Central banking and the Fed 1

Student balance sheets Generally good job Make sure you understand: - If Liab > Assets, NW is negative - Do not include future income on balance sheet. - Income (flow) v assets (stock) - Include depreciated capital (computer = $1000, depreciation = $600, value of K = $400) 2

3 Money and finance: The superstars of all time 3 Irving Fisher, Yale ( ) James Tobin, Yale ( ) Milton Friedman, Chicago ( )

4 How the Fed influences financial markets Supply of money and reserves determined by central bank (Fed, ECB, …) Demand for transactions money (M 1 ) from medium of exchange; Equilibrium of supply and demand for money/reserves → short- term nominal risk-free interest rate.

5 DRDR DRDR i ff Federal funds interest rate SRSR SRSR i ff * R* Bank reserves -Supply and demand diagram for federal funds on daily basis - Fed supplies funds through its open market operations (OMOs)

6 6 Actual Financial Balance Sheets (pre-crisis 2008:Q1) Note: the current Fed balance sheet is extremely different and not representative, so I have used an older balance sheet.

7 7 Actual Financial Balance Sheets (pre-crisis 2008:Q1) Note: the current Fed balance sheet is extremely different and not representative, so I have used an older balance sheet. Banks are required to hold reserves against transactions balances. Reserves are cash plus deposits at the Fed. Normally, R = hD, where h is required reserve ratio.

Mechanics of OMO: The Fed buys a security… 8 FedCommercial banks and primary dealers Assets Liabilities Bonds 1000 Bank borrowings 0 Cu 900 Reserves (bank deposits) 100 Investments 1000 Checkable deposits 1000 Equity 100 Reserves (bank deposits) 100

… and this increases reserves … 9 FedCommercial banks and primary dealers Assets Liabilities Bonds Bank borrowings 0 Cu 900 Reserves (bank deposits) Investments Checkable deposits 1000 Equity Fed buys bond. 2.Dealer deposits funds in bank. 3.This creates a credit in the account of the bank at the Fed and voilà! the Fed has created reserves. (red) Reserves (bank deposits)

… and normally this increases investments and M 10 FedCommercial banks and primary dealers Assets Liabilities Bonds Bank borrowings 0 Cu 900 Reserves (bank deposits) Investments Checkable deposits Equity Fed buys bond. 2.Dealer deposits funds in bank. 3.This creates a credit in the account of the bank at the Fed and voilà! the Fed has created reserves. (red) 4.In normal times, the bank lends out the excess, and this leads to money creation (blue). Today, this just increases reserves. Reserves (bank deposits)

11 DRDR DRDR i ff Federal funds interest rate SRSR SRSR i ff * R* Bank reserves Increase in reserves lowers federal funds interest rate i ff ** S’ R

How does the Fed actually administer monetary policy? 1.Federal Open Market Committee (FOMC) meets 8 times per year to determine the appropriate monetary policy. 2.FOMC = 7 Governors + 5 voting Presidents of regional Federal Reserve Banks + 7 non-voting Presidents. 3.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. 4.The primary decision is the target rate for the federal funds rate. - E.g., in July 2013: “.. the Committee decided to keep the target range for the federal funds rate at 0 to ¼ percent.” 12

5. 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. 6. Then supply and demand for reserves take over 13

14 DRDR DRDR i ff Federal funds interest rate i ff * Bank reserves Federal funds rate target Supply and demand diagram for federal with interest rate target

15 DRDR DRDR i ff Federal funds interest rate i ff * Bank reserves Federal funds rate target Supply and demand diagram for federal with interest rate target

Today’s zero interest and excess reserves 16

17 DRDR DRDR i ff Federal funds interest rate SRSR SRSR i ff * R* Bank reserves i ff ** S’ R

When Fed buys reserves today, it just increases excess reserves 18 FedCommercial banks and primary dealers Assets Liabilities Bonds Bank borrowings 0 Cu 900 Reserves (bank deposits) Investments Checkable deposits 1000 Equity Fed buys assess backed mortgage (from bank for simplicity) 2.Bank is glad to unload it, and just holds excess reserves. 3.No impact on the money supply or on federal funds rate. A (very small) impact on mortgage interest rates. Reserves (bank deposits)

The federal funds rate hits the zero lower bound 19

Excess reserves 20

Make sure you understand this graph! 21

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.” This involved making statements about future Fed policy (see next slide). 22

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. July 2013: the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. 23

Impact of forward guidance on 8/9/2011 on interest rates 24

25 Recent term structure interest rates (Treasury) 25 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.)

Older term structure interest rates (Treasury) 26 In period of very tight money ( ) short rates were very high, and people expected them to fall.

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 r t,T is rate from period t to T): (*) (1+r 0,2 ) 2 = (1+r 0,1 ) [1+E(r 1,2 )] With risk neutrality and other conditions, (*) determines term structure. (Finance people find many deviations, but good first approximation.) 27

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+r 0,2 ) 2 = (1+r 0,1 ) [1+E(r 1,2 )] ( ) 2 = ( ) [1+E(r 1,2 )] This implies: E(r 1,2 ) = 1.65 % per year [Again, finance specialists point to deviations from this simple theory.] 28

So what was the purpose of Operation Forward Guidance? To lower long run interest rates by lowering expected future short term rates! Problem for students: Go back to two period example above. Assume that second period expected rate goes to 0.3%. What happens to two-period interest rate? 29

Fed funds to short rates 30

Short rates to long rates 31

Real interest rate for businesses r b = risky rate – inflation rate = i ff + term premium + risk premium -inflation 32

The real interest rate for business: the cost of capital today is back to normal! 33