Macro-Finance for Managers II

Highlighting a Few Key Ideas and Issues

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)

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)

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

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)

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 …

1970s: Market Dominates Fed Targets

Policy Limits: Phillips Curve Tradeoff Vanishes As Fed Tries to Use It More

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

2008: Markets Dominate Fed Targets

Risks AheadWorldwide Fiscal-Monetary Problems

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

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”

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 paymentsOutlook/Evaluation

Spain, Italy, Ireland, … France Japan U.S.

… U.S. Down the Line

Implication: U.S. Treasuries

2008 Crash

Glance at Financial Crisis of 08:Debt, Debt, and More Debt

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U.S. Debt -- right scale

Debt/GDP - left scale

Mortgage Debt + A Whole Lot More

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Total Debt/GDP

Non-house-govt/gdp

House-debt/gdp

Govt Debt/gdp

Role of Commercial Lending:Vegas City Center ($10B) Bond/Loan Financed

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

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