traders to sell long-term bonds. The 3-month versus 30-year spread is greater than 2.5 percentage points.

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1 Treasury Yield Curves (Measure of Market Traders DY/Y and DP/P Expectations) Web address: No revisions, instant data from bond markets Reflects the collective wisdom on the likely direction of the economy (DY/Y) and inflation (DP/P). Expectations of future economic growth and inflation determine which Treasury debt securities are the most attractive to buy. The yield curve shape is a powerful forecasting tool. Federal Reserve sets short-term yields by targeting the fed funds interest rate. Bond traders determine longer-term yields. Normal Yield Curve Shape: Lower short-term yields with yields gradually rising with bond maturity. (longer maturities face greater unknown risks war, politics, DP/P - and hence require higher returns). The 3-month versus 30-year spread is about 2.5 percentage points with a normal yield curve. Steep Yield Curve Shape: Federal Reserve lowers short term rates to counter recession or inflation fears induce bond traders to sell long-term bonds. The 3-month versus 30-year spread is greater than 2.5 percentage points. Flat Yield Curve Shape: The economy is in danger of slipping into recession resulting in lower inflation. Bond traders buy long-term bonds to lock in higher long term yields => long-term yields fall relative to short-term yields. Probability of recession is 50% according to a Federal Reserve study. Inverted Yield Curve Shape: Short-term yields higher than long-term yields. Siren call that a recession is coming. The bond market believes the Federal Reserve is keeping monetary policy to tight and money supply growth to low. The last seven recessions have been preceded by an inverted yield curve 9 months on average - in advance. If yield inversion is greater than 2.4 percentage points, then probability of recession is 90% in the next 18 months Market Analysis: Bonds: Yield curve represents bond market Stocks: Stock prices are based on expectations of future profits and economic activity, so the yield curve can serve as an effective market-timing strategy tool Dollar: Inverted Y.C. may reduce foreign investor appetite for U.S. assets if believe recession is coming => $. However, an inverted Y.C. may attract hot money into U.S. investments if short-term U.S. interest rates are significantly above overseas short-term interest rates => $

2 Yield to Maturity 4.0 Treasury Yield Curves September 2016 January 2017 March Years to Maturity

3 7 6 Interest Rates and Recessions Recession Fed Funds 10-yr Treas Fed Funds Forecast 10-Year Treas Forecast 3% "Equilibrium" Fed Funds Rate

4 The Circular Flow Diagram

5 What is owned Lent Funds to Borrowers Assets Reserves (Vault cash/fed Dep.s) Investments Consumer Business Student Bank Balance Sheet Channel Funds Liabilities + NW Deposits Checking Deposits Savings MMDA CDs IRAs Borrowings What is owed Surplus Funds from Savers T Account Shows D in balance sheet Building Real Interest Rate Net Worth Assets = Liabilities + NW QS LF = D Deposits Stock Vs Flow + + Deposits QD LF = D S = I Loanable funds

6 Bank Balance Sheet Chapter 14 Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve. Bank run Many depositors simultaneously decide to withdraw money from a bank. Bank panic Many banks experiencing runs at the same time. Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits. Required reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves. Excess reserves Reserves that banks hold over and above the legal requirement. Fractional reserve banking system A banking system in which banks keep less than 100 percent of deposits as reserves.

7 The Federal Reserve System How the Federal Reserve Manages the Money Supply Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives. To manage the money supply, the Fed uses three monetary policy tools: Open market operations The buying and selling of Treasury securities by the Federal Reserve in order to control the money supply. Federal Open Market Committee (FOMC) The Federal Reserve committee responsible for open market operations and managing the money supply Discount policy Discount loans the Federal Reserve makes to banks. Discount rate The interest rate the Federal Reserve charges on discount loans. Reserve requirements

8 Assets FED RES Liab. + NW FX Reserves Treasury Bonds Disc. Currency in Circulation Reserves Assets HHs Liab. + NW Currency CHK Dep.s Savings MMDA CDs Other assets Net Worth Assets BANKs Liab. + NW Reserves CHK Dep.s Savings Treasury MMDA Bonds CDs Disc. Net Worth

9 Federal Reserve T-Bill +100 Reserves +100 D Deposits = (1/r) x D Reserves $1,000 = (1/0.10) x $100 M1 = Curr + Chk Deposits Open Market Purchase 1. Fed buys T-Bill from bank A 2. Bank Excess Reserves 3. r = reserve requirement = 10% Credit Union B Req. Reserves Deposits +$100 Excess Res T-Bills -100 Excess Res Bank A Asset Exchange Portfolio Rebalance Savings & Loan C Req. Reserves Deposits +$90 The act of originating a loan, is the act of creating money HH Sector Assets Liabilities Dep Dep Dep Sum = Dep. + 1, ,000

10 Let x = loaned out/pass through % Let r = required reserve ratio = 1 - x Sum of Infinite Geometric Series S = 1 + x + x 2 + x 3 + S = 1 + x [1 + x + x 2 + ] S = 1 + x [ S] S x S = 1 S = 1/(1 - x) S = 1/r Simple deposit multiplier (ratio of D chk deposits / D reserves) If r = 10%, then multiplier = 10 D checking deposits = 1/r * D reserves $1,000 = 10 * $100 Recall Expenditure Multiplier DY = (1/1-MPC) x DI

11 Household Debt (As a Percent of Disposable Household Income) 140% 130% 120% 110% 100% 90% 80% 70% 60% 50% 40% % 130% 120% 110% 100% 90% 80% 70% 60% 50% 40% Source: BEA & Federal Reserve.

12 3 Credit Categories (Based on How Funds are Spent) 1. Provident and Productively: Business, student, auto, new home loans Increase the supply of goods and services along with the demand. Increases both the numerator and denominator of the debt-to-income ratio. Economy grows with no inflation. 2. Wastefully: Consumption loans or misconceived investments Increase the demand for goods and services with no increase in capacity to produce. This increases the debt-to-income ratio. Inflation with no economic growth 3. Speculatively: that are spent on existing assets real or financial Credit and asset prices can chase each other higher This increases the debt-to-income ratio. No direct impact on inflation and/or GDP

13 Web: One revision published with 4 month lag. Annual revision in February. Producer Price Index (Measures changes in prices paid by businesses) PPI measures changes in prices that manufacturers and wholesales pay for goods during various stages of production. It is the oldest inflation measure; index began in Labor department issues questionnaires to 30,000 firms on 100,000 different items. A basket of goods is formed to create an index that starts at 100 and reflects average price of goods in PPI is the first inflation number of the month. Follow price changes along the production pipeline to determine where price pressures originate. 3 progressive stages of production give rise to 3 price indexes: PPI Crude Goods cost of raw materials entering the market for the first time (wheat, cattle, soybeans, coal, crude petroleum, sand, timber). Price changes can be a function of changing supply which is a function of droughts, freezes, animal disease, geopolitical factors. Core Crude Goods (nonfood materials less energy) is a good leading indicator of U.S. and world economic growth. This index responds quickly to shifts in economic activity. Prices are very sensitive to economic turning points. If businesses expect an increase in future demand, the demand for metals, paper boxes, timber will rise => price crude goods => price intermediate goods => price final goods. Price increases move down the production pipeline. PPI Intermediate Goods cost of commodities that have undergone transitional processing (flour, paper, auto parts, leather, fabric) PPI Finished Goods final processing stage (apparel, furniture, automobiles, meats, gasoline) Products retailers pay for. Total finished goods index is a measure of inflation in the long-run. Not a perfect leading indicator of consumer price inflation. There is a link between PPI finished goods and CPI. The two indexes may diverge on a month-to-month basis, but tend to move in tandem and are correlated over a longer (6-9 month) term. PPI does not include service prices or imported prices, whereas CPI does. Core PPI Finished Goods excludes food and energy prices and gives a more accurate reading of the underlying inflation trend. The core rate index is a proxy for near-term inflation Inflation, DP/P, is public enemy number one to the financial markets. An PPI => CPI A 12-month perspective is a better way to view the PPI numbers Market Analysis: Bonds: PPI => (DP/P) E t+1 => D Bonds => i Bonds Stocks: PPI => production costs => profits => dividends => price stocks Dollar: PPI => (DP/P) E t+1 => i short-term => dollar

14 3 Stages of Production 3 Price Indexes Manufacturer 1 Manufacturer 2 Wholesaler Crude Materials: Unmanufactured goods Grains Raw cotton Scrap steel Timber Crude petroleum Intermediate Goods: Semi-finished goods Flour Cotton yarn Steel Lumber Petroleum Finished Goods: Ready for sale to final demand user Bread Apparel Cars Furniture Gasoline

15 5% Producer Price Index Final Demand (year over year % growth) 5% 4% 4% 3% 3% 2% 2% 1% 1% 0% -1% -2% -3% Final Demand Core Goods (Excluding Food and Energy) 0% -1% -2% -3%

16 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% -6% Producer Price Index Final Demand (year over year % growth) Services Goods Construction 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% -6%

17 Federal Reserve Banks are the heart/pump of the economy Req. Reserves Bank D Currency in Circulation -$100 Deposits +$72.90 Required Reserves +100 Clear checks between A,B,C,D Savings & Loan C Req. Reserves Deposits +$81 M1 = Curr + Chk Deposits Assume: 1. RR = 0.10 x Deposits 2. Banks Max. P 3. ER = 0 Req. Reserves Credit Union B The act of originating a loan, is the act of creating money Deposits +$90 Req. Reserves HH Sector Cash = $100 Cash -$100 Dep Bank A Deposits +$100 Dep Dep Dep Sum = Dep

18 Sum of an Infinite Geometric Series Let OD = original deposit D = 0.9 OD OD OD + D = 0.9 [OD OD OD + ] D = 0.9 [OD + D ] (1-0.9)D = 0.9 OD D D = 0.9 OD (1-0.9) D = 9 (100) D = 900 = D Deposits

19 Econ 102 Chapter 14 Homework Due Friday, April 7 (in Discussion) Chapter 14 Problems: 1, 5, 6, 7, 9, 12, 14, 15