Federal Interest Rate Predictions by qmm18894

VIEWS: 18 PAGES: 37

More Info
									 How the Fed chooses the
Federal Funds Interest Rate
          Target

          Hal W. Snarr
  The Beverly Hillbillies and Banking

• In season 1, Jed had $25 million in Drysdale’s bank but by
  episode 10 in season 3 it amounted to $45 million.

• The Clampetts believed Jed’s money was safe and sitting idly
  in Milburn Drysdale’s bank vault

• The Clampett’s did not understand that bankers lend most of
  the money in savings accounts to borrowers at interest rates
  that exceed the interest rate paid to savers.
  The Beverly Hillbillies and Banking

• In episode 10 of season 3, Granny withdrew her share ($11
  million) from Drysdale’s bank to deposit it in Merchants Bank.
   – Drysdale could not cover this one-day withdrawal because a majority
     of the money in saving accounts is lent out to borrowers.
   – After Drysdale told Jed that he did not have $11 million in cash in his
     vault, Jed asked to look inside Drysdale’s vault.
   – Because the money wasn’t physically in the vault, Jed and his kin
     thought Drysdale spent the money and transferred their funds to the
     Merchants bank.
   – Later after visiting the Merchants Bank, the Clampetts asked to see
     their $45 million.
   – When John Cushing, president of Merchants bank, said he didn’t have
     it (for the same reason Drysdale didn’t have it), the Clampetts
     transferred it back to Drysdale bank.
  The Beverly Hillbillies and Banking

• By law, Milburn could not lend out all of Jed’s money because
  banks are/were required to hold a percentage of savings
  deposits as reserves (this percentage is called the Reserve
  Requirement Ratio).

• If Milburn was faced with a reserve requirement ratio of say
  10%, Milburn could lend out all but $4.5 million of Jed’s $45
  million savings deposit.

• Milburn pacified Granny every time she felt slighted by “city
  folk” or Milburn’s pampered, snooty, high-society wife
  because the Clampetts would have loaded their $45 million on
  the back of their old flatbed truck back to move back to
  Bugtussel.
   The Beverly Hillbillies and Banking

• A withdrawal of $45 million would have forced Milburn to
  borrow funds from other banks (this is done in what is called
  the federal funds market) to cover his reserve requirement.

• Banks like the Merchants Bank may have excess reserves to
  lend banks that do not have enough reserves to meet their
  reserve requirement

• Milburn wanted to avoid having to borrow federal funds from
  the Merchants Bank because he’d have to pay interest to John
  Cushing, the president of Merchants Bank

• This interest rate is called the federal funds rate.
   The Beverly Hillbillies and Banking

• The federal funds rate is the interest rate at which banks lend
  balances at the Federal Reserve to other banks overnight

• The federal funds rate target is set by the Federal Open
  Market Committee (FOMC)

• Currently, Ben Bernanke chairs the Federal Reserve Board and
  the FOMC.

• Click on the following link to learn more about the FOMC

        http://www.federalreserve.gov/fomc/fundsrate.htm
   The Federal Funds Interest Rate and its
                  Target

• If the FOMC decides to lower the target rate to avoid a
  recession, the New York Federal Reserve Bank lowers the
  actual federal funds interest rate by purchasing US Treasury
  bonds, notes, and bills from banks.

• Conversely, If the FOMC decides to raise the target rate to
  avoid rising inflation, the New York Federal Reserve Bank
  raises the actual federal funds interest rate by selling US
  Treasury bonds, notes, and bills to banks.

• US Treasury bonds, notes, and bills are constantly being sold
  and purchased to keep the federal funds interest rate at the
  target rate set by the FOMC.
   The Federal Funds Interest Rate and its
                  Target

• The FOMC regularly meets to decide whether it should
   – keep the target at its current level because economic growth is about
     3%, inflation is about 2%, and the unemployment rate is at about 5%
   – lower the target to avoid recession (negative economic growth)
   – raise the target to avoid rising inflation (this year inflation may be at
     4% but next year it will be 6%)
• The FOMC uses inflation, economic growth and
  unemployment predictions to set its target use mathematical
  rules (e.g., the Taylor Rule)
• To make these predictions, the FOMC use statistics from
  variables such as sales, output, employment, etc.
Consumer Confidence
(Consumer Comfort Index—weekly, last 5 years)




                        This chart shows
                        falling consumer
Falling consumer spending suggests that firms
                        confidence, meaning
will layoff workers, increasing unemployment
                        consumer (negative
and decreasing economic outputspending econ
growth)                 could fall dramatically
                        from its current level
                            Sales



3.5%
              However, the these growth rates
           The difference ingreen line suggest suggest
           that automobile sales aresales are declining at
              that when automobile currently                 -5%
           a blue and red lines in this chart
        The rate of about 5% per year.are suggest
              factored out, retail sales
-1.5%         actually spending is currently rate
        the consumergrowing currently at a declining
              of about 3.5% a year.
        at a rate of about 1.5% per year.
                Labor Market
                     (non-service sectors)




-7%

      The blue line suggests that construction jobs are
      currently falling at a rate of about 7% per year.
                Labor Market
                    (non-service sectors)




-4%


      The red line suggests that manufacturing jobs are
      currently falling at a rate of about 4% per year.
                Labor Market
                    (non-service sectors)




-2%


      The green line suggests that manufacturing jobs are
      currently falling at a rate of about 2% per year.
                Labor Market
                    (non-service sectors)




10%




      The black line suggests that mining jobs are
      currently GROWING at a rate of about 10% per year.
               Labor Market
                     (service sectors)

     The news in the service sectors is not as bad as
               it is in non-service sectors.




3%




     The blue line suggests that health care jobs are
     currently GROWING at a rate of about 3% per year.
               Labor Market
                     (service sectors)




1%



     The black line suggests that leisure jobs are
     currently GROWING at a rate of about 1% per year.
                    Labor Market
                            (service sectors)




-1%


      The red and green lines suggests that jobs in the financial and
      information sectors are currently declining at a rate of about 1%.
      Industrial Production

The lines on this chart all suggest industrial production is declining
especially in goods such as washing machines and dryers.
        Capacity Utilization

                           the end of recessions occur when capacity
This chart suggests thatHowever, capacity could turn around much later, suggesting
utilization turns around. that the recession could last much longer than expected.




    If capacity turns around next month, the current recession could be over.
             Bank Lending

      Despite the bad news, commercial, consumer and
             real estate loans continue to grow.


12%
            Bank Lending

     Despite the bad news, commercial, consumer and
            real estate loans continue to grow.



9%
            Bank Lending

     Despite the bad news, commercial, consumer and
            real estate loans continue to grow.




5%
                   Money
   One of the begins expanding the money supply rapidly
Today, the Fed mistakes the Fed made during the Great
        when was allowing the money supply to shrink.
  Depressionit perceives a recession is inevitable.
   Inflation signals


The value of the Euro rose rapidly
relative to the dollar until it
leveled off last summer                 Inflation fears
                                        abated after the
                                        value of the Euro
                     As a result, the fell relative to the
                 Federal Reserve feared dollar
            rising inflation
Inflation signals
                                    Those fears
                                   abated after
                                   Gold crashed



     The price of Gold rose
     rapidly and then
     leveled off

                        This too created
                     fear that inflation
                   would begin rising too fast
Inflation signals

Inflation fears eroded further as gasoline prices fell
       Econ growth, Inflation, and
            Unemployment


6.1%




         The red line suggests unemployment is on the rise.
         It was 6.1% in September, 2008.

                                                          Sept 2008
       Econ growth, Inflation, and
            Unemployment



4.9%




         The blue line suggests inflation is beginning to decline.
         It was about 4.9% in September, 2008.

                                                             Sept 2008
       Econ growth, Inflation, and
            Unemployment




0.8%
       The green line suggests that the economic growth rate is
       falling rapidly. It was only about 0.8% in September, 2008.

                                                              Sept 2008
             Augmented Phillips Curve
                                                              (monthly CPI, 1982-2008)

                                                  4
                   Change in the inflation rate

                                                                                  D p = -0.6118x + 3.4359
                                                  3                                        2
                                                                                          R =This curve
                                                                                              0.3076
                                                  2
                                                                                            demonstrates
                                                                                             how inflation
                                                  1                                            reacts to
                                                                                           unemployment
                                                  0                                        in the economy
       Thus,
                                          -1
inflation should
  fall by about
                                          -2
 1.6% per year
                                          -3

                                          -4
                                                                                                               Suppose the Fed
                                          -5                                                                    expects future
                                                                                                               unemployment to
                                          -6                                                                      rise to 8%
                                                      0   2       4       6          8         10         12
                                                                      Unemployment rate
                                     Inflation

       With the inflation rate falls by about 1.6%, the Implicit Price Deflator inflation rate
       should fall from 2.6% to 1% (a 1.6 percentage point decline)




2.6%

                                                                                                 -1.6%

 1%
      Real quarterly GDP gap
              ln(GDP) – ln(GDP potential)



The red line represents full-employment output, while the
blue line represents actual economic output.
     Real quarterly GDP gap
             ln(GDP) – ln(GDP potential)



When the red line lies above the blue one the economy
is underperforming.
     Real quarterly GDP gap
             ln(GDP) – ln(GDP potential)



When the red line lies below the blue one the economy
is overheating.
              Real quarterly GDP gap
                       ln(GDP) – ln(GDP potential)



        Suppose the Federal Reserve expects the gap to continue to widen
9.404
9.369                                                                -3.5%




           Thus, the Projected GDP gap = (9.369 – 9.404)100% = -3.5%

                                                            Jan 2009
Setting the Federal Funds Rate
             Target
Substituting in these values yields a Federal Funds rate target of


             1.51 2 0.5p  0.5   y
        i ff  1.5(p)  r  0.5(2) 0.5((y 3.5))
               1%


Expected future                                             Expected
 inflation (GDP                                             GDP gap
    Deflator)                                                –3.5%
        1%

                     Equilibrium          Fed
                    interest rate       Inflation
                         2%              target
                                           2%
Click to return to Halsnarr.com

								
To top