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Macro-Finance for Managers II
Highlighting a Few Key Ideas and Issues
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Making Sense of the Fed
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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)
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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
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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)
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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 …
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1970s: Market Dominates Fed Targets
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Policy Limits: Phillips Curve Tradeoff Vanishes As Fed Tries to Use It More
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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
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2008: Markets Dominate Fed Targets
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Risks AheadWorldwide Fiscal-Monetary Problems
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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
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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”
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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.
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… U.S. Down the Line
Implication: U.S. Treasuries
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2008 Crash
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Glance at Financial Crisis of 08:Debt, Debt, and More Debt
1.0
1.5
2.0
2.5
3.0
3.5
4.0
0
10000
20000
30000
40000
50000
60000
20 30 40 50 60 70 80 90 00
U.S. Debt -- right scale
Debt/GDP - left scale
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Mortgage Debt + A Whole Lot More
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
50 55 60 65 70 75 80 85 90 95 00 05
Total Debt/GDP
Non-house-govt/gdp
House-debt/gdp
Govt Debt/gdp
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Role of Commercial Lending:Vegas City Center ($10B) Bond/Loan Financed
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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
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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