Peach, and Jonathan Raiff

Current Issues in Economics and Finance
1997 Job Outlook: The New York-New Jersey Region, by James Orr and Rae D. Rosen
Volume 3, Number 1 (January)
The Effects of Price Limits on Trading Volume: A Study of the Cotton Futures Market, by
Joan Evans and James M. Mahoney Volume 3, Number 2 (January)
Debt, Delinquencies, and Consumer Spending, by Jonathan McCarthy Volume 3, Number 3
(February)
Falling Reserve Balances and the Federal Funds Rate, by Paul Bennett and Spence Hilton
Volume 3, Number 5 (April)
Are There Good Alternatives to the CPI? by Charles Steindel Volume 3, Number 6 (April)
The Samurai Bond Market, by Frank Packer and Elizabeth Reynolds Volume 3, Number 8
(June)

Staff Reports
A Three-Factor Econometric Model of the U.S. Term Structure, by Frank F. Gong and Eli M.
Remolona Number 19 (January)

Technological Diffusion through Trade and Imitation, by Michelle P. Connolly Number 20
(February)
Testing Under Non-standard Conditions in Frequency Domain: with Applications to Markov
Regime Switching Models of Exchange Rates and the Federal Funds Rate, by Fangxiong
Gong and Roberto S. Mariano Number 23 (April)
Foreign Investment Fluctuations and Emerging Market Stock Returns: The Case of Mexico,
by John Clark and Elizabeth Berko Number 24 (May)
Can Competition between Brokers Mitigate Agency Conflicts with Their Customers? by
Sugato Chakravarty and Asani Sarkar Number 25 (June)
Language, Learning, and Location, by Andrew John and Kei-Mu Yi Number 26 (June)

Research Papers
Traders' Broker Choice, Market Liquidity, and Market Structure, by Sugato Chakravarty and
Asani Sarkar Number 9701 (January)
Option Value of Credit Lines as an Explanation of High Credit Card Rates, by Sangkyun Park
Number 9702 (February)
On the Determinants and Resilience of Bond Flows to Less Developed Countries, 1990-95:
Evidence from Argentina, Brazil, and Mexico, by Angelos A. Antzoulatos Number 9703
(February)
Asset Market Hangovers and Economic Growth, by Matthew Higgins and Carol Osler
Number 9704 (February)
Can Competition between Brokers Mitigate Agency Conflicts with Their Customers? by
Sugato Chakravarty and Asani Sarkar Number 9705 (February)
What Moves the Bond Market? by Michael J. Fleming and Eli M. Remolona Number 9706
(February)
Disciplined Discretion: The German and Swiss Monetary Targeting Frameworks in
Operation, by Thomas Laubach and Adam S. Posen Number 9707 (March)
Does Consumer Confidence Forecast Household Expenditure? A Sentiment Index Horse
Race, by Jason Bram and Sydney Ludvigson Number 9708 (March)
Agency Problems and Risk Taking at Banks, by Rebecca S. Demsetz, Marc R. Saidenberg,
and Philip E. Strahan Number 9709 (March)
Regulatory Evaluation of Value-at-Risk Models, by Jose A. Lopez Number 9710 (March)
Split Ratings and the Pricing of Credit Risk, by Richard Cantor, Frank Packer, and Kevin
Cole Number 9711 (March)
Approximation Bias in Linearized Euler Equations, by Sydney Ludvigson and Christina H.
Paxson Number 9712 (March)
Estimating the Adverse Selection Cost in Markets with Multiple Informed Traders, by Sugato
Chakravarty, Asani Sarkar, and Lifan Wu Number 9713 (April)

Some Comparative Evidence on the Effectiveness of Inflation Targeting, by Thomas Laubach
and Adam S. Posen Number 9714 (April)
A General Model of Brokers' Trading, with Applications to Order Flow Internalization,
Insider Trading and Off-Exchange Block Sales, by Sugato Chakravarty and Asani Sarkar
Number 9715 (May)
A New Measure of Fit for Equations with Dichotomous Dependent Variables, by Arturo
Estrella Number 9716 (May)
Why Do Interest Rates Predict Macro Outcomes? A Unified Theory of Inflation, Output,
Interest, and Policy, by Arturo Estrella Number 9717 (May)
The Growth of World Trade, by Jun Ishii and Kei-Mu Yi Number 9718 (May)
Interest Rate Options Dealers' Hedging in the U.S. Dollar Fixed Income Market, by John
Kambhu Number 9719 (May)

Table of Contents EPR Summaries Current Issues Summaries Staff Report Summaries