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Financial hurricanes

The New York Stock Exchange October 2012

Course logistics

• Problem set 4 will be due on Monday November 5.• Course syllabus and schedule will be revised today or

tomorrow.• We will probably lose one class (panics or Great

Depression) and lose one problem set.• Midterms: no regrades except for clerical errors or

major problems (I will post explanation).• Grade distribution (no hard edges on grades):

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Tentative grade distribution for midterm exam

A between 60.0 and 75.0

B between 46.9 and 60.0

C between 29.2 and 46.9

D between 15.0 and 29.2

Outline of money section

1. Essence of financial markets2. Balance sheets3. Introduction to the supply and demand for funds4. Central banking and the Fed5. The term structure of interest rates6. The demand for money

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Theory of Central Bank Interest Rate Determination

• Definition of transactions money is M1= Cu + D. Assume currency is exogenous. Then analysis the supply and demand for bank reserves, which yields the equilibrium “federal funds rate.” Bold = Fed instruments.

• Demand for R:• Bank regulation: reserve requirement on checking deposits (D).• (1) R > h D• (1’) R = hD In normal times (not now!)• The demand for checking deposits is determined by output and

interest rate:(2) Dd = M(i, Y)• This leads to the demand for reserves by banks in normal times:(3) Rd = h M(i, Y)

• Supply of R:• Fed supplies non-borrowed reserves (NBR) by open-market

operations (OMO). Additionally, banks can borrow at discount rate d. This leads to supply of reserves function:

(4) Rs = NBR + BR(d)• Which yields equilibrium of the market for reserves• (5) h M(i, Y) = NBR + BR(d)

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• So this shows the way the Fed determines i:

h M(i, Y) = NBR + BR(d)

• Note the three instruments of (normal) Fed policy, h, NBR,

and d.• Essence of modern central banking:

• Banks required to hold reserves against demand deposits

• Fed intervenes through open market operations to set NBR

• The interaction of supply and demand determines short interest rates.

• This affects the entire term structure of interest rates; other asset prices; and the economy.

• However, in times of stress (financial crises), the central bank can use non-conventional tools – this is the central issue of US monetary policy today.

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Overview of Supply and Demand for Money

• Begin with short-run interest rate (federal funds rate)

• Supply of money and reserves determined by central bank (Fed, ECB, …)

• Demand for transactions money (M1) from medium of exchange;

• Equilibrium of supply and demand for money/reserves → short-term nominal risk-free interest rate.

• Then to other assets and rates:

• Short rates + expectations → long risk-free rate (term structure theory)

• Real rate = nominal rate – inflation (Fisher effect)• Risky rates = risk-free rate + risk premiums

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DR

DRiff

Federal funds interest rate

SR

SR

iff*

R* Bank reserves

Supply and demand diagram for federal funds on daily basis

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Federal Reserve Districts

How does the Fed actually administer monetary policy?

1. Federal Open Market Committee (FOMC) meets 8 times per year to determine the appropriate monetary policy.

2. FOMC = 7 Governors + 5 voting Presidents of regional Federal Reserve Banks + 7 non-voting Presidents.

3. In “normal times,” major Fed instrument is the federal funds target interest rate. This is the overnight interest rate on bank reserves lent and borrowed by banks.

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4. Actual mechanism:• Open market operations are arranged by the Domestic

Trading Desk at the Federal Reserve Bank of New York (“the Desk”)

• Every morning, staff decided if an OMO is needed to keep rate near target.

• Fed contacts the “primary dealers” (e.g., Goldman Sachs, BNP Paribas, Morgan Stanley, etc.) and asks them to make offers

• Fed generally makes temporary purchases (“repos” = purchase and forward sale, or the reverse) at 10:30 each day, but generally does not enter more than once per day.

• Because the Fed intervenes only daily, the FF rate can deviate from the target.

5. Then supply and demand for reserves take over

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Recent history of Fed Funds rate: 2007-2011

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DR

DRiff

Federal funds interest rate

SR

SR

iff*

R* Bank reserves

Supply and demand diagram for federal funds on daily basis

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DR

DRiff

Federal funds interest rate

iff*

Bank reserves

Federal funds rate target

Supply and demand diagram for federal with interest rate

target

This time is different: Federal funds rate

= federal funds rate at trough of recession.

Recent Fed policies

• The Fed has taken many steps to stimulate the economy after the deep recession. But the economy was growing slowly, and unemployment was still high.

• What would you do?• It decided to undertake “Operation Forward

Guidance.”

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• Compare Fed statements earlier and in August 2011

• This is a good example of term structure theory

Operation Forward Guidance

June 2011:The Committee decided today to keep the target range for the

federal funds rate at 0 to 1/4 percent.  The Committee continues to anticipate that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate for an extended period. 

August 2011: The Committee decided today to keep the target range for the

federal funds rate at 0 to 1/4 percent.  The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

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Different interest ratesFixed income (bond like)

- Short v. long (overnight, 3 month, 10 year, …)- Risk-free v. risky (AAA, AA, junk)- Asset-based securities (mortgage based, …)

Equities (stock like)- Residual claimant on incomes (Apple, BP,…)

Tangible capital - Ownership of durable assets (my house, Toyota plant, …)

Interest rates for business investment: risky real rate = iL,rf – πe + risk premium

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Why did the Fed’s August 10 announcement lower long-term interest rates? (“…exceptionally low

levels for the federal funds rate at least through mid-2013. …”)

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0.50

1.00

1.50

2.00

2.50

3.00

1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr

Maturity

Treasury rates

Before 8/9

After 8/9

Note on theory of the term structureMany businesses and households borrow risky long-term

(mortgages, bonds, etc.).

These differ from the federal funds rate in two respects:

- term structure (discuss now)

- risk premium (postpone)

The elementary theory of the term structure is the “expectations theory.”

It says that long rates are determined by expected future short rates.

Two period example (where rt,T is rate from period t to T):*

(*) (1+i0,2)2 = (1+i0,1) [1+E0 (i1,2)]

With risk neutrality and other conditions, (*) determines term structure. (Finance people find many deviations, but good first approximation.)

*Notation: E0 (i1,2) = expectations of interest rate from period 1

to period 2 at time 0. Clearly, E0 (i0,1) = i0,1. Make sure you

understand the meaning of this notation and why it is important.

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Example

Short rates:1 year T-bond = 0.41 % per year2 year T-bond = 1.03 % per year

Implicit expected future rate from 1 to 2 is: (1+r0,2)2 = (1+r0,1) [1+E0 (r1,2)]

(1+.0103)2 = (1+ .0041) [1+E0 (r1,2)]

This implies:E0 (r1,2) = 1.65 % per year

[Again, finance specialists point to deviations from this simple theory.]

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Recent term structure interest rates (Treasury)

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Expectations theory says that short rates are expected to rise in coming years.

Note that this can explain why Fed makes statement about future rates (look back at Fed statement.)

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

0 5 10 15 20 25 30

Yiel

d to

mat

urity

(%

per

yea

r)

Term or maturity of bond

9/18/2009 9/17/2008

Older term structure interest rates (Treasury)

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0

2

4

6

8

10

12

14

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20

0 5 10 15 20 25 30

Yiel

d to

mat

urit

y (%

per

yea

r)

Term or maturity of bond

9/18/2009 9/17/2008

9/19/2006 May-81

In period of very tight money (1981-82) short rates were very high, and people expected them to fall.

So what was the purpose of Operation Forward Guidance?

To lower long run interest rates by lowering expected future short term rates!

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Fed funds to short rates

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0

2

4

6

8

10

1990 1995 2000 2005 2010

Federal funds rate3 month Treasury bills

Short rates to long rates

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0

2

4

6

8

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1990 1995 2000 2005 2010

3 month Treasury bills10 year Treasury bonds

The evolution of risk

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The financial problem was first recognized.

The Lehman bankruptcy

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2

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1980 1985 1990 1995 2000 2005 2010

Risk premium on investment grade bonds

Baa rate minus 10-year T bond rate

The real interest rate for business:the cost of capital today is extremely low!

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3

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1980 1985 1990 1995 2000 2005 2010