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Macro-Finance for Managers II

Highlighting a Few Key Ideas and Issues. Macro-Finance for Managers II. Making Sense of the Fed. 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)

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Macro-Finance for Managers II

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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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