Download Federal Reserve

Treasury Yield Curves
(Measure of Market Traders’ DY/Y and DP/P Expectations)
Web address: http://www.federalreserve.gov/releases/h15/
No revisions, instant data from bond markets
Reflects the collective wisdom on the likely direction of the economy (DY/Y) and inflation (DP/P). Expectations of future
economic growth and inflation determine which Treasury debt securities are the most attractive to buy. The yield
curve shape is a powerful forecasting tool.
Federal Reserve sets short-term yields by targeting the fed funds interest rate.
Bond traders determine longer-term yields.
Normal Yield Curve Shape: Lower short-term yields with yields gradually rising with bond maturity. (longer maturities
face greater unknown risks – war, politics, DP/P - and hence require higher returns). The 3-month versus 30-year
spread is about 2.5 percentage points with a normal yield curve.
Steep Yield Curve Shape: Federal Reserve lowers short term rates to counter recession or inflation fears induce bond
traders to sell long-term bonds.
The 3-month versus 30-year spread is greater than 2.5 percentage points.
Flat Yield Curve Shape: The economy is in danger of slipping into recession resulting in lower inflation. Bond traders
buy long-term bonds to lock in higher long term yields => long-term yields fall relative to short-term yields.
Probability of recession is 50% according to a Federal Reserve study.
Inverted Yield Curve Shape: Short-term yields higher than long-term yields. Siren call that a recession is coming.
The bond market believes the Federal Reserve is keeping monetary policy to tight and money supply growth to low.
The last seven recessions have been preceded by an inverted yield curve 9 months – on average - in advance. If
yield inversion is greater than 2.4 percentage points, then probability of recession is 90% in the next 18 months.
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Market Analysis:
Bonds: Yield curve represents bond market
Stocks: Stock prices are based on expectations of future profits and economic activity, so the yield curve can serve as an
effective market-timing strategy tool
Dollar: Inverted Y.C. may reduce foreign investor appetite for U.S. assets if believe recession is coming =>  $. However,
an inverted Y.C. may attract “hot money” into U.S. investments if short-term U.S. interest rates are significantly
above overseas short-term interest rates =>  $
Treasury Yield Curves
6
Yield to Maturity
5
June 2007
4
March 2012
3
2
1
0
1 2 3
5
10
15
Years to Maturity
20
25
30
Interest Rates and Recessions
1988-2012
10
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
0
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Recession
Baa
Fed Funds
10-yr Treas
Chapter 13
Bank Balance Sheet
Reserves Deposits that a bank keeps as cash in its vault or on
deposit with the Federal Reserve.
Bank run Many depositors simultaneously decide to withdraw money from
a bank. Bank panic Many banks experiencing runs at the same time.
Required reserves Reserves that a bank is legally required to
hold, based on its checking account deposits.
Required reserve ratio The minimum fraction of deposits
banks are required by law to keep as reserves.
Excess reserves Reserves that banks hold over and above the
legal requirement.
Fractional reserve banking system A banking system in which
banks keep less than 100 percent of deposits as reserves.
The Federal Reserve System
How the Federal Reserve Manages the Money Supply
Monetary policy The actions the Federal Reserve takes to manage
the money supply and interest rates to pursue economic
objectives.
To manage the money supply, the Fed uses three monetary policy
tools:
 Open market operations The buying and selling of Treasury
securities by the Federal Reserve in order to control the money supply.
Federal Open Market Committee (FOMC) The Federal Reserve
committee responsible for open market operations and managing the
money supply
 Discount policy Discount loans Loans the Federal Reserve
makes to banks. Discount rate The interest rate the Federal
Reserve charges on discount loans.
 Reserve requirements
Assets FED RES Liab. + NW
FX Reserves Currency
in
Treasury
Circulation
Bonds
Assets HHs Liab. + NW
Currency
CHK Dep.s
Loans
Savings
MMDA
CDs
Reserves
Disc. Loans
Other assets
Required Reserves =
Reserves =
Required Reserves
+ Excess Reserves
Reserves =
Vault cash
+ Deposits at Fed Res
10% x CHK Deposits
Assets BANKs Liab. + NW
Reserves
CHK Dep.s
Treasury
Bonds
Loans
Net Worth
Savings
MMDA
CDs
Disc. Loans
Net Worth
Federal Reserve
T-Bill
+100
Reserves
+100
Open Market Purchase
1. Fed buys T-Bill from bank A
2.  Bank Excess Reserves
3. r = reserve requirement = 10%
D Deposits = (1/r) x D Reserves
$1,000 = (1/0.10) x $100
M1 = Curr + Chk Deposits
Savings & Loan C
Req. Reserves
+9
Loans
+81
Deposits
+$90
Credit Union B
Req. Reserves
+10
Loans
+90
Bank A
Excess Res.
+100
T-Bills
-100
Excess Res.
-100
Loans
+100
Asset
Exchange
Portfolio
Rebalance
Deposits
+$100
The act of
originating
a loan,
is the act
of creating
money
HH Sector
Assets
Liabilities
Dep. +100
Loans +100
Dep. +90
Loans +90
Dep. +81
Loans +81
Sum = Dep. + 1,000 Loans + 1,000
Let x = loaned out/pass through %
Let r = required reserve ratio = 1 - x
Sum of Infinite Geometric Series
S = 1 + x + x2 + x3 + …
S = 1 + x [1 + x + x2 + …]
S = 1 + x [ S]
S–xS=1
S = 1/(1 - x)
S = 1/r  Simple deposit multiplier
(ratio of D chk deposits / D reserves)
If r = 10%, then multiplier = 10
D checking deposits = 1/r * D reserves
$1,000 = 10 * $100
Recall
Expenditure Multiplier
DY = (1/1-MPC) x DI
Federal Reserve
Assume:
Currency in Circulation
-$100
1.
2.
3.
RR = 0.10 x Deposits
Banks Max. P
ER = 0
Required Reserves
+100
Credit Union B
Clear checks
between A,B,C,D
Banks are the
heart/pump
of the economy
Req. Reserves
+8.10
Loans
+72.90
Deposits
+$72.90
Deposits
+$81
Req. Reserves
+10
Loans
+90
Deposits
+$100
Deposits
+$90
HH Sector
Savings & Loan C
Bank D
Req. Reserves
+7.29
Loans
+65.61
Req. Reserves
+9
Loans
+81
Bank A
Cash = $100
The act of
originating
a loan,
is the act
of creating
money
Cash -$100
Dep. +100
Dep. +90
Loans +90
Dep. +81
Loans +81
Dep. +72.9
Loans +72.9
M1 = Curr + Chk Deposits
Sum = Dep. + 900
Loans + 900
Sum of an Infinite Geometric Series
Let OD = original deposit
D Loans = 0.9 OD + 0.92 OD + 0.93 OD +…
D Loans = 0.9 [OD + 0.9 OD + 0.92 OD +…]
D Loans = 0.9 [OD + D Loans]
(1- 0.9)D Loans = 0.9 OD
D Loans =
0.9 OD
(1 - 0.9)
D Loans = 9 (100)
D Loans = 900 = D Deposits
D Loans
Producer Price Index
(Measures changes in prices paid by businesses)
Web: www.bls.gov/ppi
One revision published with 4 month lag. Annual revision in February.
PPI measures changes in prices that manufacturers and wholesales pay for goods during various stages of production. It is the oldest inflation
measure; index began in 1902. Labor department issues questionnaires to 30,000 firms on 100,000 different items. A basket of goods is
formed to create an index that starts at 100 and reflects average price of goods in 1982. PPI is the first inflation number of the month.
Follow price changes along the production pipeline to determine where price pressures originate.
3 progressive stages of production give rise to 3 price indexes:
PPI Crude Goods – cost of raw materials entering the market for the first time (wheat, cattle, soybeans, coal, crude petroleum, sand, timber). Price
changes can be a function of changing supply which is a function of droughts, freezes, animal disease, geopolitical factors.
Core Crude Goods – (nonfood materials less energy) is a good leading indicator of U.S. and world economic growth. This index responds quickly to
shifts in economic activity. Prices are very sensitive to economic turning points. If businesses expect an increase in future demand, the
demand for metals, paper boxes, timber will rise =>  price crude goods =>  price intermediate goods =>  price final goods. Price
increases move down the production pipeline.
PPI Intermediate Goods – cost of commodities that have undergone transitional processing (flour, paper, auto parts, leather, fabric)
PPI Finished Goods – final processing stage (apparel, furniture, automobiles, meats, gasoline) Products retailers pay for. Total finished goods index
is a measure of inflation in the long-run. Not a perfect leading indicator of consumer price inflation.
There is a link between PPI finished goods and CPI. The two indexes may diverge on a month-to-month basis, but tend to move in tandem and are
correlated over a longer (6-9 month) term. PPI does not include service prices or imported prices, whereas CPI does.
Core PPI Finished Goods – excludes food and energy prices and gives a more accurate reading of the underlying inflation trend. The core rate
index is a proxy for near-term inflation
Inflation, DP/P, is public enemy number one to the financial markets. An  PPI =>  CPI
A 12-month perspective is a better way to view the PPI numbers.
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Market Analysis:
Bonds:  PPI =>  (DP/P)Et+1 =>  DBonds =>  iBonds
Stocks:  PPI =>  production costs =>  profits =>  dividends =>  price stocks
Dollar:  PPI =>  (DP/P)Et+1 =>  ishort-term =>  dollar
Inflation (Producer Price Index)
(year over year % growth)
20%
20%
15%
15%
10%
10%
5%
5%
0%
0%
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
-5%
-5%
-10%
-10%
-15%
-15%
Finished Goods
Intermediate Materials, Supplies, Components
Core Inflation (Producer Price Index)
(year over year % growth)
40%
35%
30%
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
-30%
-35%
-40%
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
Core Finished Goods
Core Crude Goods
Core Intermediate Materials, Supplies, Components
10
11
12
13
40%
35%
30%
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
-30%
-35%
-40%
CPI Inflation Gauge
(Measure of price inflation in retail goods and services)
Web address: www.bls.gov/cpi/
No monthly revision, annual revision in February.
CPI:
Inflation affects the following activities
Costs of doing business
Investment decisions
Retirees quality of life
Labor contracts & rental contracts
Government macroeconomic policy
Social security benefits, food stamps, alimony, child support payments
CPI is an index number which leads to a historical perspective of inflation.
(1982-84 =100)
Inflation Explanations:
Monetarist View – excessive money supply growth. Too many dollars, chasing to few goods. If DM/M > DY/Y
then DP/P > 0
Keynesian View – AD > AS => shortage =>  Prices
inflation is a function of the state of the business cycle and level of production slack/idle capacity/resource scarcity
Core-CPI - best measure of underlying inflation
2 Population Groups:
CPI-W (wage earners & clerical workers) 32% of population
benchmark for pay increases in collective bargaining agreements and for yearly cost-of-living adjustments on social
security checks.
CPI-U (all urban workers)
CPI Inflation Gauge
(Measure of price inflation in retail goods and services)
Deflationary Spiral:

prices =>  corporate profits => job layoffs =>  household income =>  consumption spending =>  inventories => 
prices
Forecasting Tool:
Business can anticipate future technology and medical costs
Investors can reassess investment strategies
Union leaders use inflation forecasts in pay negotiations
CPI is a lagging economic indicator
6 Other Price Gauges:
PCE, Producer Prices, Import Prices, Employment Cost Index, Unit Labor Costs,
GDP deflator.
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Unexpected increase in inflation
Bond Market:
 bond demand =>  bond price =>  nominal interest rates
Stock Market:
 nominal interest rates => borrowing costs =>  profits=>  stock prices
Federal Reserve  nominal interest rates =>  borrowing costs =>  profits =>  stock prices
Firms prefer an increase in output rather than an increase in prices to boost revenues
FX Market:
AD > AS => unexpected inflation
 Y =>  r =>  exchange rate (good investment environment)
 DP/P =>  i =>  exchange rate (erodes dollar-based investments held by foreigners)
Inflation (CPI)
(year over year % growth)
6%
5%
4%
3%
2%
1%
0%
95
96
97
98
99
00
01
-1%
-2%
-3%
Headline
Core (excludes food and energy)
02
03
04
05
06
07
08
09
10
11
12
Monetary policy options to prevent deflation and increase inflation expectations
1. Quantitative easing: print money to buy long-term government debt
2. Buy private-sector debt
3. Change expectations by announcing it will keep short-term rates low for a long time
4. Raise its long-run inflation target (encourage borrowing, discourage cash hoarding)
5. Reduce the interest rate paid on excess reserves.
6. Move from inflation targeting (rate of change) to price level targeting
Anticipated inflation is expected and built into planning
Unanticipated inflation is unexpected and disrupts planning
•Alters expected outcome of long-term projects
•Reduces long-term investment
•Distorts the information in prices – reduces the effectiveness of markets
•Results in actions based on price anticipation, instead of production