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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

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ba 580 interest rates

BA 580-Interest Rates

Examining the Fed’s Influence on Rates

fed powers an urban legend
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
Mechanics of Fed Increasing Money-Credit

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 figures
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
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
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
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
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
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
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
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
“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