EVENTS AFFECTING INTEREST RATES
1) The Venezuelan oil strike, now in its 51st day on January 21, 2003.
2) January 29, 2003 Fed Chairman Allen Greenspan decided to keep its
target for the federal funds rate unchanged at 1-1/4 percent despite
presence of war looming.
3) On January 7, 2003, President Bush announced a tax cut.
SUMMARY OF INTEREST RATE MOVEMENTS
Apart from the discount rate and the actual fed funds rate, the general
trend of interest rate movements over the six-week period is down. The discount
rate was 0.75% on January 15, 2003, and by the end of the six week period the
rate was up to 2.25%. The actual fed funds rate rose from 1.24% to 1.38% by the
end of the six weeks. The Fed funds target rate remained constant at 1.25%.
Over the entire six weeks, the direct commercial paper rate went down from
1.28% to 1.26%, the dealer commercial paper rate when down from 1.26% to
1.23%, the 90-day CD rate went down from 1.31% to 1.27%, and finally the 90day T-bill rate went down from 1.18% to 1.16%.
The individual rates generally move together, but not always. The 90-day
CD rate and the 90-day T-bill rate move pretty closely together in a downward
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trend. The direct and the dealer commercial paper rate also relatively follow the
same downward trend.
Changes in the direction of interest rates frequently indicate turning
points in the economy. There is a direct impact on companies when interest rates
drop and consumers postpone spending and investing decisions, thus spending
decreases. Profits decline as a result of consumers spending less in the economy.
This decline may cause companies to cut their costs as much as possible which
often results in personnel lay offs. This suggests an explanation for the current
low levels of unemployment due to record low interest rates. Additionally, as
people defer to participate in the economy, the economy falls into a slump.
Over the six week period the yield curve remains upward-sloping and
steep with long-term interest rates higher than short-term rates. The added
steepness of the yield curve sloping upward implies a broader range between
borrowing and lending rates. This can also add more of a chance of potential
profit for a financial intermediary. A rising yield curve implies various factors
based on the theories discussed in class.
According to the unbiased expectations theory, the yield curve primarily
reflects the interest-rate expectations of the financial marketplace. The
expectations theory can determine the shape of the yield curve since investors act
as a result of what they expect. For example, if rates are expected to rise in the
future, then investors may buy short-term securities and sell their long-term
securities if they are confronted with the chance of falling prices. Thus, the price
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of longer-term securities will fall, and interests will be higher. If this theory
holds true, then a rising yield proposes that interest rates are expected to rise.
The liquidity premium view contends that since there is greater risk
connected with longer-term securities, higher average returns result from those
securities, which give the yield curve an upward slope. Hence, this extra
premium presents a bias that would tend to give the yield curve a positive slope.
Finally the market segmentation and preferred habitat view of yield
curves assume that the supply of securities of different maturities affect the
shape of the curve. Thus the steep yield curve could be the result of a fall in
security prices due to an increase in the supply of longer-term securities. The fall
in prices may have initiated their yields to increase, causing an upward slope in
the curve.
ANALYSIS OF EVENT ONE
One event that may have influenced interest rate movements over the sixweek period is the crisis in Venezuela, a major supplier to the US market that
placed pressure on US inventories. The Venezuelan oil strike, now in its 51st day
on January 21, 2003 has caused prices to rise above $30.
During that time, conflicts continued to escalate between strikers and
Venezuelan President Hugo Chavez in spite of international efforts to settle the
dispute. Strikers shutting oil facilities down caused major damage, and it will
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take months for Venezuela to return to normal production levels. It was
recorded on January 21, 2003 that oil prices hit $34 a barrel in New York trading
as Iraqi tensions rose the week before. On February 27th, April crude-oil futures
on Nymex, the world’s largest energy-futures marketplace, hit $39.99 a barrel,
within a short distance of the $41.15 record high set on October 10, 1990.
As a result of these factors, oil prices have continued to rise for a longer
period, and in turn taxing the economy. Thus, the Fed is being given no other
option but to hold interest rates near their current four-decade lows.
Additionally, as the Bush Administration's stated the goal of Iraqi
disarmament and regime change, the oil-market disruptions from military
operations are expected to last even longer. Any minor political advances may
merely prolong the ambiguity on the topic of extreme oil prices.
I believe rates will remain low in, but that gradually oil prices will
stabilize at a lower price and market interest rates will rise. I believe this will
hold true because there are other factors that have increased the demand for
heating products in addition to the Venezuela and Iraqi crisis. Factors such as
market speculation, slow economic improvement, and the extensive winter
weather conditions in the U.S. have urged an increase in demand, which will
keep rates consistently low. Also, since the central bank reduced the Fed funds
rate 525 basis points from late 2000 to its current level of 1.25%; I do not believe it
will go any lower unless some drastic event occurs.
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Currently on Tuesday April 8, 2003, oil remained at $28 a barrel on the
New York Mercantile Exchange.
ANALYSIS OF EVENT TWO
Another important event that may have influenced rate movements over
this past six week period is the threat of war with Iraq, which influenced Allen
Greenspan to consider decreasing the Fed funds rate. However despite the
possibility of war on our economy and our stock market, on January 29, 2003 Fed
Chairman Allen Greenspan decided to keep its target for the federal funds rate
unchanged at 1.25%. Due to great uncertainty as troops are being prepared to
fight a battle and President Bush denounces Saddam Hussein, the Fed believes it
is not a time to raise or lower interest rates without further clarity on Iraq.
As a result of the Fed’s decision, stock prices rose and bond prices fell. The
Dow Jones industrial average that had been down more than 100 points in
trading earlier in the day was up 22 points at the close. In the last quarter of
2001, the economy only grew less than one percent, and ever since is continuing
its struggle to get back on track. A statement from the Fed noted that high oil
prices and “other aspects of geopolitical risks have reportedly fostered continued
restraint on spending and hiring by businesses.”
As a result of expectations of a war, I believe market interest rates will
continue to remain low, until more details are revealed concerning Iraq, which
may secure investor confidence. If war breaks out oil prices will continue to
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remain high and I believe there will be an increased risk of terrorism that may be
enduring. Other effects of war could be disruption in trade flows and tourism,
and a plummet in business confidence that may affect investment plans and
advertising budgets. Also, if a war occurs then bond yields would fall due to a
majority of investors turning to quality securities, such as banks, real estate,
government bonds, which would surpass the market. Thus, low interest rates
should be expected as central banks may choose not to increase rates for the sake
of the economy.
Currently, on March 18, 2003, the Federal Reserve met and again left rates
unchanged. Therefore, rates have not made any surprising moves since the
recorded six-week period, and the Fed funds rate is still at 1.25%. There is so
much uncertainty in the market that the Federal Open Market Committee “does
not believe it can usefully characterize the current balance of risks.” It appears
that the Fed wants to wait maybe a few months before coming together in
deciding another rate cut.
ANALYSIS OF EVENT THREE
Another important event is President George W. Bush’s plan to stimulate
the economy through new and accelerated tax breaks, which should benefit
almost everyone who pays taxes. On January 7, 2003, President Bush announced
a growth and jobs plan to strengthen the American economy. The plan is
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intended to have both direct and foreseeable effects, such as lowering the taxes
due, as well as bolstering stock prices and increasing business spending. Once
the plan effective, it will remove all individual taxation on all dividend payouts
and capital gains from increased stock earnings.
The purpose of the plan is to boost the economy by stimulating
investment and positioning more money in the hands of customers. According
to the government, removing taxes on investment dividends will establish more
of a reason to purchase corporate stock, allowing companies to earn a greater
cash flow. This extra cash can be used for further reinvestment and growth by
creating more jobs and supplying larger incomes and more capital. Bush also
believes that the tax cut will increase the dividend payout to investors, creating
greater consumer wealth, which will lead to more spending, benefiting the entire
economy.
As a result of the proposal, the effects would 1) quicken 2001 tax cuts to
escalate the creation and recovery of jobs, 2) eliminate double taxation of
dividends allowing small businesses to grow and promote job creation, and 3)
offer assistance for unemployed Americans, and also provide unemployment
benefits. The influence the government has on the volume of saving and
investment is an essential tool of government policy. By encouraging higher
employment through the creation of jobs, the government is hoping for growth
in the economy by stimulating spending, which increases interest rates.
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According to the classical theory of interest rates the supply of saving is
assumed to be positively related to the market interest rate, while the demand for
investment is negatively related to interest rates. The loanable funds theory
brings together the classical theory and the liquidity preference theory where the
demand for loanable funds includes credit from all areas of the economybusiness, consumers, government. The supply of loanable funds includes
savings, creation of money, and cash balances of consumers. With these theories
in mind, I expect interest rates to rise since Bush’s tax cut plans to reduce
national saving and encourage spending in the economy which will increase
interest rates.
I also believe that the elimination of individual dividend taxes will
improve the economy by increasing after-tax income, and lifting stock prices.
This could encourage consumer and business confidence, and maybe even
additional dividend payments by companies, consumers would have more cash
in their pockets, stimulating spending and increasing rates.
FED POLICY
The target Fed funds rate is currently at 1.25%. The federal funds target
rate is the rate at which banks loan other banks money. Basically, the Fed funds
rate is the cost of the money supply. The Federal Reserve has certain controls to
regulate the supply of money in our economy, and the federal funds target rate is
one of these controls. The FED can make it easier for consumers to get money, in
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order for them to spend money and breathe life into the U.S. economy. The FED’s
method of helping the consumers get access to money is by making it cheaper for
the banks to borrow the money they need to lend to the consumers, i.e. lowering
the federal funds target rate.
The current bias of the Fed is to lower the rate in order to boost the
economy in an attempt to avert a recession. At present, there has only been a
slow down in economic growth, and we have not seen recession yet. The
previous cuts in rates were an attempt the Fed is made in order to enhance
economic growth. At this time, the Fed sees no reason to cut rates due to
current expectations for recuperation in the U.S. economy as the year
progresses and geopolitical uncertainties dissolve. However, the Fed indicated
that if any adverse geopolitical events occur, then they will be prepared to cut
interest rates even further.
One day where the target rate and the actual rate were not equal was on
February 12, 2003 when the target rate was 1.25% and the actual rate was
1.22%. In order for the Fed to move to the target rate, the Fed takes control of
the volume of reserves in the banking system. The total supply of reserves can
be changed by open market operations, lending to depository institutions
through the central bank’s discount window, and by changing the legal reserve
requirements applicable to deposits held by depository institutions. In all
cases, total reserves equal required reserves plus excess reserves. The money
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multiplier also shows the relationship between the size of the supply of money,
and the size of the total legal reserves available to depository institutions.
To hit its interest rate target, the Fed predominantly depends on open
market operations—it buys and sells securities to adjust the supply of reserves
available to depository institutions to affect the quantity and growth of legal
reserves, and ultimately meet their reserve requirements and to clear payments
transactions. The option of making loans through the discount window is
traditionally not used as a customary source of funding. The Fed could also
change its operating procedures by placing a cap on the federal funds rate, and
being prepared to supply reserves on demand to competent banks at that set
interest rate cap.
Many of the open market operations are temporary and consist of very
short-maturity (usually overnight) repurchase agreements, whereby the Fed
buys securities from dealers but agrees to sell them back after a few days, and it
receives a rate of return referred to as the repo rate. By settling its transactions
involving repos with bank reserves, the Fed can determine the supply of
reserves in the banking system, and thus carry out considerable control over
the federal funds rate.
Therefore, through open market transactions the Fed can move the actual rate
up from 1.22% by increasing the deposit in reserve requirements, which decreases
the deposit and money multipliers, and in turn slowing the growth of money,
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deposits, and loans. This also reduces the amount of excess legal reserves, and
institutions lacking in required legal reserves will have to sell securities, cut back on
loans, or borrow reserves. Finally, interest rates will rise as depository
institutions move quickly to cover reserve deficiencies.
In order to raise the actual rate the Fed can also sell securities which
increases the reserves in the banking system and expands it ability make loans
and create deposits, thus increasing the growth of money and credit. When the
Fed is selling securities, there is less demand for the securities in the market,
which leads to decreases in their prices and higher yields, so interest rates
increase.
The four types of open market transaction in which this can occur are
outright market transactions, reverse repo transactions, run-off transactions,
and agency transactions. Outright market transactions result in a permanent
change in the level of reserves, repo transactions result in a temporary change
in the level of reserves, a run-off transaction results in a permanent reduction in
the level of reserves, and an agency transaction may or may not affect the level
of reserves depending on the type of transaction.
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FORECAST OF RATES IN THE NEXT SIX MONTHS
In the next six months, I believe that rates will remain low where they
currently are unless some economic improvement will increase the rates slightly
towards the end of the six month period. I believe the Fed funds rate will stay
consistent throughout the next six months, and that the ten year treasury rate will
rise at a slow pace since there are current signals that the economy is getting better.
Forecast of Target Fed Funds Rate:
May-03
1.25%
Jun-03
1.25%
Jul-03
1.25%
Aug-03
1.25%
Sep-03
1.25%
Oct-03
1.25%
Sep-03
4.05
Oct-03
4.06
Forecast of Ten-Year Treasury Rate:
May-03
3.98
Jun-03
3.98
Jul-03
4.02
Aug-03
4.04
I believe this for several reasons. In 2001, businesses cut virtually 1.8
million jobs, which left unemployment suspended between 5.7 percent and 6
percent since December 2001, leaving the economy in an uncertain state. The
prices of stocks have generally fallen for the past three years, and terrorist
attacks, the threat of terrorism, and the war on terror have been making
headlines in the news within the past year. The current war United States
entered with war in Iraq, still leave lingering uncertainty about economic costs.
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To top it all off, the prices for oil, natural gas, and gasoline have continued
increasing for the past several months.
Due to these events, I believe the Fed funds rate will remain constant at
1.25% and not move at all in the next six months. The Fed has been holding back
in cutting interest rates because they are still quite uncertain about the economy.
Some economists believe that business spending and hiring will rise once the
war is resolved, however, we are not positive how much damage will occur once
it is over. The latest drop in the Fed funds rate has decreased to below the
Consumer Price Index (CPI), a common measure of inflation. Therefore, I believe
the Fed will continue to hold back on cutting interest rates any further, and will
wait for the economy to slowly regain a positive state.
As for the ten year treasury rate, on April 23, 2003 it finally reached 4.00%,
and it has not been over 4.00% in the past several months. I believe that inflation
and the real rate pushed up the treasury yield as a result of present slow
investing. Right now, junk bonds are doing very well and due to the investment
in bonds with default risk, risk premiums are narrowing. The economy has been
risk averse for so long that finally investors are investing in more risky securities,
and the market is finally seeing commodities, equity, junk bonds, and overall
earnings up in the past few weeks.
Also, businesses have also been spending more recently, but hesitantly.
Since yield spread is wide as economy is down, buyers of corporate bonds can
lock in high interest rates with little fear of default. For this reason, I believe that
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the ten year treasury rate will slowly rise, as long as the war with Iraq ends
swiftly without major damage on our economy.
My forecasted rate movements will have a slow, but positive effect on the
overall economy. According to the loanable funds theory, when interest rates are
low demand for investment in business projects look profitable, with expected
returns exceeding the cost of funds. The low interest rate will also continue to
stimulate additional consumer borrowing.
Money supply growth will benefit from the sale of equities such as
deposits like money market funds. Once increased spending and hiring pick up
in the economy, corporate profits should increase. According to the wealth
effect, current low rates increase the value of many other financial assets,
increasing wealth and lowering the necessary volume of saving. The income
effect says that low rates may lead to a greater volume of saving, as businesses
and households must accumulate savings at a faster rate to achieve the savings
goal. For now, higher prices in terms of commodities such as oil, keep
businesses slowly but steadily moving up. In addition, if Bush’s proposed tax
cut will create more jobs as is intended, I forecast noticeable indications of a
better economy within approximately the next nine months.
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