Transcript Fed & Rates

BA 580-Interest Rates
Examining the Fed’s Influence
on Rates
Fed Powers: An Urban Legend?
Fed is an important institution
– Power to Create Money!!!
Media, Congress, …
– Impute near god-like powers
– Operate on past ideas and little sense of
history
– Reduce complex issues to sound bytes and
easy metaphors
Mechanics of Fed Increasing Money-Credit
Fed-FOMC
Inflation & Interest Targets
NY-Fed Trading Desk
Purchase (Sell) Treasury Securities
20+ Primary Securities Dealers
Key Variables in Ultimate Effect on Amount of
Money-Credit:
-- Size of “Base Money” Increase by Fed
-- Loan to Deposit ratio of Banks
-- Currency to Deposit ratio of firms/public
Deposit by Seller of Treasury
Reserves Bank X Increase
Firm A Borrows $10 mil;
Deposits $ million in Bank K
Firm B Borrows $8 mil.;
Deposits $7 mil. Bank T;
Firm C Borrows $1 mil. In Comm. Paper;
Reserves Bank Y Increase
Reserves Bank Z Increase
Some Money-Credit Figures
Vault Cash = $35-$45 billion
Bank Reserves (vault & Fed) = $100 billion
(NBR about half)
M-Base (currency + reserves) = $800+ billion
M1 (currency + checking) = $1.4 trillion
MZM2 (M1 + retail mmmf, … ) = $7 trillion
Total Credit = $35 trillion
Effects of Fed on Rates
So, Fed wants rates lower
– Increases M-Base by appropriate amount
– Supply of credit increases
– Interest rates fall
Not Quite so Simple
– Remember: R = r + Pe
– Money-Inflation (infl. Expectations) link?
– Money “real rates” link?
Money: Supply, Demand, & Inflation
Price Level & inflation rate reflect value of $ and
changes in its value
– Higher Avg. prices (inflation), value of $ lower
Demand/Supply of $ determines value per unit
($)
– Higher M-Supply, lower value each $
– Higher M-Demand, higher value each $
Main determinants M-Demand:
– Income-wealth; payment technology; infl. Expectations;
Over 2+ years, M- Supply main influence
(variations in M-demand offset each other)
– Cross-country evidence strong
– As inflation grows, relationship near 1:1
Price Level & Inflation
(A Related View)
M*V = P*y
-- (amount of $ * frequency $ used each period
equals total spending in period – prices * y)
-- V = velocity = frequency $ used in period
Rearranged: P = (M*V)/y
% change P = % change M * % change V - %
change y
– Check out irates.xls for confirmation
– Increases in M-supply increase P; increases in V
increase P; increases in y decrease P, if other
influences are held steady
Fed, Prices, & Rates
So what?
R = r + Pe
– Higher M-supply increases P and Pe
– This is opposite of publicized effect of “looser
monetary” policy
Fed’s Control Over in Inflation
– Short term volatility in velocity & income make perfect
inflation targeting impossible (see irates.xls)
– Long term very strong (Long term velocity & income
effects minimal because they tend to have ups and
downs)
Fed & Non-inflation Impacts on Markets
Long term, all agree higher inflation is only
impact of creating more money
Short term:
– Can the Fed help reduce s.t. liquidity crises?
Yes: 1987; 1998 Russian-Asian Crisis
This called “Lender of Last Resort” Function
– Can the Fed get markets to lower rates by
injecting more money?
In effect, can Fed get markets to react to more
money as if more real saving taking place without
inflation expectations more than offsetting?
Fed & “Real” Effects
Pre-Depression Answer
– No, money only effects inflation
Post-Depression Answer
– Yes, injecting money one means of offsetting unwanted
economic downturns
Stagflation: 1970s & Early 1980s provided strong
evidence against – money growth high – high inflation &
interest while economic growth low (or negative) – see
STL Fed reading on “Volker Revolution”
Current “Consensus”
– Fed Can Have S.T. effects (see readings)
Difficult to predict size (market forces, even beyond inflation hard to
manage)
Difficult to sustain (markets begin to catch on if policy becomes
regular and predictable)
Evidence from “Greespan” Era
Fed Fund Rate: Too Much Attention?
Fixation on FF Rate
– M-injections and Size of Bank (FF) Reserves
– Most closely watched of all rates wrt Fed
– Remember: discount rate only Fed-set rate
Do FF Rates Initiate or Respond to Changes in
Other Rates?
– STL Fed Article
– Irates.xls data on FF-TBill rates and FF-LIBOR rates
connections
Past FF Changes
TBill Changes (11%)
Past Tbill Changes
FF Changes (24%)
Past FF Changes
LIBOR Changes (14%)
Past LIBOR Changes
FF Changes (30%)
Makes sense, broader markets
“Fedspeak” and Interpretations of FedSpeak
Policy Objectives v. Methods
– Fed Objectives (current):
General: low inflation-steady l.t. growth
Specific: 1) low inflation-avoid deflation; 2) manage liquidity crises; 3) (rarely)
try to influence real rates to boost economy
– Methods: issues about “targeting” inflation or rates; how to best monitor
inflation; …
Media (& Congress)
– Treat Fed as nearly sole determining influence
– fixate on # 3 (“easing”, “tightening”, …)
– plus get methods (tactics) mixed in with objectives
Fed Chairman (to Media & Congress)
– “Political Speech” – accommodate views of listeners
– Fixate on mechanics
Value of reading people such as Meltzer from St. Louis Fed – insider
with analytical & historical insights but not appearing before Fed