Full text of Research Update : October 1997

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October 1997

This issue of Research Update offers detailed summaries of selected studies from the
Research and Market Analysis Group for the period July-September 1997. It also contains 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.

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October 1997

Inflation Targeting Found to Help Countries Maintain
Low Inflation Rates
Countries that adhere to publicly announced inflation targets may have an advantage in
keeping inflation rates low, according to Frederic Mishkin and Adam Posen in a special issue
of the Economic Policy Review (vol. 3, no. 3). In addition, inflation targets are found to
contribute to increased central bank accountability,
The Economic Policy Review heightened public understanding of monetary policy, and
an improved climate for economic growth.
devotes a special issue
In their comprehensive study "Inflation Targeting: Lessons
to inflation targeting.
from Four Countries," Mishkin and Posen seek to obtain a
perspective on what elements of inflation targeting work
as a strategy for the conduct of monetary policy. They examine the motivation and
experience of the first three countries to adopt inflation targets—New Zealand, Canada, and
the United Kingdom—as well as Germany, which adopted many inflation-targeting elements
before the other countries.
The authors find that target adoption in New Zealand, Canada, and the United Kingdom was
followed by the movement of inflation into, and the maintenance of inflation within, the
announced target range. Since then, inflation and nominal interest rates have remained low
relative to the amount of output growth seen. In Germany, low inflation has been maintained
for decades through the central bank's public commitment to an underlying inflation target.
Mishkin and Posen also note that inflation targeting in these countries has not required the
central banks to abandon their concerns about output growth and other economic outcomes in
order to achieve low inflation rates. In fact, targeting has likely helped improve the climate
for economic growth.
Inflation targeting, explain the authors, has become an increasingly popular monetary
strategy among central banks. It involves the public announcement of medium-term
numerical targets for inflation (a point target or a target range), with a commitment by the
country's monetary authorities to achieve them. Inflation targets can be easily understood by
the public and enable monetary authorities to achieve greater transparency in monetary
policy. The targets can also preserve a country's independent monetary policy by insulating
the central bank from short-term political pressures on interest rate decisions.
However, caution Mishkin and Posen, inflation targets come with disadvantages. For
instance, because of the uncertain effects of monetary policy on price levels, monetary
authorities cannot easily control inflation. Thus, it is
Inflation targeting, explain the
difficult for policymakers to hit an inflation target with
precision. Furthermore, because the effect of monetary
authors, has become an
policy on inflation occurs with a long lag—on the order
of two to three years—there is a delay before a country
increasingly popular monetary
can evaluate the policy's success in achieving the
inflation target. In addition, inflation targeting does not
strategy among central banks.

enable countries to eliminate inflation from their systems
without cost, and anti-inflation credibility is not achieved immediately upon the adoption of
targets.
Mishkin and Posen's study is preceded by remarks by Federal Reserve Bank of New York
President William J. McDonough on the importance of developing strategies to achieve price
stability.
Mr. Mishkin is the Bank's former research director; Mr. Posen is an economist currently on
leave from the Bank.
View entire article in Adobe Acrobat.

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.

Table of Contents Current Issues Summaries Staff Report Summaries What'sNew Also Available

October 1997

Research on Treasury Auction Design Points to Need
for Further Experimentation
In "Designing Effective Auctions for Treasury Securities" (Current Issues in Economics
and Finance, vol. 3, no. 9), Leonardo Bartolini and Carlo Cottarelli review the two main
methods for issuing treasury securities—discriminatory
Only further direct evidence on and uniform-price auctions. Drawing on the theory of
auction design and earlier empirical studies, they discuss
the performance of auction
design and earlier empirical studies, they discuss the two
methods is likely to reveal the method's revenue potential and vulnerability to
noncompetitive behavior by bidders. They then compare
the researchers' views of the two methods with the actual
best course for government
practices of forty-two countries holding auctions of
treasury securities.
treasuries to take.
"Surprisingly," report Bartolini and Cottarelli, "while much of the literature suggests that
uniform-price auctions may outperform discriminatory auctions in producing revenues for
treasuries and limiting the scope for noncompetitive behavior, most countries conduct their
treasury auctions using the more traditional discriminatory format."
In both types of auction, the winning bids are the highest bids that exhaust the whole issue on
sale. In a discriminatory auction, however, all winners pay their own bids, so that they are
charged fully for overestimating the object's resale value.
By contrast, in a uniform-price auction, all winners pay one price unit above the highest
losing bid. In theory, this feature should lower the winners' risk of paying a price that far
exceeds consensus and hence should encourage more aggressive bidding. Thus, as a means
of maximizing revenues, the uniform-price method should outperform the discriminatory
method. Bartolini and Cottarelli cite several empirical studies that support this conclusion.
Evidence on the vulnerability of the two methods to noncompetitive bidding behavior is
more mixed. Some scholars, most notably Milton Friedman, contend that the simplicity of
uniform-price auctions could reduce participants' costs of preparing bids, broaden
participation in auctions, and reduce incentives to funnel bids through brokers, thus
narrowing the scope for brokers to collude and corner markets.
Others, however, argue that collusion is more difficult to sustain in discriminatory auctions.
Overall, although disagreement exists over which auction method is more resistant to
noncompetitive behavior, most scholarly work suggests that uniform-price auctions broaden
participation in auctions and ultimately raise auction revenues.
Despite this widespread view, the authors' survey of auction techniques reveals that
discriminatory auctions are by far the most common—90 percent of the countries examined
relied on this method. Only two countries—Denmark and Nigeria—used uniform-price
auctions. Interestingly, six countries had used uniform-price auctions in the past but had
returned to discriminatory auctions before the survey was taken.

What does this split mean to practitioners and researchers? "Further experimentation with
treasury auction design, particularly in countries where the need for cost-effective allocation
of public debt is even more acute than in the United States, is warranted," suggest Bartolini
and Cottarelli. In addition, researchers of auctions may need to consider the disparity
between their findings and the actual conduct of treasury auctions worldwide. More accurate
and comprehensive models of treasury auctions may emerge from this appraisal, the authors
conclude.
View entire article in Adobe Acrobat.

Table of Contents EconomicPolicyReview Staff Report Summaries What'sNew Also Available

October 1997

Macroeconomic Announcements Trigger an Extended
Price Formation Process in the U.S. Treasury Market
Much of what we know about price formation and liquidity in financial markets is based on
circumstantial evidence from equity markets. In these markets, price changes often occur as a
result of private information that cannot be directly observed. By contrast, in the U.S.
Treasury market, price variability is largely
The recent availability of data from the driven by observable public information such
as macroeconomic announcements.
U.S. Treasury market allows us to
With this difference in mind, the authors of
examine in a new light how secondary "Price Formation and Liquidity in the U.S.
markets form prices and provide liquidity. Treasury Market: Evidence from Intraday
Patterns around Announcements" (Staff
Reports, no. 27) draw on newly available,
high-frequency data to explore how major macroeconomic announcements affect price
volatility, trading volume, and bid-ask spreads in the U.S. Treasury market.
"Our analysis suggests that major announcements set off an extended price formation
process," report Michael Fleming and Eli Remolona. The sharpest price adjustments take
place in the first few moments of the process and occur without a rise in trading volume—a
pattern not seen in the stock market. The lack of trading volume suggests that the change in
expectations caused by public announcements is widely shared among market participants.
During the moments in which prices adjust sharply to public information, the market also
suffers a dramatic liquidity loss, the authors note. The most illiquid time coincides with the
volatility spike in the first minute after the announcement, when the bid-ask spread is nearly
six times wider than its average on nonannouncement days. Liquidity returns about two
minutes after the announcement, with the spread narrowing sharply. By three minutes, the
spread is no longer significantly different from the nonannouncement day average, and
trading volume begins to surge. The rise in trading volume suggests wide disagreement
among dealers regarding the initial price adjustment.
Price volatility and trading volume both remain high for over an hour after a major
announcement as the market attempts to resolve disagreement among investors. The period
of high trading volume, however, appears to last longer than that of high volatility. Why
might extensive trading continue well after prices have stabilized? Fleming and Remolona
suggest that liquidity trading by investors who react with a lag to the price changes may
cause high volume to outlast high volatility.
Order Staff Report, no. 27.

E-Mail Addresses

Members of the Federal Reserve Bank of
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Group can be reached via e-mail at
firstname.lastname@ny.frb.org.

Table of Contents EconomicPolicyReview Current Issues Summaries What'sNew Also Available

October 1997

WHAT'S NEW?
Coming Soon: Second District Highlights
The Research and Market Analysis Group is pleased to announce Second District
Highlights, a regional supplement to the newsletter Current Issues in Economics and
Finance.
Second District Highlights will report on financial and economic developments in the
Second District, including employment growth, industry trends, income distribution, and
business conditions. In addition, each issue will feature a one-page regional update—a series
of charts tracking changes in six major economic indicators.
In the first issue, "The New York-New Jersey Job Recovery," James Orr and Rae Rosen
analyze employment growth by sector in the region since 1993. Overall, the authors present a
picture of modest but uneven growth, with the New York City metropolitan area creating the
bulk of new jobs. Look for Second District Highlights later this month.
Dorothy Meadow Sobol is the editor of Current Issues in Economics and Finance and
Second District Highlights.

The Areas of the
Second District
The Second Federal Reserve District
encompasses New York State, the twelve
northern counties of New Jersey, Fairfield
County in Connecticut, Puerto Rico, and
the Virgin Islands. The Second District is
one of twelve Districts established under
the Federal Reserve System.

Also on the Regional Economy
For those interested in monitoring Second District economic trends more closely, the
Research and Market Analysis Group has just introduced a regional economy web site.
Here, users will find a wide range of information on the region, including reports on the
Second District's major economic indicators, updates to the Bank's employment forecast, a
schedule of release dates for regional data, and descriptions of related government
publications. In addition, the site offers detailed maps of the Second District's metropolitan
statistical areas and listings of relevant Fed publications. Links to other resources, such as the
state departments of labor and the U.S. Bureau of Labor Statistics, are also available.

For a broader view of the economy, users can consult the Beige Book, the Federal Reserve's
periodic report on regional trends throughout the United States. They can also link to the U.S.
Census Bureau's statistical profile of all U.S. states and counties.
Jason Bram, an economist in the Domestic Research Function, oversees the content of the
new regional site.

Upcoming Conferences at the New York Fed
November 13-14: Excellence in Education: Views on Improving American Education.
Top academic researchers in the education field and members of the education community
will participate in a forum devoted to improving the quality of public school education.
Discussions will focus on educational resources and outcomes, competition and choice in
education, public and private school comparisons, and the role of education standards.
Scheduled speakers include New York City Schools Chancellor Rudy Crew and Federal
Reserve Bank of New York President William J. McDonough.
The conference proceedings will be published in a special volume of the Bank's Economic
Policy Review. For more information, please contact joseph.tracy@ny.frb.org.
February 26-27: Financial Services at the Crossroad: Capital Regulation in the TwentyFirst Century. The conference, cosponsored by the Bank of England, the Bank of Japan, and
the Board of Governors of the Federal Reserve System, will provide an opportunity for
researchers, bank supervisors, and industry practitioners to discuss issues relating to the role
of capital in financial institutions, regulatory capital standards, and internal capital allocation.
Topics will include the assumptions and motivations underlying various proposals for
regulatory capital standards for banks and other financial institutions, innovations in methods
used by financial firms for internal capital allocation, and capital standards for banks in
emerging economies.
A special issue of the Bank's Economic Policy Review will be devoted to the conference
proceedings. For more information, please contact beverly.hirtle@ny.frb.org.
March 27-28: The Consolidation of the Financial Services Industry. Academics and
practitioners from the United States and abroad will present and discuss the latest research on
the causes and consequences of consolidation in the financial services industry. The
conference will cover a wide range of topics, including the expansion of banking powers and
the regulation and supervision of multipurpose financial institutions, international mergers
and financial market globalization, the effect of bank consolidation on credit availability, and
the consequences of consolidation for the payments system.
The conference proceedings will be published in a special issue of the Journal of Banking
and Finance. For more information, please contact philip.strahan@ny.frb.org.

Recently Published
Angelos A. Antzoulatos. "On the Excess Sensitivity of Consumption to Information about
Income." Journal of Macroeconomics 19, no. 3.
Rebecca S. Demsetz and Philip E. Strahan. "Diversification, Size, and Risk at Bank
Holding
Companies." Journal of Money, Credit, and Banking 29, no. 3.

Arturo Estrella and Frederic S. Mishkin. "Is There a Role for Monetary Aggregates in the
Conduct of Monetary Policy?" Journal of Monetary Economics 40.
Arturo Estrella and Frederic S. Mishkin. "The Predictive Power of the Term Structure
of Interest Rates in Europe and the United States: Implications for the European
Central Bank." European Economic Review 41, no. 7.
Carol Osler. "Charting: Chaos Theory in Disguise?" Journal of Futures Markets 17, no. 5.
Carol Rapaport. "Housing Demand and Community Choice: An Empirical Analysis."
Journal of Urban Economics 42, no. 2.
Philip E. Strahan. "The Role of Monitoring in Mitigating Moral Hazard Problems
Associated with Government Guarantees: Evidence from the Life Insurance Industry," with
Elijah Brewer and Thomas H. Mondschean. Journal of Risk and Insurance 64, no. 2.
Kei-Mu Yi. "Is There Endogenous Long-Run Growth? Evidence from the United States
and the United Kingdom," with Narayana Kocherlakota. Journal of Money, Credit,
and Banking 29, no. 2.

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

October 1997

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

Economic Policy Review
Volume 3, Number 2 (July)
Creating an Integrated Payment System: The Evolution of Fedwire, by Adam M. Gilbert,
Dara Hunt, and Kenneth C. Winch
The Round-the-Clock Market for U.S. Treasury Securities, by Michael J. Fleming
Market Returns and Mutual Fund Flows, by Eli M. Remolona, Paul Kleiman, and Debbie
Gruenstein
The Evolving External Orientation of Manufacturing: A Profile of Four Countries, by José
Campa and Linda S. Goldberg
Credit, Equity, and Mortgage Refinancings, by Stavros Peristiani, Paul Bennett, Gordon
Monsen, Richard Peach, and Jonathan Raiff

Current Issues in Economics and Finance
The Market to the Rescue? The Promise—and the Price—of the New Social Security
Investment Proposals, by Susan Miller
Volume 3, Number 10 (August)
Do Rising Labor Costs Trigger Higher Inflation? by David A. Brauer
Volume 3, Number 11 (September)

Staff Reports
Traders' Broker Choice, Market Liquidity, and Market Structure, by Sugato Chakravarty and
Asani Sarkar
Number 28 (August)
Agency Problems and Risk Taking at Banks, by Rebecca S. Demsetz, Marc R. Saidenberg,
and Philip E. Strahan
Number 29 (September)

Research Papers
Market Liquidity and Trader Welfare in Multiple Dealer Markets: Evidence from Dual
Trading Restrictions, by Peter R. Locke, Asani Sarkar, and Lifan Wu
Number 9721 (July)
Retail Inventories, Internal Finance, and Aggregate Fluctuations: Evidence from Firm-Level
U.S. Data, by Egon Zakrajsek
Number 9722 (July)

Is There an Inflation Puzzle? by Cara S. Lown and Robert W. Rich
Number 9723 (August)
Rational Herding and the Spatial Clustering of Bank Branches: An Empirical Analysis, by
Angela Chang, Shubham Chaudhuri, and Jith Jayaratne
Number 9724 (August)
The Slope of the Credit Yield Curve for Speculative-Grade Issuers, by Jean Helwege and
Christopher Turner
Number 9725 (August)
Non-Linear Consumption Dynamics, by Angelos A. Antzoulatos
Number 9726 (August)
Technology, Trade, and Growth: Some Empirical Findings, by Michelle Connolly
Number 9727 (September)
Macroeconomic Forecasts under the Prism of Error-Correction Models, by Angelos A.
Antzoulatos
Number 9728 (September)
Do Better Schools Matter? Parental Valuation of Elementary Education, by Sandra Black
Number 9729 (September)
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.

Table of Contents Economic Policy Review Current Issues Summaries Staff Report Summaries What'sNew