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Understanding Macro-Finance for Strategic Managers: Fed Targets and Market Influences

Gain insights into the Federal Reserve's operational targets and tools, such as interest rates and money supply manipulation. Explore the Taylor Rule and market influences on rates, while analyzing risks and policy limits. Delve into the 2008 financial crisis and mortgage debt intricacies, understanding the importance of debt ratios and currency dynamics in evaluating fiscal stability. Anticipate future scenarios for the U.S. and global economies in the context of debt-induced crises.

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Understanding Macro-Finance for Strategic Managers: Fed Targets and Market Influences

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  1. Highlighting a Few Key Ideas and Issues Macro-Finance for Managers II

  2. Making Sense of the Fed

  3. Background: Fed Targets • Strategic Targets • Inflation (low, stable); Unemployment (low) • “Dual Mandate” by law • Weight between the two matter of debate and policy (Phillips Curve issues) • Operational Target: Interest Rates • “Discount Rate”: only rate actually set by the Fed is the Other rates are merely influenced by Fed policy • Fed Funds Rate: primary target rate • Target FF rate set at Fed (FOMC) meetings • Effective FF rate set between banks using excess funds held on account with Fed • Don’t pay too much attention to Fed rhetoric (political speech)

  4. Background: Fed Tools • Money Supply (primary tool) • No interest rate “knob” to adjust • Manipulates buying and selling Treasury bills/bonds (“Open Market Operations”) • During 2007-09 Crisis, Fed engaged in other, non-traditional ways of providing liquidity to short term lending markets

  5. How Should Fed Set FF Target?How Does Fed Set FF Target? • “Taylor Rule” • Stanford economist John Taylor • Prescribing how Fed should set rate targets • Fairly accurate in describing Fed target setting 1983-2007 Target Fed Funds Rate = 2 + 0.5*(Actual Inflation – Target Inflation) + 0.5*(Actual GDP – Potential GDP) • “2” comes from long run average “real” rate • TR: Lower FF Target when GDP growth below target (+ reverse) • TR: Raise FF Target when economy inflation above target ( + reverse) • Implies FF Target driving other short term rates • (Effective Fed Funds, Tbill Rates, Commercial Paper Rates)

  6. Market Influences on Rates • Fisher Equation Market Rates = Real Rates + Expected Inflation • Expected inflation influenced by inflation and market perceptions of Fed actions • For expected inflation: Nominal Treasury Rate – TIPS Rate • Inflation/Expectations can swamp Fed actions: • 1970s: Fed expands money to lower unemployment but …

  7. 1970s: Market Dominates Fed Targets

  8. Policy Limits: Phillips Curve Tradeoff Vanishes As Fed Tries to Use It More

  9. Market Influences on Rates • Fisher Equation Market Rates = Real Rates + Expected Inflation • Real rates reflect supply/demand for credit • Influenced by economic growth (higher when growth higher) • Estimate of Real Rate: See TIPS Rates (See Bloomberg Rates) • Markets can pull Fed FF Target, not just pushed by it

  10. 2008: Markets Dominate Fed Targets

  11. Worldwide Fiscal-Monetary Problems Risks Ahead

  12. Europe Now, Japan Around the Corner:http://www.econbrowser.com/archives/2012/08/how_long_can_ja.htmlhttp://media.chicagobooth.edu/mediasite/Viewer/?peid=f15d95d054e8442ab0cc1c60321383101d

  13. Policy Limits & Risks • Expected PV of Liabilities < = Expected PV of Assets • Liabilities = Money + Bonds • Assets = Discounted PV Expected Tax Revenue – Spending • When Markets Come to Evaluate M + B growth as much larger than Present Value of (Tax Revenue - Spending) • Debt-Currency-Inflation Crisis • Germany 1920s, Mexico 1990s, Greece 2011 (no local currency) • Views/markets tend to switch all at once – “Peso Problem”

  14. Evaluating Problems • Debt/GDP ratio useful but • Future GDP growth (tax revenues) • Possible future spending reductions • Demand for currency-debt matters in determining rates/interest payments • Outlook/Evaluation • Spain, Italy, Ireland, … France • Japan • U.S.

  15. … U.S. Down the Line • Implication: U.S. Treasuries

  16. 2008 Crash

  17. Glance at Financial Crisis of 08:Debt, Debt, and More Debt

  18. Mortgage Debt + A Whole Lot More

  19. Role of Commercial Lending:Vegas City Center ($10B) Bond/Loan Financed

  20. Why So Much Debt? • Cheap Credit • Public Sector Backing (Fannie, Freddie, Homeownership) • High Leverage (Assets/Equity) for Investment Banks (Bear, Lehman, Merrill …) + AIG • Banks Lending on 25 years of growth/repayment • Foreign Investment in US • NOTARIETY BUT TOO SMALL • Securitization (Collateralized Debt: CDOs) • Derivatives (Credit Default Swaps) • Market-to-Market Accounting

  21. Who So Much Attention on Mortgages as Cause? • Mortgage-related securities marked-to-market daily • Immediately begin to reflect deteriorating conditions in 2007 • Commercial loans on bank books valued by banks at their PV of expected cash flow • Widespread writing down of these loans doesn’t begin until 2009, giving appearance that mortgage market problems causing these problems • Problems already developing coincidental with mortgage problems in 2007-08

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