BA 580-Interest RatesBA 580-Interest Rates

Examining the Fed’s Examining the Fed’s Influence on RatesInfluence on Rates

Fed Powers: An Urban Legend?Fed Powers: An Urban Legend?

Fed is an important institutionFed is an important institution– Power to Create Money!!!Power to Create Money!!!

Media, Congress, …Media, Congress, …– Impute near god-like powersImpute near god-like powers– Operate on past ideas and little sense of Operate on past ideas and little sense of

historyhistory– Reduce complex issues to sound bytes Reduce complex issues to sound bytes

and easy metaphorsand easy metaphors

Mechanics of Fed Increasing Money-CreditMechanics of Fed Increasing Money-Credit

Fed-FOMCInflation & Interest Targets

NY-Fed Trading Desk Purchase (Sell) Treasury Securities

20+ Primary Securities Dealers

Reserves Bank Y Increase

Reserves Bank Z Increase

Deposit by Seller of TreasuryReserves 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;

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

Some Money-Credit FiguresSome Money-Credit Figures

Vault Cash = $35-$45 billionVault Cash = $35-$45 billion

Bank Reserves (vault & Fed) = $100 billion Bank Reserves (vault & Fed) = $100 billion (NBR about half)(NBR about half)

M-Base (currency + reserves) = $800+ billionM-Base (currency + reserves) = $800+ billion

M1 (currency + checking) = $1.4 trillionM1 (currency + checking) = $1.4 trillion

MZM2 (M1 + retail mmmf, … ) = $7 trillionMZM2 (M1 + retail mmmf, … ) = $7 trillion

Total Credit = $35 trillion Total Credit = $35 trillion

Effects of Fed on RatesEffects of Fed on Rates

So, Fed wants rates lowerSo, Fed wants rates lower– Increases M-Base by appropriate Increases M-Base by appropriate

amountamount– Supply of credit increasesSupply of credit increases– Interest rates fallInterest rates fall

Not Quite so SimpleNot Quite so Simple– Remember: R = r + PRemember: R = r + Pee – Money-Inflation (infl. Expectations) link?Money-Inflation (infl. Expectations) link?– Money “real rates” link? Money “real rates” link?

Money: Supply, Demand, & InflationMoney: Supply, Demand, & Inflation

Price Level & inflation rate reflect value of $ and Price Level & inflation rate reflect value of $ and changes in its valuechanges in its value– Higher Avg. prices (inflation), value of $ lowerHigher Avg. prices (inflation), value of $ lower

Demand/Supply of $ determines value per unit Demand/Supply of $ determines value per unit ($)($)– Higher M-Supply, lower value each $Higher M-Supply, lower value each $– Higher M-Demand, higher value each $Higher M-Demand, higher value each $

Main determinants M-Demand:Main determinants M-Demand:– Income-wealth; payment technology; infl. Expectations; Income-wealth; payment technology; infl. Expectations;

Over 2+ years, M- Supply main influence Over 2+ years, M- Supply main influence (variations in M-demand offset each other)(variations in M-demand offset each other)– Cross-country evidence strongCross-country evidence strong– As inflation grows, relationship near 1:1As inflation grows, relationship near 1:1

Price Level & InflationPrice Level & Inflation(A Related View)(A Related View)

M*V = P*yM*V = P*y-- (amount of $ * frequency $ used each period -- (amount of $ * frequency $ used each period

equals total spending in period – prices * y)equals total spending in period – prices * y)-- V = velocity = frequency $ used in period-- V = velocity = frequency $ used in period

Rearranged: P = (M*V)/yRearranged: P = (M*V)/y% change P = % change M * % change V - % % change P = % change M * % change V - % change ychange y– Check out irates.xls for confirmationCheck out irates.xls for confirmation– Increases in M-supply increase P; increases in V Increases in M-supply increase P; increases in V

increase P; increases in y decrease P, if other increase P; increases in y decrease P, if other influences are held steadyinfluences are held steady

Fed, Prices, & RatesFed, Prices, & Rates

So what?So what?

R = r + PeR = r + Pe– Higher M-supply increases P and PeHigher M-supply increases P and Pe– This is opposite of publicized effect of “looser This is opposite of publicized effect of “looser

monetary” policymonetary” policy

Fed’s Control Over in InflationFed’s Control Over in Inflation– Short term volatility in velocity & income make perfect Short term volatility in velocity & income make perfect

inflation targeting impossible (see irates.xls)inflation targeting impossible (see irates.xls)– Long term very strong (Long term velocity & income Long term very strong (Long term velocity & income

effects minimal because they tend to have ups and effects minimal because they tend to have ups and downs)downs)

Fed & Non-inflation Impacts on MarketsFed & Non-inflation Impacts on Markets

Long term, all agree higher inflation is only Long term, all agree higher inflation is only impact of creating more moneyimpact of creating more money

Short term: Short term: – Can the Fed help reduce s.t. Can the Fed help reduce s.t. liquidityliquidity crises? crises?

Yes: 1987; 1998 Russian-Asian Crisis Yes: 1987; 1998 Russian-Asian Crisis

This called “Lender of Last Resort” FunctionThis called “Lender of Last Resort” Function

– Can the Fed get markets to lower rates by Can the Fed get markets to lower rates by injecting more money?injecting more money?

In effect, can Fed get markets to react to more In effect, can Fed get markets to react to more money as if more real saving taking place without money as if more real saving taking place without inflation expectations more than offsetting? inflation expectations more than offsetting?

Fed & “Real” EffectsFed & “Real” Effects

Pre-Depression AnswerPre-Depression Answer– No, money only effects inflationNo, money only effects inflation

Post-Depression AnswerPost-Depression Answer– Yes, injecting money one means of offsetting unwanted Yes, injecting money one means of offsetting unwanted

economic downturnseconomic downturns

Stagflation: 1970s & Early 1980s provided strong Stagflation: 1970s & Early 1980s provided strong evidence against – money growth high – high inflation & evidence against – money growth high – high inflation & interest while economic growth low (or negative) – see interest while economic growth low (or negative) – see STL Fed reading on “Volker Revolution”STL Fed reading on “Volker Revolution”Current “Consensus”Current “Consensus”– Fed Can Have S.T. effects (see readings)Fed Can Have S.T. effects (see readings)

Difficult to predict size (market forces, even beyond inflation hard to Difficult to predict size (market forces, even beyond inflation hard to manage)manage)Difficult to sustain (markets begin to catch on if policy becomes Difficult to sustain (markets begin to catch on if policy becomes regular and predictable)regular and predictable)

Evidence from “Greespan” EraEvidence from “Greespan” Era

Fed Fund Rate: Too Much Attention?Fed Fund Rate: Too Much Attention?

Fixation on FF RateFixation on FF Rate– M-injections and Size of Bank (FF) ReservesM-injections and Size of Bank (FF) Reserves– Most closely watched of all rates wrt FedMost closely watched of all rates wrt Fed– Remember: discount rate only Fed-set rateRemember: discount rate only Fed-set rate

Do FF Rates Initiate or Respond to Changes in Do FF Rates Initiate or Respond to Changes in Other Rates?Other Rates?– STL Fed ArticleSTL Fed Article– Irates.xls data on FF-TBill rates and FF-LIBOR rates Irates.xls data on FF-TBill rates and FF-LIBOR rates

connectionsconnectionsPast FF Changes TBill Changes (11%)Past FF Changes TBill Changes (11%)Past Tbill Changes FF Changes (24%)Past Tbill Changes FF Changes (24%)Past FF Changes LIBOR Changes (14%)Past FF Changes LIBOR Changes (14%)Past LIBOR Changes FF Changes (30%)Past LIBOR Changes FF Changes (30%)

Makes sense, broader marketsMakes sense, broader markets

““Fedspeak” and Interpretations of FedSpeakFedspeak” and Interpretations of FedSpeak

Policy Objectives v. MethodsPolicy Objectives v. Methods– Fed Objectives (current): Fed Objectives (current):

General: low inflation-steady l.t. growthGeneral: low inflation-steady l.t. growthSpecific: 1) low inflation-avoid deflation; 2) manage liquidity crises; 3) (rarely) Specific: 1) low inflation-avoid deflation; 2) manage liquidity crises; 3) (rarely) try to influence real rates to boost economytry to influence real rates to boost economy

– Methods: issues about “targeting” inflation or rates; how to best monitor Methods: issues about “targeting” inflation or rates; how to best monitor inflation; …inflation; …

Media (& Congress) Media (& Congress) – Treat Fed as nearly sole determining influenceTreat Fed as nearly sole determining influence– fixate on # 3 (“easing”, “tightening”, …)fixate on # 3 (“easing”, “tightening”, …)– plus get methods (tactics) mixed in with objectivesplus get methods (tactics) mixed in with objectives

Fed Chairman (to Media & Congress)Fed Chairman (to Media & Congress)– ““Political Speech” – accommodate views of listenersPolitical Speech” – accommodate views of listeners– Fixate on mechanicsFixate on mechanics

Value of reading people such as Meltzer from St. Louis Fed – Value of reading people such as Meltzer from St. Louis Fed – insider with analytical & historical insights but not appearing before insider with analytical & historical insights but not appearing before FedFed