Presentation Transcript

1. Financial hurricanes The New York Stock Exchange October 2012
2. 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):
3. Outline of money section Essence of financial markets Balance sheets Introduction to the supply and demand for funds Central banking and the Fed The term structure of interest rates The demand for money
4. 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: Dd = M(i, Y) This leads to the demand for reserves by banks in normal times: 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: Rs = NBR + BR(d) Which yields equilibrium of the market for reserves (5) h M(i, Y) = NBR + BR(d)
5. 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.
6. 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
7. iff Supply and demand diagram for federal funds on daily basis SR DR Federal funds interest rate iff* DR SR R* Bank reserves
8. Federal Reserve Districts
9. How does the Fed actually administer monetary policy? Federal Open Market Committee (FOMC) meets 8 times per year to determine the appropriate monetary policy. FOMC = 7 Governors + 5 voting Presidents of regional Federal Reserve Banks + 7 non-voting Presidents. In “normal times,” major Fed instrument is the federal funds target interest rate. This is the overnight interest rate on bank reserveslent and borrowed by banks.
10. 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
11. Recent history of Fed Funds rate: 2007-2011
12. iff Supply and demand diagram for federal funds on daily basis SR DR Federal funds interest rate iff* DR SR R* Bank reserves
13. iff Supply and demand diagram for federal with interest rate target DR Federal funds interest rate Federal funds rate target iff* DR Bank reserves
14. This time is different: Federal funds rate = federal funds rate at trough of recession.
15. 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.” Compare Fed statements earlier and in August 2011 This is a good example of term structure theory
16. 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.
17. Different interest rates Fixed 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
18. 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. …”)
19. Note on theory of the term structure Many 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.
20. Example Short rates: 1 year T-bond = 0.41 % per year 2 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.]
21. Recent term structure interest rates (Treasury) 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.)
22. Older term structure interest rates (Treasury) In period of very tight money (1981-82) short rates were very high, and people expected them to fall.
23. So what was the purpose of Operation Forward Guidance? To lower long run interest rates by lowering expected future short term rates!
24. Fed funds to short rates
25. Short rates to long rates
26. The evolution of risk The Lehman bankruptcy The financial problem was first recognized.
27. The real interest rate for business:the cost of capital today is extremely low!