This dissertation comprises of three chapters on macroeconomics, monetary policy, and Bayesian econometrics. The first and third chapters make use of financial time series and traded market price data that explicitly represent allocation choices and beliefs of rational capital market agents, and apply Bayesian modeling and estimation to answer questions about monetary policy and optimal asset allocation. The second chapter examines the concept of negative borrowing rates in light of central bank actions taken during the COVID crisis using a theoretical model. A common thread of the three essays is the exploration of financial markets and the global macroeconomic concepts of the day.
Chapter 1 is an empirical analysis of the influence of market expectations on the Federal Reserve’s monetary policy decisions. There is a well-established literature using the unanticipated component of fed funds target changes to identify monetary policy shocks. However, the dimensions through which ex ante market expectations affect Fed policy decisions themselves have not been carefully studied. I explore their effects on 127 FOMC target announcements between 1994 and 2008 using Bayesian estimation of a two-equation ordered probit model. I find strong evidence that market expectations have a meaningful influence on FOMC outcomes. These findings are robust across a variety of model specifications and empirically show the magnitude of financial markets’ sway on FOMC policy decisions.
The second chapter examines the efficacy of implementing dual interest rates as a novel unconventional monetary policy tool. Global central banks have typically responded to the zero lower bound with unconventional monetary policies such as forward guidance and quantitative easing. During the COVID-19 pandemic, the European Central Bank offered term lending programs at minus 1 percent, which is below that of their deposit facility, implicitly introducing a novel tool – a separately targeted economy-wide benchmark lending rate. Using a financial accelerator model, I analyze the effects of removing the ZLB on lending rates while deposit rates are kept floored at zero and show that the added ability to support asset prices vis-à-vis aggregate net worth helps greatly diminish output shortfalls due to the ZLB constraint.
The last chapter introduces a novel, unifying structural dynamic factor model of asset returns. Principal component analysis is applied on a large breadth of macroeconomic indicators to estimate latent factors representing economic activity, inflation, interest rates, trade, and volatility. The returns of six asset classes are jointly modeled using the macro factors in a time-varying parameters with stochastic volatility model and estimated using Bayesian techniques. Monthly unconditional covariance matrices are generated from October 1993 to September 2022 and used to produce cross-asset correlation estimates. Out-of-sample testing is conducted on a minimum variance asset allocation strategy based on the model covariance matrix estimator and shown to produce superior Sharpe ratio performance over other benchmark portfolio optimization heuristics. As an additional empirical application of the model, I apply k-means clustering on the macro factors to characterize shifting cross-asset correlations across different market regimes.