Determination of Interest Rates and Intro to Monetary Policy

1
Determination of Interest Rates and Intro to
Monetary Policy

• Econ 280

2
Monetary Conditions vs. Monetary Policy

• Monetary Conditions reflect changes in the
  economy (the amount of loanable funds available,
  the productive capacity of the economy, expected
  rate of inflation etc.)
• Monetary Policy responds to monetary condition
  ,and attempts to smooth monetary conditions.

3
Monetary Policy

• Changes in monetary conditions (an increase in
  inflation for example) can cause a change in the
  level of interest rates. However, it does not
  necessarily imply a change in monetary policy.

4
Basic DefinitionsShort Term Interest Rates

• Federal Funds Rate Rate charged on overnight
  loans between banks
• Discount Rate Interest rate charged on
  overnight loans from Fed Reserve to banks
• Prime Rate the interest rate commercial banks
  charge their large (best) customers
• CDs
• Treasury Bills
• Commercial Paper

5
Basic DefinitionsLong Term Interest rates

• Treasury Bonds
• Municipal Securities
• Corporate Bonds
• Other

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Outline

• What determines the level of Interest rates
• The Asset Market (last class)
• The Money Market (next class)
• International (future class)
• Today
• Federal Reserve and Monetary Policy
• Taylor Rule
• The Yield Curve

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The Federal Reserve SystemBackground and overview

• 12 Regional Banks
• Fed board of Governors 7 members, 14 year
  appointments
• Federal Open market Committee (FOMC), Board of
  Gov, Bank of NY Pres, 5 other Fed bank pres.
• Independence of the Fed

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FOMC

• Federal Open Market Committee (FOMC), Board of
  Gov, Bank of NY Pres, 5 other Fed bank pres.
• After each meeting they issue a statement
  outlining any changes in the target for the
  federal funds rate.
• Since February 2000, the committee has included a
  discussion of the Feds ability to accomplish its
  long run goals (price stability and sustainable
  economic growth) and any risks that may hinder
  its ability to meet its goals.

9
Federal Reserve Monetary Policy

• Tools of Monetary Policy
• Discount Window Lending
• Reserve Requirements
• Open Market Operations

10
Discount Rate

• The Federal Reserve provides short- term loans to
  banks to enable them to meet depositors demands
  and reserve requirements.
• The Fed sets the discount rate which the rate of
  interest changed on the loans.

11
Using the Discount Rate

• When the Fed increases the discount rate it
  discourages banks from borrowing, reducing the
  money supply.
• Increases in the discount rate raise the cost of
  borrowing
• When the Fed decreases the discount rate banks
  are more willing to borrow so the money supply
  will increase

12
Discount Window Loans

• Adjustment Credit Loans Most common type of
  loan to cover short falls of reserves
• Seasonal Credit given to a limited number of
  banks that operate in vacation and agriculture
  areas, rate tied to the average of the monthly
  average Fed Funds rate and CD rates.
• Extended Credit Banks with severe liquidity
  problems. ½ point above the rate on seasonal
  credit

13
Discount Window Disadvantages

• Disadvantages to using the discount window as a
  source of funds
• Cost associated with Discount window
  lendingInterest rate is high compared to other
  sources
• Concerns that might be raised about the health of
  the bank causing increased monitoring
• More likely to be turned down in the future.

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Problems with The Discount Window

• The rate is set by the Fed, but it cant control
  the amount of lending.
• It is difficult to revise.
• It can cause large fluctuations in the spread
  between rates in general and the discount rate,
  causing unintended changes in the volume of loan
  and hence the money supply.

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Reserve Requirements

• Setting of the of required reserves in the
  banking sector.
• The reserves must either be cash on hand or on
  deposit at the Fed.
• If reserve requirements are increased banks hold
  more money in reserve decreasing the amount that
  is available for lending.
• If reserve requirements are decreased banks hold
  less money in reserves increasing the amount
  available for lending.

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Monetary Control Act of 1980

• Moved much of the responsibility of reserve
  requirements from the Fed to the Congress.
• Rules also expanded to include all depository
  institutions. A basic ratio of 12 was
  established for all checkable deposits. Likewise
  a basic rate of 3 was set for time deposits.
• Fed given ability to change the checkable deposit
  rate between 8 and 14.

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Using Reserve Requirements

• Advantage is that reserve rules affect all banks
  the same
• Can have large impact because of multiple deposit
  creation.
• Can cause immediate liquidity problems for banks
  with low excess reserves.
• Is not used very often.

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Open Market Operations

• When the Fed purchases securities on the open
  market it must use cash reserves (money which
  was out of circulation), therefore the amount
  banks have available to lend (excess reserves)
  will increase.
• When the Fed sells it already owns on the open
  market individuals and institutions pay for them
  with cash which the Fed then holds in reserve, in
  effect removing it from circulation, reducing the
  amount of excess reserves in banks.

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Open Market Operations

• Dynamic
• Intended to change the level of reserves and the
  monetary base
• Defensive Open Market Operations
• Intended to offset movements in other factors
  that affect reserves and the monetary base.

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Advantages of Open Market Operations

• Conducted at the initiative of the Fed (with the
  discount rate they can only encourage banks to
  loan more or less)
• Flexible and precise
• Easily reversed
• Implemented quickly

21
Recent Adjustments to Federal Funds Rate

• In 2004 Fed started to increase Fed Funds to
  return to a neutral (neither expansionary or
  contractionary) level
• Federal Funds Rate Targets
• June 2003 July 2004 1
• Increases stopped at August 8, 2006 meeting
• Currently 5.25

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Open Market Operations

• The buying and selling of US government
  securities by the Federal Reserve on the open
  market.
• In other words, it is buying and selling the
  securities at the market price and yield.

23
Open Market Operations

• When the Fed purchases securities on the open
  market it must use its cash reserves (money
  which was out of circulation), therefore the
  amount banks have available to lend will
  increase.
• When the Fed sells these securities on the open
  market individuals and institutions pay for them
  with cash which the Fed then holds in reserve
  removing it from circulation, reducing the amount
  of excess reserves in banks.

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Open Market Operations

• Dynamic
• intended to change the level of reserves and the
  monetary base
• Defensive Open Market Operations
• Intended to offset movements in other factors
  that affect reserves and the monetary base.
• Only buys and sells US Treasury and government
  securities to avoid conflicts of interest

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Daily Open Market Operations

• Conducted at the trading desk, (at the New York
  Fed), Both Dynamic and Defensive Operations are
  undertaken.

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A Day at the Trading Desk

• Review of developments in Fed Funds Market on the
  previous day and check ofactual amount of
  reserves on the previous day.
• Detailed Forecast developed by staff of short
  term factors affecting reserves(treasury
  deposits, float, publics holding of currency)
• Monitor the current developments in the Fed Funds
  Market

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A Day at the Trading Desk continued

• Use forecasts to decide if sales or purchases
  need to be made to keep the Fed Funds rate in its
  target range.
• Call treasury to get updated info on planned moves

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A Day at the Trading Desk continued

• Contact Monetary Affairs Division at the Board of
  Governors in D.C. andformulate a proposes course
  of action.
• Midmorning Conference call with Director of
  Monetary affairs and one of theregional bank
  presidents to propose course of action for the day

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A Day at the Trading Desk

• Execution of temporary Open Market Operations
  mainly through the use of repurchase agreements
  and reverse repurchase agreements. The effect of
  these changes are reversed at the maturity of the
  agreement.
• Conduct any Outright Open market operations
  (purchase and sale of securitiesdirectly)

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Advantages of Open Market Operations

• Conducted at the initiative of the Fed (with the
  discount rate they can only encourage banks to
  loan more or less)
• Flexible and precise
• Easily reversed
• Implemented quickly

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Repurchase Agreements

• The sale of a security with the promise of
  repurchasing it in a very short time (usually
  overnight) at a premium.
• The seller is essentially borrowing money from
  the other party and using a security (usually
  issued by the treasury) as collateral.

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Repurchase Agreements

• The difference in price represents the interest
  rate paid on the loan (it is often referred to as
  the repo rate).
• Reverse Repos are just taking the opposite side
  of the agreement (lending the money today,
  agreeing to sell back the security it he future).

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Open Market Repurchase Agreements (Repos)

• Used when the Fed believes that there will be an
  event that is significant but not long lived.
• An example may be a large payment from the US
  treasury such as Tax Refunds or Social Security
  payments (either would create a temporary
  increase in the amount of reserves available)

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A Big Picture Question

• Do we need a lender of last resort if the FDIC is
  in existence?
• The Announcement Effect Signal future monetary
  policy moves.
• The role of lender of last resort promotes safety
  and soundness, but the lending function is not
  very effective as a tool.

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How is monetary policy determined?

• The Fed is attempting to attain a given set of
  macroeconomic goals.

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Goals

• High employment Full Employment and Balanced
  Growth Act of 1978 (Humphrey Hawkins). Committed
  the government (and the Fed) to promoting high
  employment consistent with a stable price level.
  
• Key is how big should or can employment be? The
  natural rate of unemployment constrains the
  ability to always increase employment.

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Economic Growth

• Growth is measured by increases in real GDP.
• Biggest current question is why has growth slowed
  in the last 20 years?

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Price Stability

• Targeting inflation is the latest fad among
  central banks. The belief is that keeping prices
  stable can decrease uncertainty and lead the
  economy toward the other goals.

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Interest rate Stability

• Again the main idea is decreasing uncertainty and
  promoting Stability in Financial Markets

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Stability in Foreign Exchange Markets

• Not always able to control Asian Financial
  crisis is a good example.

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Conflict among Goals.

• The goals often interfere with each other, for
  example stable prices and high employment.
• If the Phillips curve is correct there is a
  tradeoff between unemployment and inflation.
  Often low unemployment has resulted in high
  inflation ad vice versa.

42
Conflicts continued

• Likewise since interest rates are linked to the
  price level (fisher equation) Interest rate
  stability and high employment are not always
  compatible.
• Which should a central bank target? How should
  they set their objective?

43
Goals vs. Targets

• Sets Goals (Employment, Inflation) then
  establishes targets for key variables that should
  be consistent with reaching the goals
• The targets are the means of obtaining the
  desired goals.

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Operating Targets

• Variables that are directly effected by the
  policy tools of the central bank.
• Some examples include reserve aggregates, the
  monetary base, federal funds rate, borrowed
  reserves

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Intermediate Targets

• Variables that have a direct effect on the goals,
  but are not directly effected by the central
  banks monetary tools.
• Examples include M1, M2 etc

46
Monetary Policy

• Since Targets are more long term in nature, the
  central bank aims at the targets in an attempt to
  steer the economy toward its goals.
• Often there is conflict in choosing the correct
  target.
• For example in class we showed, choosing a
  monetary aggregate lessens the ability of the
  bank to control interest rates and vice versa.

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Choosing Targets

• Operating Targets should be
• Measurable
• Central Bank has some control over changes in the
  variable
• Have an intermediate target as its goal.
• Intermediate Targets should be
• Measurable
• Central Bank has some control over changes in the
  variable.
• Have a predictable impact on the goal

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A quick Historical Perspective of the Fed

• Pre 1920s Discount rate is the primary tool
• 1920 1930 Expanded use of Open Market
  Operations
• 1930s The Great Depression
• The introduction of the Reserve Requirement
  (Thomas Amendment to the Agricultural Adjustment
  Act of 1933
• Pegging of Interest rate and war finance. Fed
  would make Open Market Purchases to keep the
  interest rates fixed to pre war levels.

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Historical Perspective continued

• 1950sand 60s
• Money Market Conditions. Use of Free reserves as
  indicator resulting in procyclical monetary
  policy.
• 1970s Targeting Monetary Aggregates and the
  federal funds rate
• Widening of target range for Fed Funds Rate
  Specifically the Fed targeted the amount of non
  borrowed reserves (total reserves less those
  borrowed from the discount window)

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Historical Perspective continued

• 1982-early 1990s
• De-emphasis on monetary aggregates, return toward
  federal funds targeting
• Target became growth in borrowed reserves was
  kept to a specific range.
• Fed recognizes the need to target foreign
  exchange rate stability
• Stock market crash of 1987 forced Fed to think
  about stability in the financial markets which
  also became a point of emphasis.

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Historical Perspective continued

• Mid to late 1990s
• Fed still used the fed funds rate as primary
  tool, but was more tolerant of growth than
  before.
• One explanation was a possible new paradigm of
  increased productivity. There has been debate
  about whether or not this new productivity growth
  actually exist.

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Taylor Rule

• Key determinants of the level of the fed funds
  rate are the level of unemployment and the level
  of inflation.
• 1 change in core inflation 1 change in Fed
  Funds
• 1 change in growth rate 1 change in Fed Funds

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The Taylor RuleGreenspan Era

• FF 7.271.54(CoreCPI)-1.78(UN)0.18(IPM)
• (22.6) (17.0) (9.2)
• Adj Rsqr .927 1987.3 1997.3
• FF Fed Funds Rate
• Core CPI change in core rate of Inflation
  past 6 qtrs
• UN Current Unemployment Rate
• IPM change in index of industrial production

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Taylor Rule and Monetary Policy

• If the Taylor Rule holds what impact would an
  inflation target have on the level of the fed
  funds rate?

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Equilibrium Fed Funds Rate?

• A rate that will keep inflation low and promote
  stable long term growth
• Based on growth rate of productivity and growth
  of labor force.
• At full employment nominal rate will increase
  by more than expected inflation (real fed funds
  increases)
• Slow growth the real fed funds rate will
  decrease.

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Yield Spreads

• The differences in rates between different assets
  is a function of their riskiness (including the
  amount of time before the asset matures)
• Changes in the differences provides information
  about the economy.

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The Yield Curve

• Differences in rates based on maturity (for
  similar default risk) are often used as a
  predictor of future economic activity.
• The yield curve graphs the return paid on
  treasury bills, notes, and bonds at a given point
  in time.

58
Shifts in the Yield Curve

• The shape of the yield curve and changes in the
  shape can provide information to the market
  concerning future interest rates.
• Want to investigate two things, overall shifts in
  the curve and changes in its slope.

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Historical Evidence (FDIC.gov)
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Recent Yield Curves
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Parallel Shifts
Short Intermediate Long Maturity
Short Intermediate Long Maturity
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Approximate Parallel Shift
Change in rates is approximately the same for all
maturities
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Twists
Flattening Twist
Short Intermediate Long Maturity
Steepening Twist
Short Intermediate Long Maturity
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Flattening of the curve
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Steepening of the Curve
Change for long term is greater than for short
term
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Butterfly Shifts
Positive Butterfly
Short Intermediate Long Maturity
Negative Butterfly
Short Intermediate Long Maturity
67
Positive Butterfly shift
Increase for short term and long term is greater
than for intermediate term
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Negative Butterfly Shift
Decrease for short term and long term is greater
than for intermediate term
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Why does the Yield Curve usually slope upwards?

• Three things are observed empirically concerning
  the yield curve
• Rates across different maturities move together
• More likely to slope upwards when short term
  rates are historically low, sometimes slope
  downward when short term rates are historically
  high
• The yield curve usually slopes upward

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Three Explanations of the Yield Curve

• The Expectations Theories
• Pure Expectations
• Local Expectations
• Return to Maturity Expectations
• Segmented Markets Theory
• Biased Expectations Theories
• Liquidity Preference
• Preferred Habitat

71
Pure Expectations Theory

• Long term rates are a representation of the short
  term interest rates investors expect to receive
  in the future. In other words, the forward rates
  reflect the future expected rate.
• Assumes that bonds of different maturities are
  perfect substitutes
• In other words, the expected return from holding
  a one year bond today and a one year bond next
  year is the same as buying a two year bond today.
  (the same process that was used to calculate our
  forward rates)

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Pure Expectations Theory A Simplified
Illustration

• Let
• rt todays time t interest rate on a one
  period bond
• ret1 expected interest rate on a one period
  bond in the next period
• r2t todays (time t) yearly interest rate on a
  two period bond.

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Investing in successive one period bonds

• If the strategy of buying the one period bond in
  two consecutive years is followed the return is
• (1rt)(1ret1) 1 which equals
• rtret1 (rt)(ret1)
• Since (rt)(ret1) will be very small we will
  ignore it
• that leaves
• rtret1

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The 2 Period Return

• If the strategy of investing in the two period
  bond is followed the return is
• (1r2t)(1r2t) - 1 12r2t(r2t)2 - 1
• (r2t)2 is small enough it can be dropped
• which leaves
• 2r2t
•  

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Set the two equal to each other

• 2r2t rtret1
• r2t (rtret1)/2
• In other words, the two period interest rate is
  the average of the two one period rates

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Applying the model

• The 2 year rate is an average of the current 1
  year rate and the expected rate one year in the
  future.
• This implies that the yield curve will slope
  upward when the expected one year rate is
  expected to increase compared to the current one
  year rate.
• Similarly the yield curve will slope downward
  when the expected rate is less than the current
  rate.

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Expectations Hypothesis r2t (rtret1)/2

• If you assume that the expected rate is
  representative of the long run average and that
  rates will move toward the average, empirical
  fact two is explained.
• When the yield curve is upward sloping (R2tR1t)
  The current rate would be less than the long run
  average and it is expected that short term rates
  will be increasing.
• Likewise when the yield curve is downward sloping
  the current rate would be above the long run
  average (the expected rate).

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Expectations Hypothesis r2t (rtret1)/2

• As short term rates increase the long term rate
  will also increase and a decrease in short term
  rates will decrease long term rates. (Fact 1)
• This however does not explain Fact 3 that the
  yield curve usually slopes up. Given the
  explanation of Fact 2 the yield curve should
  slope up about half of the time and slope down
  about half of the time.

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Problems with Pure Expectations

• The pure expectations theory also ignores the
  fact that there is reinvestment rate risk and
  different price risk for the two maturities.
• Consider an investor considering a 5 year horizon
  with three alternatives
• buying a bond with a 5 year maturity
• buying a bond with a 10 year maturity and holding
  it 5 years
• buying a bond with a 20 year maturity and holding
  it 5 years.

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Price Risk

• The return on the bond with a 5 year maturity is
  known with certainty the other two are not.
• The longer the maturity the greater the price
  risk.
• If interest rates change the return and the 10
  and 20 year bonds will be determined in part by
  the capital gains resulting from the new price at
  the end of five years.

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Reinvestment rate risk

• Two new options
• Investing in a 5 year bond
• Investing in 5 successive 1 year bonds
• Investing in a two year bond today followed by a
  three year bond in the future.
• Again the 5 year return is known with certainty,
  but the others are not.

82
Local expectations

• Local expectations theory says that returns of
  different maturities will be the same over a very
  short term horizon, for example 6 months.
• This assumes that all the forward rates currently
  implied by the spot yield curve are realized.

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Local Expectations

• Previously we calculated the zero spot rates
  using the bootstrapping method for the on the run
  treasury securities given below.
• Maturity YTM Maturity YTM
• 0.5 4 2.5 5.0
• 1.0 4.2 3.0 5.2
• 1.5 4.45 3.5 5.4
• 2.0 4.75 4.0 5.55

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Zero spot Review (local expectations example)

• Given the assumption that all of the on the run
  treasury securities were selling at par we found
  the 1.5 year zero coupon rate by discounting the
  coupons by the respective zero coupon rates.

85
Zero spot curve (local expectations example)

• Continuing the same process for future rates we
  started to build a zero spot yield curve
• Time YTM Zero Spot
• 0.5 4 4
• 1.0 4.2 4.2
• 1.5 4.45 4.4459
• 2.0 4.75 4.7666

86
Forward Rates(local expectations example)

• Given the zero spot rates it is possible to find
  the forward rates.
• Let 1fm be the 1 period (six month) forward rate
  from time m to time m1.
• The forward rate can then be found as

87
Forward Rate(local expectations example)

• Given the 6 mo. zero spot rate of 4 and the 1
  year zero spot rate of 4.2, the one period
  (6mo.) forward rate from 6 months to 1 year would
  be
• (1.021)2 (1.02)(11f1) 1f1 .022
• Similarly the 6 month forward rate from 1 year to
  1.5 years can be found from the 1 year zero spot
  rate of 4.2 and the 1.5 zero spot rate of
  4.4459
• (1.021)2(1 1f2) (1.022293)3 1f2 .024884
• Likewise 1f3 .02847

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Local expectations example

• Local expectations theory says that returns of
  different maturities will be the same over a very
  short term horizon, for example 6 months.
• The return from buying the 2 year 4.45 coupon
  bond that makes semiannual payments selling at
  par and selling it in six months should be equal
  to the return on a 1 year coupon bond with a YTM
  of 4.2 if you hold it 6 months.

89
6 mo return on 1 year bond

• The 1 year bond has a current YTM of 4.2. This
  means that a equivalent bond selling at par would
  make a 2.10 coupon payment at eh end of 6 months
  and at the end of 1 year.
• If you bought this bond at t 6 months and sold
  it at t1 year you should earn 1f1 (the 6 mo.
  forward rate) over the time you own the bond.
• The price of the bond at t6 mos should reflect
  this.

90
6 mo return on 1 year bond

• At time t1 year the bond makes payments of
  102.10. The total return from owning the bond is
  the capital gains yield and interest yield and it
  should equal 1f1.022

91
6 mo return on 1 year bond

• Buying the bond at time 0 and selling it at the
  end of the first 6 months would then produce a
  return of
• Which is equal to the spot (zero coupon) six
  month rate

92
Return on the 2 year bond

• The price of the 2 year bond at the end of 6
  months should also equal the PV of its expected
  cash flows discounted back at the forward rate
  (otherwise there would be an arbitrage
  opportunity).
• By finding the price at the end of 6 months we
  can again find the return from owning the bond
  for 6 months form t0 to t6 mos.

93
6 mo return on 2 year bond

• There are three coupon payments left from time t
  6 mos to t 2 years, using the forward rates
  the price of the bond at t6mos should be

94
Total Return on holding 2 year bond for 6 months

• The 2 year bond originally sold for par and it
  made a 2.375 coupon payment at t6mos. The
  total return from owning it is then
• Which is the same as the 6 month return on the 1
  year bond (and the same as the 6 month spot rate)
  

95
Local Expectations

• Similarly owning the bond with each of the longer
  maturities should also produce the same 6 month
  return of 2.
• The key to this is the assumption that the
  forward rates hold. It has been shown that this
  interpretation is the only one that can be
  sustained in equilibrium.

96
Return to maturity expectations hypothesis

• This theory claims that the return achieved by
  buying short term and rolling over to a longer
  horizon will match the zero coupon return on the
  longer horizon bond. This eliminates the
  reinvestment risk.

97
Expectations Theory and Forward Rates

• The forward rate represents a break even rate
  since it the rate that would make you indifferent
  between two different maturities
• According to the pure expectations theory and its
  variations are based on the idea that the forward
  rate represents the market expectations of the
  future level of interest rates.
• However the forward rate does a poor job of
  predicting the actual future level of interest
  rates.

98
Segmented Markets Theory

• Interest Rates for each maturity are determined
  by the supply and demand for bonds at each
  maturity.
• Different maturity bonds are not perfect
  substitutes for each other.
• Implies that investors are not willing to accept
  a premium to switch from their market to a
  different maturity.
• Therefore the shape of the yield curve depends
  upon the asset liability constraints and goals of
  the market participants.

99
Biased Expectations Theories

• Both Liquidity Preference Theory and Preferred
  Habitat Theory include the belief that there is
  an expectations component to the yield curve.
• Both theories also state that there is a risk
  premium which causes there to be a difference in
  the short term and long term rates. (in other
  words a bias that changes the expectations result)

100
Liquidity Preference Theory

• This explanation claims that the since there is a
  price risk and liquidity risk associated with the
  long term bonds, investor must be offered a
  premium to invest in long term bonds
• Therefore the long term rate reflects both an
  expectations component and a risk premium.
• This tends to imply that the yield curve will be
  upward sloping as long as the premium is large
  enough to outweigh an possible expected decrease.

101
Preferred Habitat Theory

• Like the liquidity theory this idea assumes that
  there is an expectations component and a risk
  premium.
• In other words the bonds are substitutes, but
  savers might have a preference for one maturity
  over another (they are not perfect substitutes).
• However the premium associated with long term
  rates does not need to be positive.
• If there are demand and supply imbalances then
  investors might be willing to switch to a
  different maturity if the premium produces enough
  benefit.

102
Preferred Habitat Theoryand The 3 Empirical
Observations

• Thus according to Preferred Habitat theory a rise
  in short term rates still causes a rise in the
  average of the future short term rates. This
  occurs because of the expectations component of
  the theory. Therefore the long and short rates
  move together and fact 1 is explained.

103
Preferred Habitat Theory

• The explanation of Fact 2 from the expectations
  hypothesis still works. In the case of a
  downward sloping yield curve, the term premium
  (interest rate risk) must not be large enough to
  compensate for the currently high short term
  rates (Current high inflation with an expectation
  of a decrease in inflation). Since the demand
  for the short term bonds will increase, the yield
  on them should fall in the future.

104
Preferred Habitat Theory

• Fact three is explained since it will be unusual
  for the term premium to be so small or negative,
  therefore the the yield curve usually slopes up.

105
Measuring Yield Curve Risk

• Key Rate Duration, Calculating the change in
  value for a security or portfolio after changing
  one key interest rate keeping other rates
  constant.
• Each point on the spot yield curve has a separate
  duration associated with it.
• If you allowed all rates to change by the same
  amount, you could measure the response to the
  security or portfolio to a parallel shift in the
  yield curve.

106
Federal Reserve

• Goals vs. Targets BCLP?
• Overview of the system
• Discussion of appropriate goals / role of
  monetary policy
• A day at the Federal Reserve Desk
• Taylor Rule (determination of Fed Funds Rate)
• Changes overtime on effectiveness of Fed /
  changes in Banking

107
Determinants of Long Term Rates

• Expectations Hypothesis
• Temporary vs. Perm shifts in short term rates

108
Bond Yields and Expectations

• The long term yield definitely has an
  expectations component.
• Assume that inflation has started to increase,
  but the Fed Res has not increased the Fed Funds
  rate Long Term rates will increase in
  anticipation of an increase in rates.

109
Other? Influences on Long Term Rates

• Average rate of inflation over past 5 years.
  Expectations of increased inflation cause LT
  bond yield to increase. (expected increase in
  future ST rates)
• Changes in real growth rate Bond yield may even
  decline during recovery (lag in impact (last
  class)

110
Other? continued

• Negative Correlation with government budget
  deficit/GDP (rates increase as deficit increases)
  segmented markets?
• Positive Correlation with ratio of capital
  Spending to GDP (firms compete for capital rates
  increase) (models from last class)

111
Yield Spread and Forecasting

• Is the Yield Spread a good Forecaster of future
  economic activity?

112
The Conundrum and Lags

• Changes in inflationary expectations are tied to
  changes in Fed Policy
• If fed rate is below expectations Inflationary
  pressure exists
• If fed pushes rates up quickly inflationary
  pressure eases and it is easy for the rate to be
  too high (overshot by the Fed)
• If it does not increase rates and they are too
  low still have inflationary pressure