BA 580-Interest Rates

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# BA 580-Interest Rates - PowerPoint PPT Presentation

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

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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
• Reduce complex issues to sound bytes and easy metaphors
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
• 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: 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
• No, money only effects inflation
• 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%)
“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