The Federal Reserve’s New Target Range

On December 16, 2008, one of the most significant monetary policy decisions in US history was handed down by the Federal Reserve's Open Market Committee (FOMC). In an effort to combat accelerating deflation in the Consumer Price Index (CPI) and massive job losses, the FOMC announced a reduction of its federal funds rate target from 1% to an unprecedented range of 0% to 0.25%. While critics of the move might point to relatively stable core inflation rates (which exclude food and energy), the FOMC was clearly more concerned about the state of the job market and the accelerating deflation reflected in the headline CPI. In fact, for two consecutive months, the US experienced record CPI deflation with rates of -1% in October and -1.7% in November of 2008. Along with OPEC's attempts to curtail oil production, this move by the FOMC is likely to help stabilize the price level.

The Fed announcement is historic for the low level of rates in its targeting and for the unique setting of a target range. This gives the Fed modest room for flexibility above the nominal floor of a zero federal funds rate. Whether it will be enough to spur the feeble economy is doubtful. Fortunately, the FOMC also announced that the federal funds rate is likely to remain within the target range for an extended period. The central bank is also prepared to purchase agency debt and mortgage-backed securities. Furthermore, through the Fed's expanded toolkit, it will begin direct loans to households and small businesses starting in 2009.

Fed chairman Ben Bernanke recognizes that the US economy is ripe for implementing the tenets of his Bernanke Doctrine, outlined in his 2002 speech titled "Deflation: Making Sure 'It' Doesn't Happen Here." In that speech, well before he was appointed to chair the Fed, he stated, "the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending—namely, recession, rising unemployment, and financial stress." Bernanke now has the chance to run the Fed during the precise scenario that he described six years ago.

In fact, the FOMC's press release of December 16, 2008 announces policy that effectively implements most of the seven steps of the Bernanke Doctrine. The FOMC's bold move may stave off a severe recession, but it does not come without potential costs. The combination of aggressive monetary policy, and recent and proposed fiscal stimulus could eventually reduce confidence in the US Treasury's ability to service its debts.

For the time being, Chairman Bernanke appears to be doing what is necessary to support another of his statements from six years ago:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve System. I would like to say to Milton and Anna [Friedman]: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

Discussion Questions

1. What could be the negative ramifications of implementing such a bold expansionary monetary policy at this time? How likely do you think it is that such negative ramifications occur?

2. Do you believe that historically low interest rates will be sufficient to save businesses struggling to avoid bankruptcy, such as those in the auto industry?

3. The current state of the US economy bears remarkable similarity to that of the beginning of the Great Depression. Do you think that Chairman Bernanke and his doctrine will keep the US out of a deflationary spiral? Will the doctrine, along with fiscal policy from recently elected officials, be enough to keep America out of a depression?

4. The US national debt held by the public is currently about $6.4 trillion or 45% of the nominal GDP in 2008. Is there any reason to worry over the ability of the US Treasury to meet national debt obligations? Why or why not?

5. Now that gasoline prices have returned to low levels, some economists may believe that it is an appropriate time to raise the federal gasoline tax. Do you agree with this position? Why or why not?

Debit or Credit?

As an economist and beloved shopper, I shudder in disbelief at how many credit-card owners still purchase items with their debit card. Assuming that you have a debit card and a credit card that is not maxed out, I present the following economic argument for why you should choose to use your credit card over your debit card.

The classic rebuttal I get to this argument is, "People are not responsible; they simply charge things without keeping track until their bill comes in." But how sound an argument is this? When you use your debit card, you still need to maintain a positive balance in your checking account so you don't overdraw and incur any fees. It only takes a little more effort to keep track of credit card purchases if you get into a routine of noting expenditures. For example, you could do the following: Upon making a purchase, set aside the purchased amount into a separate interest-bearing checking or savings account (which is easy and quick to do thanks to online banking), or track purchases in a spreadsheet or program (also easy to do with programs such as Microsoft Excel or Microsoft Money).

Another common response I hear is, "Some people keep a high balance on their credit card." When you use a debit card, the money is automatically withdrawn from your account. So the existing balance on your credit card is irrelevant when deciding whether to purchase the next item with either debit or credit since using your debit card would imply you have the cash on hand to buy it.

Even under the assumption that there is some cost to tracking expenses, there are still three significant reasons why you should use your credit card over your debit card.

1. The time cost of money
2. Typically credit cards offer better rewards programs
3. Build credit

Everyone knows that a dollar today is not worth the same as a dollar tomorrow. If you can forgo spending a dollar until a later time, then that dollar can earn interest until you actually spend it. In economics and finance, we analyze problems such as this using the concepts of present value (PV) and future value (FV). That is, the future value (FV) of a dollar today (PV) is

FV = PV x (1 + r),

where r is the interest rate over the time period in question. Since your debit card requires you to pay for the good today while the credit card allows you to pay for the good in the future at the same nominal price, economically you are better off letting the payment value collect interest until the balance is due and then paying off the balance.

Although debit cards are beginning to offer more competitive rewards programs, credit card companies typically still offer more diverse and appealing options such as cash back, miles, and points programs.

Last, the use of debit cards does not contribute to your credit rating. The responsible use of a credit card is a significant way that you as a consumer can build credit and improve your credit rating.

Discussion Questions

1. Why are some consumers unable to qualify for a credit card? Is their inability to qualify a good signal of their financial well-being?

2. How do rewards programs affect the bottom line of a credit card company? How can they afford to offer such incentives?

3. What kind of rewards would induce you to pay for something immediately rather than in the future by using your debit card over your credit card?

4. One argument for the use of debit cards is the option to receive cash back with your purchase if your bank's ATM is not near by. How does this affect your choice to use you a debit or credit card?

America's Looming Liquidity Trap

In October 2008, the US unemployment rate hit 6.5%, a 14-and-a-half year high, as announced by the Labor Department. This lofty rate is likely to increase in the coming months in the wake of the ongoing financial crisis and adjustments in the real estate market. It also comes despite two 50 basis point cuts in the target federal funds rate made by the Federal Reserve during that month. These interest rate reductions brought the target fed funds rate down to 1%, a very low target rate by historical standards and close to the nominal rate floor of 0%. The Federal Reserve therefore finds itself in the thorny situation of having only 100 basis points left to work with for possible target rate cuts. (Note that a basis point represents 1/100th of a percentage point, so 1% is 100 basis points.)

The fed funds rate cannot go below 0% because a transaction at a negative nominal rate implies a negative nominal cost of borrowing funds. Furthermore, that implies a positive nominal payoff to the borrower and a positive nominal loss to the lender. Under typical, positive rates of inflation, the real costs and payoffs are amplified. This is shown in the following Fisher equation where i is the nominal interest rate, r is the real interest rate, and is the inflation rate:


This floor for the nominal fed funds rate brings up the very real possibility that the US will soon be mired in a liquidity trap—a situation in which "the monetary authority is unable to stimulate the economy with traditional monetary policy tools." One explanation for this weakness of monetary policy comes from the analysis on the real interest rate given above. In difficult economic times, why would financial institutions take on the risk of lending out money to a borrower who may default on the loan when the real return on even a fully repaid loan is negative!

An excellent source on how our nation might remedy its liquidity trap is given by the 2008 Nobel Laureate in Economic Sciences, Paul Krugman. His 1999 article "Thinking About the Liquidity Trap" offered policy solutions for springing the Japanese economy from the type of liquidity trap that now threatens the United States. Krugman's figure 1 from that paper shows a nice IS-LM example of the ineffectiveness of monetary policy. Wikipedia provides a good introduction to the IS-LM model. Below I present a modified version of Krugman's figure 1, in the context of current US interest rates, to represent traditional monetary expansion with a looming liquidity trap.



An economy may also happen to face declining consumption expenditures, as the US currently does, due to concerns about a rising unemployment rate, which can result in lower exogenous consumption and a falling marginal propensity to consume. In that case, the resulting leftward movements of the IS curve make monetary policy even less effective. Krugman's solution to the scenario is to have the monetary authorities credibly commit to sustained higher future inflation. The expectation that such higher inflation will eat away at the purchasing power of cash holdings should convince consumers to ramp up their spending and move the IS curve rightward.

President-elect Obama and the new Congress will undoubtedly undertake expansionary fiscal policy to attempt to move the IS curve rightward. However, our already massive national debt and the likelihood of waste involved in government spending, support Krugman's solution. Our newly elected officials and the Federal Reserve Board are facing unenviable policy choices.

Discussion Questions

1. Suppose that you were in control of US fiscal and monetary policy. What policies, if any, would you implement to improve US economic conditions?

2. Do you believe that America will soon face a liquidity trap? Why or why not?

3. The International Monetary Fund forecasts that the world's rich economies will collectively experience economic contraction for the first time since World War II. When was the last time America faced a liquidity trap? What circumstances led to that liquidity trap environment?

Financial Market Risks and Negative Nominal T-bill Rates

On September 17, in the immediate aftermath of the Lehman Brothers bankruptcy, the AIG bailout, and the mortgage crisis, negative nominal Treasury bill rates briefly appeared for the first time since January 1940. As Madlen Read points out, a negative nominal Treasury bill rate implies that “investors were willing to take a small loss on the security.”

At first glance, such behavior on the part of seasoned investors seems odd. Why pay more for a security than the amount the US Federal government guarantees to pay you in the future¹? One possibility would be that the general price level could fall so that the smaller future payment would represent more purchasing power than the current price of the security. That is, if the price level falls enough, the $1000 payment one receives in several months could buy more than, say the $1000.05 price of the bill could buy today. There is some evidence for this: the US Bureau of Labor Statistics reports that in 2008, on a monthly basis, the percentage change in the CPI was 1.1% in June, 0.8% in July, and –0.1% in August. However, if that is the case, one would still get more purchasing power by holding the $1000.05 in cash through the period of falling prices than by receiving only $1000 in the future. Yet, where can such cash be stored safely?

A more likely explanation is that growing fears of systemic risk have discouraged investors from holding any but the safest financial assets. One example of systemic risk comes from the Reserve Primary Fund, the oldest U.S. money-market fund, which lost two-thirds of its asset value due to its investment in Lehman Brothers’s debt. Wary investors fear that similar losses could threaten other financial institutions. Since US Treasuries are generally considered to be the safest investment possible, there was apparently a rush to invest in these securities. Therefore, an increase in demand for T-bills was likely accompanied by a reduced willingness to sell such securities. The latter represents a decline in the supply of T-bills. Both sides of the market then acted in unison to push up the price of T-bills to such an extent that their sales prices briefly exceeded their maturity values. The maturity value, represented on the graph below by the M=1000 line, is the amount, typically $1000, that the bill specifies will be paid to the owner at maturity.


We can solve for the negative nominal rate mathematically using the following formula:


where M is the bill’s maturity value, PB is the bill’s price, and r is its annualized rate of return on the bill when it is held to maturity.

To illustrate the negative rate phenomenon, suppose that for a $1000 maturity value, the market trades a 3-month T-bill at a price of $1000.05. The nominal rate of return, r, is therefore –.02%.

Negative nominal rates were described here in the context of the Japanese market by Daniel L. Thornton in the January 1999 issue of "Monetary Trends." In the article, Thornton states that “investors are willing to accept a negative nominal return on a risk-free asset because holding it is cheaper and less risky than transporting and storing cash.” So it seems that for one day at least, investors were willing to lock in a nominal loss on a safe asset rather than risk leaving cash in financial institutions.

Discussion Questions
1. The Lehman Brothers bankruptcy, the AIG bailout, and the mortgage crisis have apparently shaken investor confidence in financial institutions. Do you think their fears are justified? Do you believe that these financial events have had an impact on your life? If yes, how, and if not, then why not?

2. How might forecasts of a falling general price level in the near future help to explain investors' willingness to accept negative nominal T-bill rates?

3. The dramatic shifting of funds into the safety of Treasuries implies that funds left other sectors. With many financial sites available, you can find information the returns on various financial assets online. Which investment sectors had the largest declines on Sept. 17, 2008? Which investment sectors had the largest gains on that day? How would you explain the results that you found?
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¹ Recall that T-bills have zero coupons which means that they make no payment until the maturity date.

Creating Money (or Jobs) Out of Thin Air

Today, amid foreign financial market volatility, the Federal Reserve cut the federal funds rate from 4.25% to 3.5% to prevent a recession. You may read the official press release here. The move is rare for two reasons. The Federal Reserve reduced the federal funds rate before its regularly scheduled meeting next week, and the Federal Reserve reduced the rate by 75 basis points, as opposed to its usual 25 or 50 basis point increments. In summary, today’s move is rare for its timing and magnitude.

The federal funds rate, or the interest rate that U.S. banks charge each other for overnight loans, is the benchmark rate for many short-term and long-term interest rates in the United States. A reduction in the federal funds rate, often times (though not always), decreases the interest rate on credit cards, automobile loans, and mortgages. Lower interest rates encourage consumers to spend and businesses to build new offices and purchase computers, machinery, and software. A boost in consumption (e.g. buying new clothes) and investment (e.g. building new offices) spending are exactly what the economy needs when it is slipping into a recession caused by sudden drops in overall spending. Though the U.S. economy is NOT officially in a recession, the Federal Reserve forecasts “slowed growth” and would like to cut rates just-in-case.

The previous explanation shows how the Federal Reserve could use monetary policy to minimize the depth and length of a recession. However, what is less well known is the process with which the Federal Reserve is able to manipulate the federal funds rate. Essentially, the Federal Reserve lowers the federal funds rate by expanding the money supply. This is easier said than done.

First and foremost, the Federal Reserve does NOT print new dollar bills. So how is it able to create new money? There are two main forms of money—cash in circulation and checking deposits held in banks. Separate from the money supply are “reserve accounts” that commercial banks are required to have at the Federal Reserve. These reserve accounts hold cash for the commercial banks in case depositors cash-out some of their deposits.

The Federal Reserve can expand the money supply by expanding the amount of deposits held in the U.S. commercial banking system. One way to do so is to purchase U.S. government bonds issued by the U.S. Treasury department. When the Federal Reserve purchases government bonds from commercial banks, it takes bonds out of circulation and electronically credits reserve accounts. U.S. commercial banks armed with more cash reserves will issue new loans which are then deposited back into the banking system. This method effectively increases the dollar amount of checking deposits in the economy, and hence, expands the money supply.

Discussion Questions

1. Suppose U.S. commercial banks are highly reluctant to issue new loans even if they are armed with more reserves. How would this impact the Federal Reserve’s ability to expand the money supply and lower the federal funds rate?

2. Republican presidential candidate, Ron Paul, believes that the Federal Reserve “debases and depreciates” the currency through its manipulation of the money supply. In fact, he wants to abolish the Federal Reserve altogether. Using the definition of the money supply and the relationship between interest rates and unemployment, how could the money supply be “pro-cyclical” without the Federal Reserve?

What's a Fiscal Authority to Do?

The likelihood of slow growth or a recession in the United States has policymakers looking for ways to soften the blow. There are two basic ways the government can stabilize output: monetary policy (changes in the money supply and interest rates) or fiscal policy (changes in government taxation and spending). The U.S. monetary authority, the Federal Reserve (or Fed), responded to the threat of recession by lowering interest rates. Lower interest rates reduce the cost of borrowing, accommodating investment and consumption spending during downturns (with the added benefit of lowering the value of the dollar and thus boosting U.S. exports). The timing and magnitude of interest-rate changes are always tricky, but even if rate cuts don't avert a downturn altogether, they'll almost certainly reduce the depth and length of a recession.

But what, if anything, can the fiscal authority—Congress and the President—do to assist the economy? According to Fed chair Ben Bernanke, "Fiscal action could be helpful in principle, as fiscal and monetary stimulus together may provide broader support for the economy than monetary actions alone." (Read this New York Times article for more.) However, Bernanke is hedging a bit here. By saying that tax cuts or spending increases "could be helpful in principle," he implicitly acknowledges that such measures may be ineffective, or even harmful, in practice. The process of agreeing on and passing legislation limits the usefulness of fiscal policy for stabilizing mild fluctuations in economic output. By the time our representatives haggle over and pass legislation, the downturn may be over or the resulting policy may reflect political rather than economic considerations. For this reason and others, recent commentaries by Greg Mankiw and Robert J. Samuelson argue that we should leave the Fed to address mild ups and downs in the business cycle, reserving fiscal policy for deep or prolonged recessions.

Discussion Questions

1. Limitations of fiscal policy aside, Bernanke seems to understand that politicians seeking a track record to run on will often favor policy action over informed inaction. What advice does he give policymakers who are eager to implement fiscal policy?

2. Three specific types of "lag" may delay the beneficial effects of economic policies. The recognition lag is the time it takes us to figure out we're in an economic pickle. We often don't know that we're in a recession until months after it's started. The implementation lag is the time it takes policymakers to agree on and implement policies. The impact lag is the time it takes a policy to work its way through the economy and affect economic output and unemployment. For example, an increase in government spending on highway construction will show up as additional output over the entire life of the project, not all at once. How might these lag times differ between monetary and fiscal policy?

3. Plotting economic output over time reveals two basic observations: the smooth upward trend in output growth over the long haul, and the up-and-down wiggle of output in the short term. To paraphrase Aplia's founder Paul Romer, it's easy to lose sight of the trend for the wiggle. Policymakers can get so wrapped up in temporary economic tumults that they lose focus on the bigger picture. If we're headed for recession, odds are that it will be mild by historical standards and the Fed will have plenty of policy ammunition to soften its adverse effects. Meanwhile, small changes in the long-run rate of economic growth have large impacts on future living standards. Given that, what policies would you recommend the action-minded fiscal authority focus on to improve the long-term growth prospects of the U.S. economy?

For more on the appropriate role of fiscal policy, listen to Bloomberg’s interview with Stanford economist John Taylor.

Monetary Policy Reaction Function

The recent financial turmoil and its economic consequences have led the Federal Reserve to aggressively cut the federal funds rate, a key benchmark for all interest rates. In a previous blog post, I explained how the Fed could keep the federal funds rate constant while money demand increases. Now I want to focus on how and why the Federal Reserve reduces the federal funds rate.

The "how" question is easily answered in most economics textbooks. Once the Federal Open Market Committee (FOMC) decides to cut the federal funds rate by 50 basis points, the Open Market Trading Desk purchases the quantity of government securities necessary to reach the new federal funds rate. The graph on the right shows how open-market purchases could lower the federal funds rate from 5.25% to 4.75%.

So far, I have stuck to the facts without building a model of the Fed's behavior. Economists sometimes find it convenient to model the behavior of the Fed in terms of a monetary policy reaction function (MPRF). The following is an example of an MPRF from Ben Bernanke and Robert Frank's Principles of Economics:

Of course, the MPRF above is just one example, and there are other examples (such as the Taylor Rule) that are more complex. For teaching purposes, let's just use the simple MPRF.

In addition to equations, economists often use graphs to depict models. The following graph shows the simple MPRF with the real interest rate on the Y-axis and the inflation rate on the X-axis. Assume a 3% actual and long-run target inflation rate.

The graph shows that a downward shift in the MPRF reduces the actual real interest rate from 2.25% to 1.75% when the actual inflation rate is equal to the initial target inflation rate of 3%. Assuming that the actual inflation rate remains constant in the short run, the shift in the MPRF causes a reduction in the real interest rate, and consequently stimulates investment and consumption. The ultimate goal is to stimulate aggregate demand and prevent the recent financial turmoil from drastically affecting the broader economy.

Discussion Questions

1. Refer to the simple MPRF equation. A downward shift of the MPRF could be accomplished by a reduction in the long-run target real interest rate (r*). The Fed typically sets r* in line with the equilibrium real interest rate that prevails in the market for loanable funds. Is there reason to believe that the recent financial turbulence has disrupted investment, private saving, public saving, or net capital inflows?

2. A downward shift of the MPRF could also be accomplished by an increase in the long-run target inflation rate. Is there reason to believe that the Fed has increased the long-run target inflation rate?

3. Are there other factors that the Fed should consider in its MPRF?

Monetary Policy and Flexible Exchange Rates

The Federal Open Market Committee (FOMC), the monetary policy arm of the Federal Reserve, announced a 50-basis-point reduction in the target federal funds rate on Tuesday, September 18. The stock market soared in response to the rate cut because most market watchers were only expecting a 25-basis-point reduction. Read the FOMC statement for the reasons behind the rate cut. After the announcement, the U.S. dollar decreased in value against the euro, the British pound, the Japanese yen, and the Canadian dollar. This was no coincidence, and the reduction in the value of the dollar actually reinforces the Federal Reserve's goal of maintaining moderate economic growth.

The federal funds rate is a benchmark for other interest rates in the United States. For simplicity, let's imagine for a moment that the federal funds rate is the only interest rate in the United States. If this is true, then the U.S. interest rate is also the dollar rate of return for holding U.S. assets. However, the United States is not the only country in the world. The European Union has its own interest rate that represents the euro rate of return for holding EU assets. For a given amount of volatility in asset prices, investors place their savings in assets that offer the best rate of return after adjusting for the exchange rate.

A reduction in the U.S. interest rate makes U.S. financial assets relatively less attractive than before because the EU interest rate has remained unchanged. U.S. investors will want to purchase more EU assets (i.e., there will be an increase in the supply of U.S. dollars), and EU investors will want to purchase fewer U.S. assets (i.e., there will be a decrease in the demand for U.S. dollars). Figure 1 shows the subsequent changes in the market for U.S. dollars.

A depreciation of the U.S. currency will make U.S. exports relatively inexpensive for foreigners while making imports from foreign countries relatively expensive for Americans. A decrease in the interest rate causes an increase in net exports and reduces the size of the U.S. trade deficit. Figure 2 shows the relationship between the exchange rate and net exports. Since net exports are a component of total spending in the U.S. economy, the Fed's rate cut provides two boosts to aggregate spending: (1) the rate cut stimulates consumption and investment because the cost of borrowing decreases; and (2) the rate cut stimulates net exports due to U.S. dollar depreciation. By cutting the target fed funds rate, the Fed intends to prop up spending and growth at a time when tightening credit conditions threaten to slow or reverse the growth of economic output.

Discussion Questions

1. The previous analysis assumes that the United States and the European Union operate under a flexible exchange rate regime. Would the Fed be able to maintain moderate output growth after a severe shock, such as the subprime mortgage meltdown, if U.S. dollars were fixed to a currency such as the euro?

2. What if the Fed is wrong about the adverse effects of tightening credit conditions? What if growth would have continued at a moderate pace even without a rate cut? How would the decision to cut rates affect output and inflation in the short run and in the long run?

3. Suppose that at the next FOMC meeting on October 31, 2007, a jump in the inflation rate is reported. What would the FOMC do to the interest rate? How would this affect the exchange rate and net exports?

The Fed's Rate Cut

As Greg Mankiw recently pointed out and Wall Street Journal reporter David Wessel was quick to observe nearly a month ago, the actual federal funds rate has been trading below the Fed's target federal funds rate of 5.25%. The federal funds rate is the rate at which banks borrow from one another overnight, and it is the key benchmark interest rate for monetary policy. The Fed targets a relatively low, or loose, fed funds rate in order to encourage borrowing, speed up economic growth, and avoid recession. The Fed targets a neutral rate when it wants neither slower nor faster growth than the economy is currently experiencing. The Fed targets a relatively high, or tight, rate when it wants to discourage some borrowing, slow the pace of economic growth, and ensure price stability (low and stable inflation).

According to Mankiw, the actual fed funds rate averaged 5.02% during August—23 basis points lower than the target—while in the preceding 13 months, the Fed had never allowed the actual rate to deviate from the target by more than 1 basis point. Although we can't be sure until the next Federal Open Market Committee (FOMC) meeting on Tuesday, September 18, the behavior of the actual rate in August seems to suggest that the Fed will cut the target federal funds rate to at least 5.0%. A rate cut would mean that the Fed is backing away from a tighter policy stance associated with reducing inflation, and moving instead toward a more neutral monetary policy that will allow it to wait and see how the recent subprime and housing-market turmoil plays out in the broader economy.

The prospect of a rate cut raises the issue of moral hazard. Some critics feel that any loosening by the Fed will bail out borrowers who have taken on risky subprime mortgages and investors who have purchased the assets backed by such mortgages. By cutting rates, the Fed may encourage borrowers, lenders, and investors to make similar gambles in the future on the assumption that the Fed will intervene if things turn sour. Tyler Cowen's latest New York Times column argues that while the Fed should not go out of its way to help poor decision makers, the Fed's mandate—price stability and full employment—should not be sacrificed for fear of instigating moral hazard.

Discussion Questions

1. If banks become increasingly reluctant to lend to one another and to individual borrowers, what will happen to the types of consumption and investment expenditures that are typically financed by borrowing?

2. If borrowing difficulties persist for an extended period of time, what would you expect to happen to housing prices? What about economic growth? How should the Fed respond to this type of credit crunch?

3. Consider the borrowers, lenders, and investors who made poor decisions in the subprime market. Will some of them benefit from an FOMC decision to cut rates? Can the Fed prevent all moral hazard associated with monetary policy decisions? Can Fed policy provide total relief to the borrowers, lenders, and investors who made poor decisions in the subprime markets?

Interest Rates and Inflation

The central bank of China has been combating surging inflation, which recorded an 11-year high of 6.5% last month. The inflation has contributed not only to the erosion of purchasing power, but also to negative real interest rates in China. Recall that

Real Interest Rate = Nominal Interest Rate – Inflation Rate

While nominal interest rates are never negative, real interest rates will be negative if the inflation rate exceeds nominal interest rates.

Interest rates play a dual role in the economy. On the one hand, they determine the interest payments banks make to depositors; on the other, they determine the interest payments borrowers make to banks. Since the interest rate is the return on deposits, negative real interest rates imply a loss of purchasing power if people deposit money into banks. This will discourage people from saving and encourage them to withdraw their funds for current consumption and investment.

At the same time, negative real interest rates mean that the cost of borrowing is low or even negative. Because of this, negative real interest rates can boost aggregate demand, or total spending, and fuel a bubble in the stock market. As observed by Dong Zhixin of China Daily, low interest rates have played an important role in fueling the Chinese stock market, with people withdrawing or borrowing from banks to buy stocks.

In August, the People’s Bank of China raised nominal interest rates for the fourth time this year in an effort to cool the economy. This will boost real interest rates and raise the cost of borrowing at any given inflation rate. The higher cost of borrowing will hopefully curb excessive spending and ultimately reduce inflation.

Discussion Questions

1. Is it possible or even desirable for the Chinese government to fine-tune the real interest rate by adjusting the nominal interest rate? Why?

2. China's currency, the yuan, is fixed to the U.S. dollar within a narrow band in the foreign exchange market. What impact do rising interest rates in China have on the exchange rate?

Lender of Last Resort

Rising foreclosures among homeowners with subprime mortgages led to unusually tight credit conditions in the banking system last week. Banks became reluctant to provide routine short-term loans to one another for fear that a borrowing bank's balance sheet would be too heavily concentrated in shaky subprime loans. When banks are reluctant to lend to each other, they tend to make fewer loans to businesses and households. Liquidity—the ease with which banks lend to creditworthy costumers and institutions—began to dry up. On August 17, the Fed entered the fray.

In two press releases (here and here), the Fed acknowledged that recent reluctance to lend posed a threat to economic growth, and in a rare move, it encouraged banks with limited credit access to borrow directly from the Fed by lowering the discount rate. The discount rate is the interest rate at which banks borrow from the Fed. The Fed typically sets the discount rate 100 basis points (1 percentage point) above the rate at which banks lend to one another (the federal funds rate). On August 17, the Fed narrowed the spread between the discount and federal funds rates to 50 basis points—thereby reducing the penalty associated with borrowing from the Fed.

By lowering the discount rate, the Fed was fulfilling its function as the lender of last resort. To see why the Fed stepped in, it helps to consider how subprime fears might affect the availability of loans for creditworthy borrowers. Banks, especially large ones, often borrow in order to meet the Fed's reserve requirement (the fraction of the bank's deposits that must be held in reserve rather than being lent out). Without knowledge of which big banks will be affected by subprime foreclosures, other banks that would typically lend some of their excess reserves to big banks at the federal funds rate will be reluctant to do so. If large banks that are short on required reserves find it difficult to borrow reserves in the federal funds market, they will be forced to call in loans, and they'll be hesitant to make any further loans. If banks call in loans and hesitate to lend to even creditworthy people and businesses, loan-dependent consumption and investment spending will fall, leading to slower economic growth, or worse, recession.

By reducing the discount rate, the Fed hopes to increase liquidity in financial markets by making it easier for banks to obtain short-term loans. If the policy works, creditworthy borrowers will not have any trouble obtaining loans for houses, cars, factory expansions, office buildings, and the like. As the subprime crisis subsides, regular credit conditions should prevail and the Fed will be able to return the spread between the federal funds rate and discount rate to its initial value of 100 basis points. If the credit crisis persists in spite of the discount rate move, the Fed will have to take stronger action. Read a recent Bloomberg column by John Berry to find out more.

Discussion Questions

1. In times of financial crisis, the Fed functions as a lender of last resort. More typically, the Fed's role is one of economic stabilization—maintaining low and stable inflation as well as full-employment output. How does the Fed's discount rate decision help it to fulfill its roles as lender of last resort and economic stabilizer?

2. Berry's column mentions "moral hazard" several times. In what way does the Fed's discount rate decision risk moral hazard?

3. Fears about losses from assets backed by subprime mortgages were at the root of much of the financial turmoil of recent weeks. According to Berry's column, how do the estimated losses from the default of subprime borrowers compare to the total assets of the U.S. and Euro-area banking sectors?

4. If the credit crisis continues and economic growth suffers, how might the Fed respond?

5. According to Berry, "…growth may have been damaged even if [credit] markets do settle down relatively soon." How would a temporary credit crisis damage economic growth? Consider the links between lending, housing prices, household wealth, and consumption, as well as the link between lending and investment.

A Chinese Dilemma

The People's Bank of China announced on May 18 that it would allow the yuan to float within a 0.5% band around a government-imposed exchange rate. For example, if the government-imposed rate were 7.6938 yuan per U.S. dollar, the central bank would allow the exchange rate to fluctuate between 7.6553 and 7.7323 yuan per U.S. dollar. Due to a soaring economy and a widening trade surplus with the United States, the yuan closed at a record high of 7.6686 yuan per U.S. dollar on the first day of the new exchange rate policy. In other words, after the announcement, the yuan strengthened against the U.S. dollar.

A "stronger yuan" means that 1 yuan can purchase more U.S. dollars than before. If the exchange rate were 1 yuan per U.S. dollar, yuan holders could obtain $1 for each yuan exchanged. If the exchange rate fell to 0.5 yuan per U.S. dollar, yuan holders could obtain $2 for each yuan exchanged. Hence, the yuan gets stronger as its exchange rate falls, and is stronger at 7.6686 than at 7.7323 yuan per U.S. dollar.

The stronger yuan makes Chinese products more expensive for Americans, reducing net exports and therefore lowering China's real GDP growth rate. Why would the People's Bank of China want to destroy jobs in its exports sector by favoring a stronger yuan? One popular explanation is that the Chinese government is giving in to U.S. political pressure to strengthen the yuan. A stronger yuan would reduce the U.S. trade deficit with China, boosting American goodwill towards China and avoiding the passage of U.S. restrictions on Chinese imports.

There is also an economic explanation for China's new exchange rate policy. Along with China's recent double-digit economic growth comes the prospect of high inflation and economic instability. The standard monetary policy remedy for an overheating economy is higher interest rates. Raising the cost of borrowing reduces overzealous consumption and runaway investment spending. Furthermore, higher interest rates attract more foreign investors, raising foreign demand for Chinese currency, which strengthens the value of the yuan. At the same time, higher interest rates encourage Chinese investors to keep more of their yuan in Chinese assets, leading to a reduction in the supply of yuan, which adds additional upward pressure on the value of the yuan.

Therefore, the People's Bank of China faces an economic dilemma. If it wants to tame the roaring economy, it must allow the yuan to strengthen. But if it wants to maintain a fixed exchange rate, it would need to keep the interest rate unchanged. Today, the central bank has chosen economic stability over exchange rate stability.

Discussion Questions

1. The central bank coupled the exchange rate announcement with a Q&A document for the public. In what ways is the central bank's explanation for widening the exchange rate band similar to our analysis? In what ways is it different?

2. Why would the central bank hesitate to allow the yuan to float freely? In other words, what are the drawbacks of immediately eliminating exchange rate controls?

3. For some time, U.S. policymakers have complained about China's exchange rate policy. How would a weaker U.S. dollar affect American consumers of Chinese products? How would a weaker dollar affect American producers who compete with Chinese producers? How would a weaker dollar affect Chinese consumers of American products and American firms that export goods to China?

Inflation, Taxes, and Saving

What's so bad about inflation? Economists typically break the discussion of inflation costs into two categories: the costs of low, predictable inflation and the costs of high, unpredictable inflation.

Economies with high, unpredictable inflation tend to experience slower growth rates. With unpredictable inflation, borrowers and lenders cannot be sure what the real interest rate will turn out to be over the course of a loan. This uncertainty makes people less likely to lend their money (for example, by buying bonds), which in turn leads to less investment and a slower rate of long-term economic growth.

If the inflation rate is low and stable, it imposes fewer economic costs. As prices rise, one dollar will purchase fewer and fewer goods and services over time. This slow erosion of purchasing power encourages people to invest their savings in interest-bearing accounts, keep more of their money in the bank and less in currency, and generally spend more time managing their assets than they would in the absence of inflation; but savings rates are pretty much unaffected… right?

Not quite. Even if inflation is relatively tame, it can still have some major consequences on savings rates because of the way investment gains are taxed. In a recent Slate column, Henry Blodget argues that the design of the tax system in the United States discourages saving—in part because portions of the tax code do not attempt to correct for distortions caused by inflation. Read Blodget's article to find out more about the tax treatment of savings and the tax distortions from inflation.

Discussion Questions

1. According to Blodget, what non–tax-related factors explain the negative U.S. personal savings rate in 2005 and 2006?

2. Suppose you purchase a $1,000 T-bill that offers a 4% nominal rate of return. The inflation rate is 3% per year and you're in the 15% tax bracket.

• What is the before-tax nominal return on your T-bill in the first year?
• As Blodget notes, the U.S. government treats the return on your T-bill as income and assesses a 15% tax on the nominal return from your T-bill. How much tax would you pay on your nominal return from the T-bill?
• By how much does inflation erode the purchasing power of your nominal return?
• What is the after-tax, inflation-adjusted return on your T-bill in the first year?

3. What are the differences between taxes on gains from stocks and taxes on gains from holding T-bills? Suppose you purchase a share of stock that immediately doubles in value. What tax event will you trigger in the event that you sell the share of stock at its new, higher price?

4. How does low, predictable inflation distort savings decisions when the government taxes the nominal gains on savings vehicles such as stocks and bonds?

5. What are Blodget's suggestions for making the tax system less hostile to saving? How does he suggest taxing the capital gains from the sale of stocks? How would he treat the interest earned on T-bills? Can you think of other changes to the tax system that would encourage rather than discourage saving?

Subprime Primer

Subprime mortgage lenders make home loans to "subprime" borrowers—people who don't have the income, wealth, or credit history to qualify for the traditional lending terms offered to prime borrowers. The recent housing slump pushed multiple subprime lenders into bankruptcy as a rising number of subprime borrowers failed to make their mortgage payments. As subprime lenders go belly-up and subprime borrowers fall on hard times, lawmakers have been quick to find signs of fraud and abuse, and quicker to propose new regulations for the subprime market. Events in the subprime market offer a glimpse of several issues behind the housing market correction in the United States. A recent New Yorker column by James Surowiecki explains the subprime fiasco.

Surowiecki suggests that focusing solely on "predatory lending" practices does not suffice to explain the trouble in subprime markets. He notes that lawmakers cannot consider instances of lender fraud and abuse without also considering the "overambition and overconfidence of borrowers." For example, borrowers who expected sharp increases in home prices used the easy credit offered by subprime lenders to make speculative purchases—buying a home with the intention of selling quickly and for a substantial profit. Other borrowers were enticed by low introductory interest rates and placed too much confidence in the ability of their future selves to pay the mortgage when the low rates expired and higher, adjustable interest rates kicked in.

University of Chicago economist Austan Goolsbee calls for restraint in the regulatory backlash against subprime lending in his New York Times column. Goolsbee focuses on a research paper by three economists: Kristopher Gerardi and Paul Willen from the Federal Reserve Bank of Boston and Harvey Rosen of Princeton. The paper suggests that innovations in the market for home loans, including subprime lending, offer more upside than down. According to the authors, a government crackdown on subprime lending could reduce homeownership opportunities among young people, minorities, and people without a lot of money for a down payment.

Discussion Questions

1. What's a "liar" loan? How did borrowers use such loans to make speculative gambles in the housing market?

2. What's a 2/28 loan? In what ways do consumers tend to "overvalue present gains at the expense of future costs," as Surowiecki suggests? (Think about decisions on whether to consume today or save for the future, or whether to study for an exam or attend a party.)

3. According to Surowiecki, what percentage of subprime borrowers were living in their homes and making monthly mortgage payments at the time the article was written? What does this suggest about the wisdom of an outright ban on "exotic" subprime lending products like the 2/28's?

4. In what way do subprime loans (such as 2/28's) benefit currently low-income households that expect to earn much higher income in the future? How do subprime rates reflect the fact that the expectation of higher future income is not a guarantee of higher future income?

5. What factors traditionally cause homeowners to foreclose? Do recent numbers suggest that subprime lending is the leading cause of foreclosures in the United States?

6. According to Goolsbee, what is the link between the expansion of subprime lending and the growth of homeownership among African-American and Hispanic households?

7. According to both Goolsbee and Surowiecki, the vast majority of subprime borrowers are making their mortgage payments on time. As higher, adjustable rates kick in on home loans with low introductory rates, how might the rates of delinquency (missed payments) and default (failure to pay the loan entirely) change? Suppose the housing market correction continues and home prices continue to fall. How will this affect the bets of speculative borrowers in the subprime market?

8. How would a continued housing slump affect economy-wide consumption and investment expenditures? (Recall that part of investment is residential investment—purchases of new homes and apartment buildings.)

Saving America

The U.S. trade deficit increased 2.4% between March and April 2006, which should be no surprise to our blog readers (archived entry: trade deficit and the negative saving rate). Some people point to China's fixed exchange rate or to the high oil prices for America's trade woes, but many macroeconomists contend that it is the lack of national saving that drives the trade deficit in the long run.

There are two markets that we have to consider when we examine the impact of saving on the trade deficit. First, consider the market for loanable funds, which determines the long-run real interest rate. Second, consider the relationship between the real interest rate and net exports. For simplicity, we're going to deal with absolute amounts (dollars) rather than relative amounts (percentages).

The market for loanable funds is where savers and lenders interact. Like any market, there's a supply and a demand. The demand for loanable funds consists of U.S. firms that want to borrow. The supply of loanable funds consists of U.S. firms, households, foreigners, and governments that want to lend. The price of loanable funds is the real interest rate, which is considered the "cost of borrowing" to borrowers and the "rate of return" to savers. The equilibrium real interest rate is where supply intersects demand, r*.

So what happens when the federal government increases its budget deficit and households decide to spend a larger share of their disposable income? An increase in the government budget deficit reduces public saving, and the increase in consumption reduces private saving. Put those two effects together, and we have a net decline in the supply of saving, which causes the equilibrium real interest rate to rise from r* to r2. (See Fig. 1.)A decrease in total saving in the United States pushes up the real interest rate. The real interest rate represents the rate of return for holding U.S. assets. If the real interest rate rises, then foreigners will want to buy more U.S. assets than they did before the rise. In order for foreigners to purchase U.S. assets, they must purchase U.S. dollars. Consequently, the demand for dollars increases, which increases the price of U.S. dollars. An appreciation of the U.S. currency, in real terms, will make U.S. exports less competitive and imports from foreign countries more attractive. An increase in the real interest rate causes a decrease in net exports and worsens the U.S. trade deficit. (See Fig. 2.)

Discussion Questions

1. According to our analysis, a fall in total saving actually increased the U.S. consumer's purchasing power of foreign goods and services (more U.S. imports) while it decreased the foreign consumer's purchasing power of U.S. goods and services (fewer U.S. exports). Is this an economic disaster or a sign that Americans are relatively wealthier than most people in the world?

2. A decrease in total saving increases the real interest rate, and a higher real interest rate increases foreign demand for U.S. assets, causing the price of the dollar--the real exchange rate--to rise. China purchases many U.S. assets in order to keep the value of its currency, the renminbi, relatively cheap compared to the dollar. In doing so, China intends to sustain American demand for Chinese-made goods. How does China's fixed nominal exchange rate policy affect the U.S. trade deficit in the long run?

3. If permanently higher oil prices reduce U.S. potential output, how does this affect national saving in the long run? How does this affect the trade deficit in the long run?

Fedspeak

Ever wonder what in the world the Fed is saying? In its most recent press release, the committee that sets monetary policy for the Federal Reserve Board said that “some further policy firming” may be needed. But for most of 2005, the releases said that “policy accommodation can be removed.” According to Greg Ip, a sharp journalist at the Wall Street Journal, this “sounds like they are removing the sofa beds from the Fed’s executive lounge.” What does the Fed mean when it says these things? And what’s behind the recent change?

In his column On Language, William Safire offers up this quote from Ip and goes on to explain the special language that the Open Market Committee of the Federal Reserve Board uses to describe its actions. He also gives the explanation that Ip, whom he calls the master code breaker of financial jargon, offers for why they speak in code.

1. Safire identifies several key words and phrases that the Fed uses frequently--words he calls “Fedspeak.” These include productivity gains and possible increase in resource utilization. Can you explain how these economic concepts relate to inflation, which the Fed is tasked with managing? What would productivity gains imply about expected inflation, and why? How would an increase in resource utilization impact inflation?

2. Another key term Safire identifies as “Fedspeak” is accommodative. When applied to policy, Safire says that this code word is supposed to mean “low interest rates that boost the economy.” Some economists refer to a neutral interest rate; that is, a rate which makes actual output in an economy grow at the same rate as the economy's capacity or potential output. The Fed never uses the term neutral interest rate, but if they did, how might they explain the reason for the switch from saying that "policy accommodation can be removed" to "further policy firming may be required?"

3. Safire calls the Federal Reserve a “House of Hints” because it uses these somewhat obscure “code phrases.” Why isn’t the Fed more straightforward? Ip suggests that the Fed relies on “Fedspeak” to retain flexibility in its future policy prescriptions. Can you think of any other reasons why the Fed would speak so cryptically? Imagine that you are the Fed Chairman--an official who is confirmed by Congress and oversees a body (the Fed), whose powers are determined by Congress. Further, imagine that it is an election year, and some politicians running for office are looking for a chance to get some media attention. What type of language would you use if you were considering implementing tighter (i.e., higher interest rate) monetary policy?

Topics: Monetary policy, the Fed, Interest rate