Highlighting a Few Key Ideas and Issues

 Strategic Targets  Inflation (low, stable); Unemployment (low) ▪ “Dual Mandate” by law ▪ Weight between the two matter of debate and policy (Phillips Curve issues)  Operational Target: Interest Rates  “Discount Rate”: only rate actually set by the Fed is the Other rates are merely influenced by Fed policy  Fed Funds Rate: primary target rate ▪ Target FF rate set at Fed (FOMC) meetings ▪ Effective FF rate set between banks using excess funds held on account with Fed ▪ Don’t pay too much attention to Fed rhetoric (political speech)

 Money Supply (primary tool)  No interest rate “knob” to adjust  Manipulates buying and selling Treasury bills/bonds (“Open Market Operations”)  During Crisis, Fed engaged in other, non-traditional ways of providing liquidity to short term lending markets

 “Taylor Rule”  Stanford economist John Taylor  Prescribing how Fed should set rate targets  Fairly accurate in describing Fed target setting Target Fed Funds Rate = *(Actual Inflation – Target Inflation) + 0.5*(Actual GDP – Potential GDP)  “2” comes from long run average “real” rate  TR: Lower FF Target when GDP growth below target (+ reverse)  TR: Raise FF Target when economy inflation above target ( + reverse)  Implies FF Target driving other short term rates ▪ (Effective Fed Funds, Tbill Rates, Commercial Paper Rates)

 Fisher Equation Market Rates = Real Rates + Expected Inflation  Expected inflation influenced by inflation and market perceptions of Fed actions  For expected inflation: Nominal Treasury Rate – TIPS Rate  Inflation/Expectations can swamp Fed actions:  1970s: Fed expands money to lower unemployment but …

 Fisher Equation Market Rates = Real Rates + Expected Inflation  Real rates reflect supply/demand for credit  Influenced by economic growth (higher when growth higher) ▪ Estimate of Real Rate: See TIPS Rates (See Bloomberg Rates)(See Bloomberg Rates)  Markets can pull Fed FF Target, not just pushed by it

Worldwide Fiscal-Monetary Problems

 Expected PV of Liabilities < = Expected PV of Assets  Liabilities = Money + Bonds  Assets = Discounted PV Expected Tax Revenue – Spending  When Markets Come to Evaluate M + B growth as much larger than Present Value of (Tax Revenue - Spending)  Debt-Currency-Inflation Crisis ▪ Germany 1920s, Mexico 1990s, Greece 2011 (no local currency)  Views/markets tend to switch all at once – “Peso Problem”

 Debt/GDP ratio useful but  Future GDP growth (tax revenues)  Possible future spending reductions  Demand for currency-debt matters in determining rates/interest payments  Outlook/Evaluation  Spain, Italy, Ireland, … France  Japan  U.S.

 Implication: U.S. Treasuries

 Cheap Credit  Public Sector Backing (Fannie, Freddie, Homeownership)  High Leverage (Assets/Equity) for Investment Banks (Bear, Lehman, Merrill …) + AIG  Banks Lending on 25 years of growth/repayment  Foreign Investment in US  NOTARIETY BUT TOO SMALL ▪ Securitization (Collateralized Debt: CDOs) ▪ Derivatives (Credit Default Swaps) ▪ Market-to-Market Accounting

 Mortgage-related securities marked-to-market daily  Immediately begin to reflect deteriorating conditions in 2007  Commercial loans on bank books valued by banks at their PV of expected cash flow  Widespread writing down of these loans doesn’t begin until 2009, giving appearance that mortgage market problems causing these problems  Problems already developing coincidental with mortgage problems in