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Financial hurricanes
The New York Stock Exchange October 2012
1
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):
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
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Outline of money section
1.
2.
3.
4.
5.
6.
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
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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 → shortterm 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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iff
DR
SR
Supply and demand
diagram for federal
funds on daily basis
Federal funds
interest rate
iff*
DR
SR
R*
Bank reserves
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Federal Reserve Districts
8
How does the Fed actually administer monetary policy?
1.
2.
3.
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 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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iff
DR
SR
Supply and demand
diagram for federal
funds on daily basis
Federal funds
interest rate
iff*
DR
SR
R*
Bank reserves
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iff
DR
Supply and demand
diagram for federal
with interest rate
target
Federal funds
interest rate
Federal funds rate target
iff*
DR
Bank reserves
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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.”
• Compare Fed
statements
earlier and in
August 2011
• This is a good
example of
term structure
theory
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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 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
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Why did the Fed’s August 10 announcement lower longterm interest rates? (“…exceptionally low levels for the
federal funds rate at least through mid-2013. …”)
3.00
Treasury rates
2.50
Before 8/9
2.00
After 8/9
1.50
1.00
0.50
1 mo 3 mo 6 mo
1 yr
2 yr
3 yr
5 yr
7 yr
10 yr
Maturity
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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.
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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.]
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Recent term structure interest rates (Treasury)
4.5
Yield to maturity (% per year)
4
Expectations theory
says that short
rates are expected
to rise in coming
years.
3.5
3
2.5
2
1.5
9/18/2009
1
9/17/2008
0.5
0
0
5
10
15
20
25
30
Note that this can
explain why Fed
makes statement
about future rates
(look back at Fed
statement.)
Term or maturity of bond
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Yield to maturity (% per year)
Older term structure interest rates (Treasury)
20
9/18/2009
9/17/2008
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9/19/2006
May-81
In period of very
tight money (198182) short rates
were very high, and
people expected
them to fall.
16
14
12
10
8
6
4
2
0
0
5
10
15
20
25
30
Term or maturity of bond
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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
10
Federal funds rate
3 month Treasury bills
8
6
4
2
0
1990
1995
2000
2005
2010
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Short rates to long rates
10
3 month Treasury bills
10 year Treasury bonds
8
6
4
2
0
1990
1995
2000
2005
2010
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The evolution of risk
Risk premium on investment grade bonds
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6
The Lehman
bankruptcy
5
4
3
The financial
problem was
first
recognized.
2
1
1980
1985
1990
1995
2000
2005
2010
Baa rate minus 10-year T bond rate
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The real interest rate for business:
the cost of capital today is extremely low!
12
11
10
9
8
7
6
5
4
3
1980
1985
1990
1995
2000
2005
2010
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