The Other Side of the Coin

... the FRS impact upon interest rates

© 2011-2013 Gary R. Evans. May be used only for non-profit educational purposes only without permission of the author.

Key Interest Rate Definitions

(remember handout from LF lecture!)

Federal Funds Rate

Discount Rate
U.S. Treasury Securities Rates
Prime Rate
Corporate
Corporate Securities Rates
Municipal Note and Bond Rates
Mortgage Rates

1
Net Effect of Open Market Operations

1. Increases Reserves

2. Increases Lending (Money

and Credit)

3. Decreases Interest Rates

Loanable Funds – Case 2

The effect of FRS Open Market Operations

SF1

SF2
r1 e1

r2 e2

DF1

Volume of Credit

2
 The Federal Funds Market
• At the end of the day
– some banks have excess reserves
– some banks with heavy lending have shortages
• In the Federal Funds Market
– reserves are lent "overnight" (short maturity)
– the interest charged is the Federal Funds Rate
(always expressed as an annual rate)

The important effect? This keeps the system running tight.

Federal Funds Target Rates

January 2000 - March 2012
Upper limit of 0.25 range

7.00

6.00
Currently at
5.00
Too low 0.0% - 0.25%
4.00 too long
3.00

2.00

1.00

0.00

… a general tightening after June 30, 2003, to forestall inflation and curb low interest
speculation, then a severe reduction beginning September 2007 to curb effects of the
credit crunch.

3
 How OMOs should affect all rates ...
yield

... is supposed to provoke

a sympathy move at the
long end, raising the
entire structure of interest
Raising the rate rates.
(fed funds) at the
Fed Funds short end ... 30 year
maturity

... but the influence may not be felt here.

... which in turn ... which through

The FRS directly
strongly influences ... competitive pressure
controls ....
should influence

Mortgage Rates
Bank Lending Rates
Corp. Bond Rates
Federal Funds Rate
U.S. Treasury Rates
Collateralized Rates

... but sometimes they don't have much effect ... other private Rates
upon the separated rates (right column)
because of perceived risk or other problems
in that sector.

4
 Select Interest Rates 2007 vs. 2013
(April comparisons)
3.390
15 year FRM
5.59
Interest rates are
4.130
lower, but more so 30 year FRM
5.86
short-term rates
rather than long-term Prime Rate
Prime Rate
3.250
8.25
rates.
5.120
High Yield Junks
Look at the bottom 7.10

end compared to the 3.130

Corp 5 YR AAA
stuff at the top. 5.13
2012
3.320
30 year Treasury 2007
4.90

2.180
10 year Treasury
4.73

0.320
2 year Treasury
y y
4.71

0.040
13 week Treasury
4.86

0.250
Federal Funds  target
5.25

0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00

Source: The Wall Street Journal and finance/yahoo, select dates. FRM data are for conforming
loans, no points, from SchoolsFirst FCU, a typical lender, for April 15, 2013.

The Term Structure of Interest Rates

(yield spreads)
When comparing
p g different maturities of the same class of
interest bearing securities, like U.S. Treasury securities, the
yields (interest paid) of securities with longer maturities are
normally higher than the yields of shorter maturities. For
example, we would expect a 20-year bond to have a higher
yield than a 26-week bill.
This is because there is a greater risk associated with holding
a long-term security (such as the risk imposed by inflation).
The mapping of these yield spreads, shown in the next slide,
is called the “term structure of interest rates,” and it
normally slopes up.

5
 Treasury Yield Spreads (example)
(term structure of interest rates)
7.00 The “term structure of interest
rates” normally rises with
6 00
6.00 longer maturities because of
the higher risk associated with
5.00 them.

4.00
This is a “normal”
3.00 term structure,
reflecting higher risk
with higher yields.
yields
2.00

1.00

0.00
3 Mon 6 Mon 2 Yr 3 Yr 5 Yr 10 Yr 20 Yr 30 Yr

The Treasury Yield Curve 2007 vs. 2013

6

QE2, QE3 and

3 Operation 2013
Twist (now 2007
2 discontinued).
Normal yield curve
1
shape but sharp
reduction in all rates
0
Federal Funds  13 week Treasury 2 year Treasury 10 year Treasury 30 year Treasury
target

6
 Was it ever normal? Old slide from 2005
Treasury Yield Spreads
(term structure of interest rates)

6.00

5.00
As can be seen, this Fed action
is influencing only short-term
4.00 rates. Mar-05
3.00 Jan-04
FRS raises This is a “normal”
2.00 term structure,
g
FFR targets reflecting higher risk
1.00 with higher yields.

0.00
1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr

The Trade-off between targeted interest rates and

money/credit growth rates in monetary policy
M2
growth Monetary Policy
rate
Tradeoff Line

MSo

Ro Interest Rate

7
 M2
growth ... OMO target ranges
rate

6%

5%

3% 4%
Fed Funds Rate

M2 Range: 5% to 6%
FFR Range: 3% to 4%

c:\graph\mpto2.drw

Meeting the targets

Remember,
R b th the FOMC willill always
l
desire net expansion of reserves and net
expansion of any monetary or credit
target. An expansionary policy might
involve raising the reserve growth rate
from 4% to 7%. A contractionary policy
might involve lowering the reserve
ggrowth rate from 6% to 3%,, but not
reducing it below zero. ... think of this as regulating
How does the FOMC contract, which a flow through a faucet;
will reduce the reserve growth rate and tighten up a little and the
raise interest rates? By reducing the flow slows down, ease up a
frequency and size of individual OMOs. little and the flow increases.
But there is always a flow.

8
 The subtlety of a "contraction"
SF1
The original simplistic loanable
funds model suggested that to SF2
raise interest rates, the FRS
contracted the supply of funds. r2
r1
In a robust economy where
credit demand is always DF2
growing, as shown here, the
FRS can and does raise interest DF1
rates by increasing the supply Modest growth in
of funds modestly. supply of funds ... Volume Credit
.. robust growth in
Generally, if the FRS keeps credit demand ...
reserve growth below the
growth of credit demand, rates ... results in an increase in interest rates, even
should rise. though there has been an increase in the supply of
funds.

Why FFR Targets are Emphasized

over monetary targets

You can't "see" money operationally

.. long lags in data
Money growth rates wildly volatile
.. definitions imperfect
.. fickle public use of monetary
assets
Endogenous money supply

9
Money Supply Growth Rates
Jan 1996 – Jan 2013, monthly, annualized previous 12 months, LN continuous, SA

% 0.25

Spec expansion Bad recession Spec expansion Bad recession

0.20

0.15

0.10

0.05

0.00

-0.05 No meaningful correlation is visible here – this is more the effect of things
that matter than the cause of anything. Likewise, these current numbers have
no capacity to predict inflation.
-0.10
1996‐01 1998‐01 2000‐01 2002‐01 2004‐01 2006‐01 2008‐01 2010‐01 2012‐01

M1 M2 12 per. Mov. Avg. (M1) 12 per. Mov. Avg. (M2)

Source: Federal Reserve Statistical Release H.6 Money Stock Measures Earlier slide repeated.

The Endogenous Money Supply

(your teacher’s contribution)
The use of freely
freely-exchangeable
exchangeable monetary and financial assets
have become so widespread and so easy to convert from one
asset to the other, at low cost and online, that the growth rate of
any single component can be very volatile and unpredictable.
For example, you can make an online or ATM transfer from
your checking account (M1) to your savings account (M2),
causing M2 to grow without causing M1 to fall
fall.
Also, because of credit cards and the extreme liquidity of all
financial assets, you are no longer constrained any longer by
the size of your M1 or M2 monetary balances.

10
Policy lesson: Why it is harder to cure
an existing inflation than prevent one
• The problem is seriously compounded by
inflationary expectations
– this inflation pushes interest rates up, building in an
inflation premium, keeping real rates of return
positive;
– this also causes a decline in bond values and often stock
values.
• In an extreme inflation (more than double digit)
the correctional policy is necessarily Draconian
and does severe damage to the economy.

Over Time ..
.. policy abuse
The effort to keep interest rates artificially low can
introduce inflationary expectations and eventually
raise rates, contrary to your policy. This happened in
r the 1970s.
inflation

natural rate
low rate policy

time

11
Inflationary expectation in the loanable funds model

The effect of inflationary expectations

SF2
e2 SF1
r2
The “inflation
premium” on
interest rates
r1
e1
DF2

DF1

Select Interest Rates and CPI

1970-2011

18.00

16.00 Inflationary period: Note that FFR and

note how bad it got 3 Mo effectively
14.00 and how long it took 0.0% and inflation
12.00
to correct! rate now above
Treasury Rates.
10.00

8.00

6.00

4.00

2.00

0.00
1970. 1975. 1980. 1985. 1990. 1995. 2000. 2005. 2010.

Federal Funds 3 Mo T Bill AAA Corps 30 YFR Mortg 10 Yr UST Note CPI

Source: Economic Report of the President, 2012. Data kept with 104 slides.

12
 The CPI, the 10 yr UST & 30 yr FRM
%
18 Think about what 17% mortgage
rates would imply
16 Negative here

14 Note the long lag in

coming back down.
down
12 Historical spread about 1.4%
and fairly consistent. Max about
10 2.5%. This makes the 10 yr a
Bellwether rate.
8

-2
1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011

CPI 30 Yr FRM 10 Yr T-Bond

Important Theoretical Point

IF inflation emerges ...

.. and interest rates are rising as a
result

The only policy option is contraction

... which will cause rates to rise more!!

The problem must be made worse to

make it better.

13
 M2 Monetary Policy
Grth Tradeoff Line
Rate

a
MSo Contraction!!!

b
MS
a

Ro Ra Interest Rate

The Volcker Correction of 1979

r
inflation • Under previous FRS chairs FRS had been
running a policy that was too loose and
low rate policy
natural rate generous.
time
• Inflation, inflationary expectations, and
16

14
CPI Inflation 3 Mo. T-Bill interest rates were well into double digit
12 levels.
10

8 • Policy activist Paul Volcker appointed

6

4
FRS chair.
2
• October 1979 FRS enacted a severely
0
1960

16
1965 1970 1975 1980 1985 1990
contractionary policy,
policy Fed Funds rate goes
14 to 23% at one point.
12

10 • Banks finally crack down on credit in 2nd

8

6
quarter 1980.
4

2
• Severe recession finally squeezes inflation
3 Mo.T-Bills Mortgage Rates
0
1965 1970 1975 1980 1985 1990 out by 1982.

14
 The Volcker Correction of October 1979
Note the long lag
16

14

12

10

2
3 Mo.T-Bills Mortgage Rates
0
1965 1970 1975 1980 1985 1990

Modern Policy Lessons from the

Volcker Correction
• Inflation control is the primary goal
– low interest rates are secondary
• Anti-inflation policy must be preemptive
and preventive
– tighten as you approach the inflationary region
• Err on the side of caution
• Recognize and respect the long lags
between action and result

15
 Primary long-
long-term problems in
monetary policy
1 Using expansionary monetary policy to
1.
offset problems being caused elsewhere
• such as offsetting the interest rate effects of
chronic budget deficits
• bailing out screwups in the private sector
2. Targeting interest rates too low too
frequently
• which leads to too much debt formation

This will be a lead-in to our topical lecture as you might imagine.

Do you remember doing this in MS2?? What magic!!
Loanable funds: "monetizing" the budget deficit
... and any other kind of spending that we
want to "monetize."
SF1 This shift due to FRS
accommodation.

SF2
1% FRS allowable
trading range
e1 e2
0%
DF2
This shift due to the
budget deficit.
DF1
Vol
One unambiguous result: a
strong growth in credit & debt

16
 Domestic Non
Non--financial Debt / National Income
1962--2012
1962
3.5
How many times are you going to show this
slide, Professor Evans??
30
3.0
“You were right – the debt was unsustainable,”
Daniel Strenge (HMC class unknown, Cargill
2.5 lead sugar trader).
Millennium
craziness
2.0

The 80s
discover
1.5 credit
Stability

1.0
1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

Source (debt): Federal Reserve Flow of Funds Accounts, Z1 statistical release

Final comment before we move into policy

in 2012
We keep reading terms like "the FRS is printing money" and they are
"monetizing
monetizing the deficit"
deficit or "monetizing
monetizing the crisis recovery.
recovery " We now know
that these are only metaphors. Once one insists upon a precise definition of
money, and then measures whatever that happens to be, you realize that the
wild fluctuations in "money" measures have nothing to do with what has
happened recently or presently.
To be precise, when we now use the term "monetizing" we really mean that
they are creating copious amounts of net new credit, which implies higher
levels of indebtedness,
indebtedness even (especially) when normalized against our
national output as represented by national income or GDP.
And when the Federal Reserve System is doing it, the credit is being created
from nothing - erasing a number and writing a bigger number in its place.
Is this undesirable? Only if it is done to excess. Has it been done to excess?

17