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Global Interest Rates Turn More Negative by Guest Blogger Buck Klemkosky
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The Suckling Fed: A Central Bank Acting without License
Guest Blogger Buck Klemkosky: The QE Punch Bowl Has Been Taken Away. Is the Party Over?Trick or Treat — The Fed’s Balance Sheet

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Let’s review what we know so far.

  • The central bank wants money to be the right amount to allow the economy to grow normally with low acceptable inflation.
  • This correct amount of money translates into a proper amount of AD that is compatible with goals for potential real GDP and inflation
  • Simply put – the correct amount of money yields the correct amount of AD which yields the correct amount of output and inflation.

Nowhere in this story have we talked about interest rates. So let’s work backwards. We know that several parts of AD are very interest sensitive. Mortgage interest rates can and do have impacts on housing demand. Bank corporate loan rates and bond rates of returns may also influence the demand for plants and equipment. Auto loan rates affect the decision of households and firms to buy cars and trucks. Clearly, if the central bank is to attain an AD goal, it is important that interest rates attain the right values.

This makes one see the importance of the correct level of interest rates if the central bank is to attain its goals. But here is the surprising part of this story – neither the Fed nor the ECB nor most any central bank has any direct control over auto rates, corporate loan rates, or any of the interest rates that really matter. This means that the Fed must use its tools to INFLUENCE the key interest rates – but it in no way directly sets them.

So how does a central bank INFLUENCE these rates so that they can achieve the correct amount of AD? The answer is that central banks have several mechanisms to do this. But keep in mind that while there are several ways to do this – the thing that is common to all these approaches is that the central bank is CREATING NEW MONEY for the economy. That is, it is INJECTING (OR WITHDRAWING) AN AMOUNT OF MONEY IN THE ECONOMY. It is the act of injecting or withdrawing this money that impacts the interest rates.

While we discuss three tools below, the most common and important tool is the last one in this list – open market operations. Nevertheless over time and space all three of these tools have been and can be potentially used to inject or withdraw money.

Change the required reserve ratio
Commercial banks cannot loan out all their deposits. They need cash reserves to pay customers who wish to withdraw their deposits. In addition, most central banks require commercial banks to keep a small portion of any deposits in what are called bank reserves. They must hold these legally required reserves as vault cash or deposits at a Federal Reserve Bank. On any day, a bank will be sitting on a sizeable amount of such reserves. For details of the Fed’s reserve requirements, click here.  If the Fed announces a reduction in the required reserve ratio – say from 5% of deposits to only 4% of deposits — then banks would quickly move to loan out the freed up assets. When the banks loan out this money, they become new bank deposits and so the money supply has increased. To loan out this extra money, commercial banks often need to lower their own interest rates on loans for cars, homes, etc. Thus, we see the connection between the interest rates that impact AD and one of the tools of the central bank.

 

Change the discount  rate
Yes, central banks do directly control some interest rates. In the U.S. we call this rate the discount rate. (note: The reason we call this a discount rate is because until January 9, 2003, this rate was always lower than various market rates (e.g. the federal funds rate defined below.) More explicitly what is often referred to as a discount or rediscount loan is generally the result of discounting promissory notes and bills of exchange at a Federal Reserve Bank.  After January 9th, the Fed decided it made more sense to keep this rate 100-150 basis points above the federal funds rate. Despite the change, it is still called the discount rate. The ECB speaks of main financing operations or standing facilities and directly controls the interest rates on these instruments. Regardless of the terminology, these are interest rates on loans that the central banks make to commercial banks. They are usually very short-term loans. The main idea is that if the central bank announces that one of these rates has been reduced, then it is a signal to commercial banks that it is appropriate to borrow from the central bank in larger quantities. These commercial banks then lend out these new monies to households and companies. This adds to bank deposits and implies more money is in the system. To loan out more money, banks often need to lower their own interest rates on loans for cars, homes, etc. Thus, we see the connection between the interest rates that impact AD and one of the tools of the central bank.

 

Open market operations
This is the primary way that the money supply is changed in the U.S. Open market operations involve the central bank’s purchases and sales of short-term treasury securities from the banks and non-bank public. They are designed to impact something called the fed funds rate. But the intended end result is just like the two examples above – an open market purchase leads to more money in banks, more money loaned, and more deposits. To loan out more money, banks often need to lower their own interest rates on loans for cars, homes, etc. Thus, we see the connection between the interest rates that impact AD and one of the tools of the central bank.

To explain this process more fully, we expand the case of open market operations. What follows directly below is an elaboration about the use of open market purchases to increase the money supply.

Why do an open market purchase? The Fed has decided that the economy is not growing at potential – so it wants it to grow faster. Its goal is to reduce interest rates and increase AD. It decides to do so through an open market purchase. (The end result of this story would be the same if the Fed had reduced the discount rate or the required reserve ratio).

The next chart shows you a graph of U.S. real GDP and potential GDP. Notice how in 1998, 1999 and 2000 that real GDP was greater than potential. That doesn’t happen very often but it does happen. By 2001 the gap was again very negative. Use the following link to update this information.

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Step 1: The Fed buys bonds from the public

  • First, the Fed buys existing government bonds from the public.
  • Where did these bonds come from? They exist because the government has had deficits in many past years and borrowed from the public. The public now owns or holds trillions of dollars of these bonds.  In 1973 when Wilma Flintstone was only a small toddler, her mommy bought a nice new government bond and put it away in a special place. Wilma stumbled across the bond the other day and said, “yikes, I’m rich.” Anyway, the government has been nice enough to issue trillions of dollars worth of such bonds and lots of people have them.
  • Wilma has a bond broker (motto: we will make you rich, man) named Big Max who called and said, “Hey man, the Fed is buying bonds today. Do you want to take advantage of their outstanding offer?
  • Second, Wilma says, “So what’s the deal?” Big Max indicated that the Fed was being very aggressive that day and that the price of bonds had gone up several points. Interest rates fell….why?
  • Wilma reached for her pocket calculator-Blackberry-datebook-lawnmower and realized that she could net, after taxes and Taco Bell, a bunch of money. More pertinent to the whole market, however, is that because bond prices were rising that day, anyone buying bonds that day would receive a lower return (recalling that the more you pay for a fixed amount of interest the lower is your yield or return).
  • In short, the Fed had driven down market interest rates on government bonds.
  • Recall that Wilma just sold her bond to the Fed. She mails it to the Fed and a couple days later Wilma receives a check from Ben Bernanke. Wilma deposits the check into her checking account because she is ready to spend! Note that if Wilma was very worried about the banking system she might just cash the check and put the cash into a pillow case. But that would not be the normal case.

Step 2. Banks now have more deposits and reserves

  • Wilma’s bank takes the check and deposits it into its account with the Fed. Banks hold such accounts with the Fed and use them to execute payments. They also trade them among each other depending on their needs to make payments during their daily business. Overnight accounts with the Fed are known as “fed funds.”
  • Banks have to hold about 5% of their customers’ deposits as reserves (in the form of cash or fed funds) and can lend the rest of it to other customers.
  • Imagine that the Fed purchased $10 million in bonds. That implies that commercial banks now have $10 million in new deposits. They have to hold on to about $500,000 in required reserves but they can lend the rest out. Note that if the bank was really worried about lots of defaults coming up in the near future, it might hold more or all of the money that Wilma deposited. But that isn’t the normal case, so let’s just assume there is plenty of money in the bank.

Step 3. The fed funds market and the fed funds rate

  • Which brings us to the fed funds market. Fed funds are the normal usual regular everyday (did I say normal?) way that banks get money to lend to the hottest loan prospects when normal cash flow leaves them insufficient. So, if Dan Smith walks into the bank and wants, like $3 billion to add a porch to his house, and if Bank One’s vault is a little empty that day, Bank One calls Bank Tew and says, “what are you guys having for lunch today? And could you lend us about $3 billion for a few days? Bank Tew says, “macaroni and cheese and no problem man, we will wire the money to you before you can say Wayne Winston works weekly with Winny Wing.
  • Bank Tew charges interest to Bank One for the loan – the rate is called the fed funds rate.
  • The next chart shows you the U.S. Fed Funds rate graphed with various inflation rate targets. Notice that the fed funds rate varied over time. It rose to over 6% at one point (the Fed was very concerned about inflation and then it declined until it was 1% (the Fed was very concerned about the GDP gap). See the following link to update this information:http://research.stlouisfed.org/publications/mt/page10.pdf

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  • Note that now the government bond rate and the fed funds rates have been greatly influenced by the open market purchase. The rates are probably down. If they don’t go down at first, the Fed keeps buying bonds until those stubborn rates finally fall.   Now comes the fun part. ☺

Step 4. Reserves and Bank Loans and other Interest Rates

  • Ole Lar has been wanting to buy a bunch of rock & roll albums in pure vinyl. Anyway, he hears that Bank One has loads of money and because the Fed did this or that, Bank One has lowered its loan interest rates so as to unload all this money (before the other banks beat them to it). That is too much for Lar to bear and he spends 19 days and nights filling out paperwork to get $111.18 from Bank One.
  • This last point explains why other rates start falling and before you know it, every interest rate from here to Ellettsville has fallen too. The point is that the Fed’s action has put a lot of new funds in banks and they want to loan them out. If Bank One wants me to borrow from them (rather than Bank Tew), then they might be the first to lower their consumer loan (or business loan) rates. So we might expect other interest rates to fall – on auto loans, housing loans, business loans, etc. Of course, that should in the normal case. But if bankers are especially worried or if they think inflation is about to rev up, then they might not reduce all these other rates.

 

Step 5. Real Interest Rates versus Market Interest Rates

  • Definition: Expected Real interest rate = market interest rate minus inflation expectations
  • The expected real interest rate is important for spending and saving decisions. Suppose I tell you I have a bond whose market interest rate is 1%. You say – wow – this is a great time for borrowing. I was going to wait a year to buy a cool Road Star, but I am going to buy it right now since rates are so low. Why should I save money when I am only going to get 1% on my saving?
  • But focusing on this market rate is incorrect and can be very misleading. Suppose I told you that many people expect the general level of prices of goods and services to decline by 5% next year. Wouldn’t it be a better deal to wait a year and buy the motorcycle at a price that is 5% lower than today? Wouldn’t it be better not to borrow the money? Yes. The real interest rates helps you see why.
  • Recall the definition: Expected Real interest rate = market interest rate minus inflationary expectations = 1% – (-5%) = 6%.
  • The answer is in the expected real interest rate – which in this example is 6%. Borrowing at 6% is actually a pretty high rate. Saving at 6% isn’t as bad as it looked at 1%.
  • Market interest rates can be very misleading. This example shows that a 1% market rate might actually be compatible with a 6% real rate. Notice the high real rate suggests this would be a good time for saving – not for borrowing. The expected real interest rate brings in two important parts of your decision about how much to spend and how much to save
    • The market interest rates
    • The expectation of future changes in prices of goods and services.

The next chart below shows you some real interest rates – the real fed funds rate and the real rate on government bonds with 1-year maturity. These rates are historical or ex-post real rates – that is, they use the actual past inflation rate rather than the expected future rate.  Notice that ex post real rates, unlike nominal rates, can become negative (e.g. from 2002 to 2004). Negative real rates mean that the rate of inflation rate over the year was greater than the nominal interest rate on those instruments in those years. Tell me about your propensity to want to save in those years. To update this information use the following link: http://research.stlouisfed.org/publications/mt/page8.pdf

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  • For the Fed to be successful, its policy must impact a broad spectrum of interest rates – from short-term to long-term – because these are the rates that are closest to buying behavior.
  • Market competition generally keeps these rates close to one another. For example, the interest rate on a one-year note and a 10-year note are usually fairly similar.
  • But during normal times, a 10-year note usually has a higher interest rate. What would make them dissimilar?
    • Risk
    • Inflation expectations
    • Special factors
  • If you expect less financial risk over the coming year than over the next 10 years, then you would expect a lower market yield on the one-year note.
  • If you expect a lower inflation rate over the coming year than over the coming 10 years, you would expect a lower market yield on the one-year note.
  • If special supply and demand conditions imply an insufficiency of demand for 10-year notes, then you would expect a lower market yield on the one-year note (assuming the 10-year and on-year notes are imperfect substitutes).
  • The chart below takes you to a graph of the term structure of interest rates which shows that short-term rates are generally lower than longer-term yields: Link to term structure of interest rates on Treasury securities: http://research.stlouisfed.org/publications/net/page7.pdf
  • Notice how flat the curve is in March of 2006. Since February 2005 you see that short-term rates rose considerably more than long-term rates.

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Step 6. The Term Structure of Interest Rates

Step 7. Real Interest Rates, the Term Structure and the Success of Fed Policy

  • Monetary policy may be aimed at reducing the whole term structure of real interest rates, but it doesn’t always work that way. Any given Fed policy or other AD shock might affect inflation expectations and risk. Other shocks might also impact markets as when the government decided to stop issuing 30-year government securities and that expected scarcity drove down rates on longer-term bonds relative to short term-bonds.
  • The result is that the Fed’s policy isn’t successful unless it moves most interest rates in the desired direction. Other factors might prevent many rates from falling. To the extent that they do, the full impact of the policy will be missing and people will be making guesstimates about when and if the key rates will change.

Step 8. The end of the story – interest rates fall and AD rises – or do they?

  • That is just about the whole story. After Bank One lowers rates and Lar buys a bunch of vinyl, the demand in the economy really picks up. Some firms raise prices. Others raise output. Some do both. Some steal all the money and send it to a tax haven in Brooklyn.
  • If the stimulus was too little, then interest rates might not fall enough: AD and the economy would not be much impacted.
  • If the monetary action came at a time of such uncertainty that people would not put money in banks, or banks desired not to lend money out, or people were not willing to borrow money- then neither interest rates nor AD would be affected and the policy would not reach its goal.
  • If the stimulus was such that it raised inflation expectations, increased risk, or otherwise did not lead to a reduction in the real term structure of interest rates, then AD and the economy would not be sufficiently impacted.
  • The above points explain why some monetary experts talk about a “time-lag” when it comes to monetary policy. The Fed may be trying to induce a change in spending, but changes in expectations, confidence, and risk can intervene and impact the timing of these policies.
  • If the monetary dose of stimulus was just right, the economy moves toward Potential Real GDP and the unemployment rate declines.
  • If the stimulus was too large or is kept going too long, then stagflation (worse than a colonoscopy) eventually occurs.
  • You may go back to sleep now. Happy dreams ☺