Full text of Research Update : July 1998

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July 1998

Research
U P D AT E
f r o m t h e F e d e r a l R e s e r v e B a n k o f N e w Yo r k
RESEARCH AND MARKET ANALYSIS GROUP

Rigid Inflation Targeting Can Lead to Wide Swings
in GDP Growth
Central banks that adopt a fixed inflation target run the risk of creating considerable variability in output growth, according to Stephen
Cecchetti in “Policy Rules
If a policymaker were to focus on and Targets: Framing the
Central Banker’s Problem”
inflation alone, the likely result— (Economic Policy Review,
vol. 4, no. 2).

in the absence of fundamental

Cecchetti bases this
conclusion on his analysis
changes in the structure of the of the difficulties facing
policymakers who must
economy—would be a very high maintain steady economic
growth while keeping inflalevel of real output variation. tion rates low. Because it is
generally not possible to
maintain both output and prices at their optimal levels, policymakers routinely balance
the costs of output fluctuations against the
costs of price fluctuations. But when policymakers introduce a system of rigid price-level

or inflation targeting, they “are implicitly
altering the relative importance of inflation
and output variability in their objectives,
increasing the weight they attach to the former relative to the latter.”
This change in emphasis can have undesirable side effects. Drawing on empirical estimates of the impact of monetary policy shifts
on output and prices over the 1984-95 period,
Cecchetti finds that the output-inflation
variability trade-off is extremely steep: in
other words, an effort to decrease inflation
variability modestly causes output to deviate
significantly from its optimal path. Consequently, central banks that try to keep a tight
rein on price fluctuations in order to meet an
inflation target may see a sharp rise in the
volatility of GDP growth. “Someone who cares
about output variability is made substantially
worse off by a decision to target the path of the
price level,” the author writes. “As a result,

New Research: Apr il–June 1998

when considering policies based on prices
alone, policymakers must be very cautious
and ask whether they really care so little about
output and other real quantities.”
Cecchetti’s discussion of inflation targeting
is part of a broader analysis of the central
banker’s task. The article presents an analytical framework for the formulation of a central
bank policy rule—a systematic rule for adjusting interest rates as the state of the economy
changes. In this framework, the deviations of
output and prices from their optimal paths
are treated as the “loss function” that central
bankers seek to minimize through their control over interest rates.
The author also addresses several conceptual and practical issues that bear on the

development of policy rules. These issues
include the influence of various types of
uncertainty on policymaking, the possible
justifications for interest rate smoothing, and
the consequences of the fact that the nominal
interest rate cannot fall below zero.
In the final section of the article, Cecchetti
considers why it might be advantageous for
central banks to follow policy rules. First, he
notes, policymakers’ claims that they will
adhere to a zero inflation policy will not be
believed by the public unless these claims are
supported by a formal commitment. Second,
rules make policymakers more accountable
by providing the public with clear and
explicit standards for measuring central
bank performance.

Publications and Papers
The Research and Market Analysis Group produces a wide range of publications
and discussion papers:
• The Economic Policy Review—a policy-oriented research journal focusing on macroeconomic, banking, and financial market topics. www.ny.frb.org/rmaghome/econ_pol
• Current Issues in Economics and Finance—a newsletter-style publication offering concise
analyses of economic and financial topics. www.ny.frb.org/rmaghome/curr_iss
• Second District Highlights—a regional supplement to Current Issues covering financial
and economic developments in the Federal Reserve System’s Second District.
www.ny.frb.org/rmaghome/curr_iss/sec_dis
• Staff Reports—technical papers presenting research findings, designed to stimulate
discussion and elicit comments. These papers are intended for publication in leading
economic and finance journals. www.ny.frb.org/rmaghome/staff_rp
• Research Papers—discussion papers reporting preliminary research findings.
www.ny.frb.org/rmaghome/rsch_pap
• Publications & Other Research—a brochure spotlighting the Group’s research output for
the year. www.ny.frb.org/rmaghome/otherres

Vertical Specialization Spurs Increase in International
Goods and Services Flows
Vertical specialization in international trade
has contributed significantly to the heightened global flows of goods and services in
recent years, reports a new study in the
Economic Policy Review (vol. 4, no. 2).
In “Vertical Specialization and the
Changing Nature of World Trade,” David
Hummels, Dana Rapoport, and Kei-Mu Yi
note that the world’s economies have
become increasingly inteThe authors find that vertical grated and increasingly
global, as witnessed by the
specialization accounts for rising export shares of GDP
of many emerging countries
a large and increasing share as well as many highly
developed nations. The
of international trade authors add that the internationalization of producover the last several decades. tion is also contributing to
the greater globalization of
trade, noting that many multinational firms
now use production plants in numerous
countries, rather than in just one.
“Increased international production, however, does not always lead to increased international trade,” say Hummels, Rapoport, and Yi.
For international production to be associated
with increased trade, they argue, countries
need to be linked through vertical specialization. Vertical specialization occurs when a
country uses imported intermediate parts to
produce goods it later exports. Countries link
sequentially to produce a final good, with each
country specializing in a particular stage of the
good’s production process. Horizontal specialization, by comparison, involves countries that
trade goods made from start to finish in one
country.

To support their hypothesis that vertical specialization is significantly influencing global
trade, the authors use four international-trade
case studies to calculate the level and growth of
vertical trade. For example, they find that at
least half of all U.S.-Mexican trade could be due
to vertical trade. They then examine trade data
for ten developed countries in the Organization
for Economic Cooperation and Development
(OECD) to confirm that their estimates can be
generalized to entire countries.
Hummels, Rapoport, and Yi find that vertical specialization has accounted for a large
and increasing share of international trade
over the last several decades—and this share
has been as high as 50 percent in some of the
smaller countries examined. Moreover, by the
beginning of the 1990s, vertical-specializationbased trade in the ten OECD countries had
increased by 20 percent from the late 1960s and
early 1970s. Analysis of the OECD data reveals
“a strong statistical association between the
increased vertical specialization share of total
trade and the rising trade shares of GDP.” The
authors conclude that “globalization has gone
beyond just ‘more trade.’” The fact that countries increasingly specialize in the production
of certain stages of a good, rather than in the
making of a complete good, means that the
very nature of trade has changed.
The authors also predict that the developments that have led to increased vertical
specialization—lower trade barriers and
transportation and communications technology enhancements—will continue. “Thus,
we can expect the importance of vertical
trade to grow as the world economy heads
into the twenty-first century.

Federal Reser ve Bank of New York

Foreign Ownership of U.S. Treasury Securities Is Difficult
to Determine from Published Data
Although considerable information is released
on foreign holdings of U.S. Treasury securities,
it is not possible to learn from the published
data exactly which foreigners own Treasury
debt and how much of this debt is in foreign
hands. In “Foreign Ownership of U.S. Treasury
Securities: What the Data Show and Do Not
Show” (Current Issues in Economics and
Finance, vol. 4, no. 5), Dorothy Sobol contends
that this inability to determine foreign ownership with complete certainty stems mainly from
two factors: the Treasury Department’s obligation to respect the confidentiality of individual
respondents and the design of the reporting
guidelines themselves.
In her overview of the data collected by the
Treasury Department, the author explains that
each month the Treasury asks banks, other
depository institutions, and brokers and dealers to report both short-term Treasury securities held in custody for foreigners and foreign
purchases and sales of long-term Treasury
securities. In soliciting data, the Treasury
assures respondents that the information they
provide will be held in confidence. To meet this
commitment, the Department publishes data
on foreign holdings only in aggregate form,
leaving the amounts reported by individual
respondents undisclosed.
The determination of foreign ownership is
also made difficult by the Treasury’s reporting
guidelines, which direct respondents to assign
nationality on the basis of counterparty location. In some cases, the counterparty may be
acting on behalf of a firm or individual residing
in another country. If so, the nationality of the
ultimate owner of, or transactor in, the security
will go unreported. For example, “if a U.S. bank
buys a long-term Treasury security from a

Japanese resident’s account with Merrill Lynch
in London, the transaction will be reported as
a sale by a U.K. resident and not a Japanese
resident,” Sobol explains. Similarly, if a U.S.
institution sells a long-term Treasury security
to the Sydney, Australia, branch of a French
firm, the new holder of the security will be
identified as an Australian resident.
The author indicates that somewhat better
information on the ultimate owners of longterm Treasury securities is available at the time
of the Treasury Department’s benchmark surveys of foreign holdings. Nevertheless, because
the surveys are conducted only at five-year
intervals and their findings are published with
long lags, the information
Government data on foreign
they contain loses relevance
over time.

holdings of U.S. Treasury securities

Sobol contends that the
Treasury’s confidentiality
do not necessarily capture the
rules and reporting guidelines have important implinationality of the ultimate owners
cations for the tracking of
foreign official institutions’
of these securities.
activity in U.S. Treasury
securities. Although the data
on foreign holdings show whether foreign official institutions as a group are buying or selling long-term Treasury securities from month
to month, they do not reveal the actions of any
individual country’s central bank at any given
time nor indicate whether that central bank
is buying or selling Treasury bills, notes, or
bonds. “Any press or other reports stating
that a specific country’s central bank is
unloading Treasury securities are based on
purely speculative or anecdotal evidence,”
the author concludes.

ATM Surcharges Bring Both Benefits and Costs
In April 1996, the two largest national automated teller machine (ATM) networks, Plus
and Cirrus, ended their prohibition on direct
fees for using an ATM. Since that decision,
many banks and nonbanks that own
machines have chosen to impose these fees,
known as surcharges, on users who are not
depositors of the machine owner.
In “ATM Surcharges,” James McAndrews
provides a brief overview of the organization of
ATM networks, the fees they charge member
financial institutions (most of which are
banks), and the fees banks and ATM owners
charge consumers for ATM services (Current
Issues in Economics and Finance, vol. 4, no. 4).
“Surcharges entail both benefits and costs for
ATM owners, consumers, banks, and ATM
networks,” reports McAndrews. The primary
customer benefit is that surcharges have the
potential to lead to a better match between the
supply of ATM locations and customer demand
for remote access to their accounts. In particular, surcharges encourage the deployment of
ATMs to high-cost, high-value areas such as
airports, stadiums, and ski resorts.

Surcharges, however, also impose direct
costs on consumers even for the most routine
transactions. Surveys show that these fees,
which can reach as high as $5.00, average
about $1.00. To avoid these direct costs, many
customers appear to be going out of their way
to visit their own banks’ machines in place of
network machines. Besides inconveniencing
customers, this change in usage has clear
negative implications for the networks themselves: to the extent that customers rely on
their own banks’ machines, ATM networks
and network banks stand to lose revenue from
surcharges and other transaction fees.
According to McAndrews, surcharges may
also change how customers choose their
banks. By exempting customers of ATM
owners from surcharges, the current system
reduces the role of the shared ATM network
to which a bank belongs and expands the
role of the bank’s own chain of machines.
This arrangement encourages customers
who most prize convenience to establish
deposit accounts with banks that have
ATMs located in the customers’ preferred
locations rather than with banks that offer

Recently Published
Donald R. Davis.“Does European Unemployment Prop Up American Wages? National Labor
Markets and Global Trade.” American Economic Review 88, no. 3: 478-94.
Arturo Estrella.“A New Measure of Fit for Equations with Dichotomous Dependent Variables.”
Journal of Business and Economic Statistics 16, no. 2: 198-205.
Michael J. Fleming and Anthony P. Rodrigues.“How Workers Use 401(k) Plans: The
Participation, Contribution, and Withdrawal Decisions,” with William F. Bassett.
National Tax Journal 51, no. 2: 263-89.
Matthew Higgins.“Demography, National Savings and International Capital Flows.”
International Economic Review 39, no. 2: 343-70.

Federal Reser ve Bank of New York

the highest interest rates on deposit accounts.
Hence, in the long term, ATM surcharges
could weaken deposit interest rate competition among banks.

some state legislatures and congressional

Since surcharges were introduced in 1996,
consumers, banks, and legislators have been
engaged in lively debate over the legitimacy
of these fees. Consumer complaints have led

Although the public policy debate is far from

committees to consider bills to ban surcharges. To date, however, only two state
banking regulators have imposed such bans.
settled, McAndrews notes, the widespread
adoption of direct fees by ATM owners suggests that surcharging will continue.

Volatility of GDP Growth Is Linked to Volatility
in Durable Goods Production
A dramatic decline in the volatility of U.S. GDP
growth in the early 1980s can be attributed to a
reduction in the volatility of durable goods production, according to Margaret McConnell and
Gabriel Perez Quiros in “Output Fluctuations in
the United States: What Has Changed since the
Early 1980s?” (Staff Reports, no. 41). In turn,
this structural break in durable goods production may derive from the reduced role played
by inventory fluctuations after 1984.
Using quarterly GDP growth data from
1953 through mid-1997, the authors show that
the variance of output fluctuations through
1983 is more than four times as large as the
variance from 1984 onward.
To explore this drastic fall in volatility, the
authors first determine that the break in U.S.
output volatility in 1984 stems from a development unique to the U.S. economy. They
then disaggregate U.S. output into components—the contribution to growth of the
goods, services, and structures sectors of the
economy—and examine the components for
breaks. After eliminating the latter two sectors, they focus on the growth rate of goods—
decomposing the rate into contributions from
durables and nondurables growth. The growth

rates of goods and durables are each found to
break in the first quarter of 1985; no evidence
of breaks is found for nondurables. The
authors conclude that “the magnitude of the
decline in durables volatility alone is sufficient to account for the break in the volatility
of aggregate output.”
The authors also examine four possible reasons why output volatility fell so dramatically
in the early 1980s. After analyzing and discounting three reasons—changes in the composition of the U.S. economy, the stabilizing
effect of monetary policy, and changes in trade
patterns—McConnell and Perez Quiros focus
on inventory movements, to determine if they
have become a smaller share of durables production. Since inventories traditionally
account for a large fraction of the variability of
aggregate output, the authors contend, a
declining share of inventories could have substantial effects on the volatility of output fluctuations. Strong evidence of a break in inventories is found in the third quarter of 1984—a
date that corresponds closely to the date found
for the change in aggregate output volatility.
“Once we subtract purchases of inventories
from total purchases, we have eliminated the
volatility break,” note the authors.

Papers Presented by Economists in the Research
and Market Analysis Group
Paul Bennett, Richard Peach, and Stavros
Peristiani. “Structural Change in the Mortgage
Market and the Propensity to Refinance.”
American Real Estate and Urban Economics
Association Mid-Year Meetings, Washington,
D.C., May 26.
The authors test the hypothesis that the
interest savings that trigger a home mortgage
refinancing have become smaller, because of a
combination of technological, regulatory, and
structural changes that have made mortgage
origination more competitive and more efficient. Their results strongly support the
hypothesis that structural change in the mortgage market has increased homeowners’
propensity to refinance.
Sandra Black. “How to Compete: The Impact
of Workplace Practices and Information
Technology on Productivity,” with Lisa Lynch.
Society of Labor Economists Meeting, San
Francisco, May 2.
Using a new dataset, Black looks at how highperformance workplace practices affect establishment productivity. Firms with these newer
practices are found to have higher productivity.
James Harrigan. “International Trade and
American Wages in General Equilibrium,
1967-1995.” University of Copenhagen
Conference
on
International
Trade,
Copenhagen, June 20.
Harrigan’s empirical examination of the
causes of increased wage inequality finds a
large role for relative price and relative factor
supply changes and a small direct role for
international trade.
Kenneth Kuttner and Cara Lown. “Government
Debt, the Composition of Bank Portfolios, and
the Transmission of Monetary Policy.” Bank of
England Conference on the Relationship

between the Level and Composition of
Government Debt and Monetary Policy,
London, June 18-19.
Kuttner and Lown find some evidence from
the 1990s to support the hypothesis that an
increase in outstanding government debt leads
to an increase in banks’ holdings of this debt.
They also find that during periods of tight
monetary policy, banks holding a large fraction of their assets as securities sell these securities and continue to lend—a practice that can
at least partially undercut the goals of monetary policy.
Carol Osler. “Identifying Noise Traders: The
Head-and-Shoulders Pattern in U.S. Equities.”
Conference on Forecasting Financial Markets,
cosponsored by the Imperial College of
Business and Banque National de Paris,
London, May 27-29.
Osler’s paper shows that technical speculation using the head-and-shoulders pattern—a
price formation involving three consecutive
price peaks—is not profitable and therefore is
not rational. Nonetheless, such trading is quite
active in U.S. equity markets, and it affects
returns slightly.
Kei-Mu Yi. “The Growth of World Trade.”
Midwest Macroeconomics Conference, cosponsored by Macroeconomic Advisors and
the Federal Reserve Bank of St. Louis,
St. Louis, April 17-19.
Yi’s paper explains the increasing importance of vertical specialization in world trade
and shows that a model including vertical
trade can more easily explain the growth of
trade than standard trade models.
Individual copies of these papers can be
obtained by e-mailing requests to the
authors at firstname.lastname@ny.frb.org.

Federal Reser ve Bank of New York

RESEARCH AND MARKET ANALYSIS GROUP
PUBLICATIONS AND PAPERS:
APRIL–JUNE 1998
Economic Policy Review

Research Papers

Volume 4, Number 2 (June)

Rethinking the Role of NAIRU in Monetary Policy:
Implications of Model Formulation and Uncertainty,
by Arturo Estrella and Frederic S. Mishkin
Number 9806 (April)

Policy Rules and Targets: Framing the Central
Banker’s Problem, by Stephen G. Cecchetti
The Expanding Geographic Reach of Retail Banking
Markets, by Lawrence J. Radecki
Dealers’ Hedging of Interest Rate Options in the
U.S. Dollar Fixed-Income Market,
by John E. Kambhu
Does Consumer Confidence Forecast Household
Expenditure? A Sentiment Index Horse Race,
by Jason Bram and Sydney Ludvigson
Vertical Specialization and the Changing Nature of
World Trade, by David Hummels, Dana Rapoport,
and Kei-Mu Yi

Current Issues in Economics
and Finance
ATM Surcharges, by James J. McAndrews
Volume 4, Number 4 (April)
Foreign Ownership of U.S. Treasury Securities:
What the Data Show and Do Not Show,
by Dorothy Meadow Sobol
Volume 4, Number 5 (May)
How Effective Is Lifeline Banking in Assisting the
‘Unbanked’? by Joseph J. Doyle, Jose A. Lopez,
and Marc R. Saidenberg
Volume 4, Number 6 (June)

Staff Reports
Consistent Covariance Matrix Estimation in
Probit Models with Autocorrelated Errors,
by Arturo Estrella and Anthony P. Rodrigues
Number 39 (April)
Economic Geography and Regional Production
Structure:
An
Empirical
Investigation,
by Donald R. Davis and David E. Weinstein
Number 40 (May)
Output Fluctuations in the United States: What
Has Changed since the Early 1980s? by Margaret M.
McConnell and Gabriel Perez Quiros
Number 41 (June)

Institutional Affiliation and the Role of Venture Capital: Evidence from Initial Public Offerings in Japan,
by Yasushi Hamao, Frank Packer, and Jay R. Ritter
Number 9807 (April)
Risksharing within the United States: What Have
Financial Markets and Fiscal Federalism
Accomplished? by Stefano Athanasoulis
and Eric van Wincoop
Number 9808 (April)
Stock Market Crises in Developed and Emerging
Markets, by Sandeep Patel and Asani Sarkar
Number 9809 (April)
Import Demand under a Foreign Exchange Constraint, by Angelos A. Antzoulatos and Simone Peart
Number 9810 (April)
The Changing U.S. Income Distribution: Facts,
Explanations, and Unresolved Issues, by David Brauer
Number 9811 (April)
Can VARs Describe Monetary Policy?
by Charles L. Evans and Kenneth N. Kuttner
Number 9812 (April)
An Analysis of Brokers’ Trading, with Applications to
Order Flow Internalization and Off-Exchange Block
Sales, by Sugato Chakravarty and Asani Sarkar
Number 9813 (May)
Estimating the Adverse Selection and Fixed Costs of
Trading in Markets with Multiple Informed Traders,
by Sugato Chakravarty, Asani Sarkar, and Lifan Wu
Number 9814 (May)
Risk and the Democratization of Credit Cards,
by Sandra E. Black and Donald P. Morgan
Number 9815 (June)
Securities Class Actions, Corporate Governance,
and Managerial Agency Problems,
by Philip E. Strahan
Number 9816 (June)

The views expressed in Research Update are those of the authors and do not necessarily reflect the
position of the Federal Reserve Bank of New York or the Federal Reserve System.