Transcript Chapter 6

Chapter 6
Introduction to Monetary Policy
Interest Rates as an Equilibrating
Mechanism
• Theoretically, “the” interest rate equilibrates
investment and saving, and hence the product
and income sides of the economy
• However, there are many interest rates. In
particular, long and short term rates have
different characteristics.
• The yield spread between these rates is an
important determinant of GDP.
• In practice this means the availability as well as
the cost of credit are both important.
Monetary Policy
• Monetary policy is supposed to adjust the
cost and availability of credit to keep
inflation at low stable levels and keep real
growth growing at its maximum
sustainable rate.
• When used properly, monetary policy
mitigates and reduces business cycles.
Only rarely does it intensify them.
Tools of Monetary Policy
• The tools of monetary policy utilized by the
central bank – in the U.S., the Federal
Reserve Bank – have changed
substantially over the past decades.
• Currently, the major tool of monetary
policy is the change in the Federal funds
rate. The Fed can also buy or sell
Treasury securities to influence the
amount of bank credit available.
Goals of Monetary Policy
• Central bankers often state that their only
goal is to keep inflation at low, stable
levels.
• However, in fact, they are generally
required to ease policy when real GDP
declines and the unemployment rate rises.
• Also, they should always insure an
adequate flow of liquidity for the needs of
commerce and industry
Can/Should the Fed Try to Control
Fluctuations in the Stock Market?
• “Moral suasion” and statements about
“irrational exuberance” have proved
spectacularly unsuccessful. Exhortations to buy
stock when prices are low have never been
successful either.
• However, if the stock market seems too high, the
Fed could substantially boost interest rates.
• It could also raise margin requirements on
stocks, although that is usually consider a
“sledgehammer” approach that was not tried
even in the runaway market of 2000.
The Federal Funds Rate
• The determinants of the Federal funds rate
have varied substantially under different
Fed chairman.
• Since Alan Greenspan became chairman
of the Fed in mid-1987, however,
fluctuations in the funds rate have been
closely tied to the rate of core inflation, the
growth rate, and the unemployment rate.
The Taylor Rule
• Empirically, this relationship was first proposed by John
Taylor in the early 1990s and has been reestimated
many times since then.
• Currently, the regression shows that the if the economy
were at full employment (4% unemployment) and
growing 4% per year, the Federal funds rate would be
2% plus 2 times the rate of inflation. Every 1% rise in
the unemployment reduces the Fed funds rate by 2%
(these coefficients change slightly over time).
• Thus for 2% inflation, the Fed funds rate would be set at
6%. If the unemployment rate rose to 6%, the funds rate
would then fall to 2%, and it would fall to 1% if the
unemployment rate rose to 6 ½%, as happened in 2003.
Credit Availability
• The role of the banking system has changed
substantially since it was deregulated in 1982.
• Most bank deposits are no longer are subjected
to ceiling interest rates, which had restricted the
amount of deposits they could attract.
• Currently, individual banks may offer whatever
interest rate they think is appropriate to attract
deposits.
• In that case, where are the constraints?
Restraints on Bank Credit
• When interest rates rise, consumers and
businesses are likely to borrow less
because of the higher cost or repayment.
• In the late 1980s, improper and possibly
illegal loans made by some banks caused
much stricter regulation, and a cutback in
the amount of money banks would lend.
• Earlier, credit controls were imposed in
1980, but the authority has since lapsed.
How the Yield Spread Affects
Economic Activity
• Suppose the Fed boosts the funds rate
above the government bond rate.
• Banks would then be more likely to invest
in short-term assets with no market risk
and no default risk.
• Borrowers are more likely to default on
loans at high interest rates.
• As a result, banks make fewer loans, and
real growth declines.
What Determines Bond Yields
• Short-term rates are closely correlated with the rate of
inflation and the rate of unemployment.
• The spread between long and short-term rates varies
substantially over the business cycle.
• Thus, other factors must determine bond yields.
• The principal factor is the expected rate of inflation.
• While expectations can never be measured or predicted
exactly, that expected rate generally depends on the
current stance of monetary policy and the size of the
Federal government budget surplus or deficit relative to
GDP (the budget ratio).
The Importance of the Budget
Ratio
• In 2002 and 2003, the Federal budget deficit
increased significantly, yet both short and longterm interest rates declined sharply.
• An increase in the budget deficit does not raise
interest rates during periods of economic slack
and a large trade deficit.
• An increase in the budget deficit does raise
interest rates if it boosts the expected rate of
inflation. If investors think large deficits now will
lead to higher inflation later, the yield spread will
widen. If they do not think inflation will rise, it will
be unaffected.
How Current Monetary Policy
Affects Expectations
• As long as the Fed retains credibility that it will
tighten as soon as inflationary pressures start to
build, negative real interest rates will not
necessarily worsen inflationary expectations.
• During the 1960s and 1970s, it was widely
believed that the Fed funds rate would lag
behind inflation, so bond rates rose in
anticipation of higher inflation. Since the mid1980s, that has no longer been the case.
Transmission of Monetary Policy
(case of tightening)
• Higher Cost of Debt Capital
• Reduced Availability of Bank Loans
• Negative Impact of Lower Stock Prices on
Equity Capital
• Negative Impact of Lower Stock Prices on
Availability of Bank Loans
Higher Cost of Debt Capital
• Key link is the rise in real interest rates.
• Capital spending declines because
projects must now generate a higher rate
of return.
• Consumer spending declines because the
cost of time payments increases.
• Higher interest rates generally boost the
value of the dollar, which decreases net
exports.
Reduced Availability of Bank Loans
• Higher interest rates cause banks to
reduce their loans to consumers and
businesses.
• Higher interest rates also boost the cost of
debt service, hence diminishing profit
margins.
Negative Impact of Lower Stock
Prices on Equity Capital
• When the cost of equity capital rises,
many firms – especially smaller firms and
those in the high-tech sector – cannot
raise money through stock offerings.
• In businesses where “the assets go down
the elevator every night”, banks are less
likely to offer business loans based on
existing assets, so equity capital financing
becomes increasingly important.
Negative Impact of Lower Stock
Prices on Bank Loans
• When the stock market declines, the
perceived risk of failure of smaller firms
rises, so banks are less likely to offer
loans.
• Also, as equity falls, the debt/equity ratio
of many firms rises, putting them in danger
of violating loan covenants, hence further
reducing the opportunities for financing.
The Yield Spread as a Predictive
Tool
• Ever since 1969, an inverted yield curve
has always been followed by a recession
the next year in the U.S. economy. There
are no exceptions to this rule.
• Furthermore, there has never been a
recession that has not been preceded by
an inverted yield curve.
The “Conundrum”
• If the Fed boosts the funds rate but it is still
below equilibrium as defined by the Taylor rule,
inflationary expectations may remain high,
necessitating further hikes in that rate.
• However, once the Fed has boosted the rate
high enough that inflationary expectations have
subsided, the funds rate is now too high and
needs to be reduced. However, lowering it too
quickly will rekindle inflationary expectations.