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-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