OUTLINE November 22, FFR & Other Interest Rates. Long-term Interest Rates. Historical pattern of interest rates 11/20/ :15 AM

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1 OUTLINE November 22, 2016 The Fed & Monetary Policy, cont. Interest Rates & Yield Curve Zero Lower Bound Phillips Curve Why a Tradeoff? Shifts of Phillips Curve Comprehensive Essay prompt will be distributed electronically (via bcourses) Nov 27 & due via bcourses Wed Dec 7 at noon FFR & Other Interest Rates Different types of loans are substitutes for each other What are choices for bank that wants to make loans? Federal funds rate influences other interest rates Prime rate (for best commercial customers) Home mortgage rates Home equity loan rates And many other interest rates Historical pattern of interest rates Long-term Interest Rates Borrowing for investment spending is mostly longterm borrowing 10-year, 20-year, 30-year loans Fed policy directly affects short-term interest rates Rate paid on excess reserves (IOER) Overnight rate (federal funds rate, FFR) Treasury-bill rate (30-day, 90-day, 1-year) What s the connection between short-term and longterm interest rates? Generally, LT rate = average (current & future expected ST rates) + term premium 1

2 Yield Curve Yield curve shows on any one day relationship between short-term rates and long-term rates Zero Lower Bound (ZLB) (Traditionally?) Target FFR can t go below 0 Fed s target for Federal Funds Rate was in the range of percent Fed was at zero lower bound So Fed tried other strategies Quantitative Easing ( ) Operation Twist (late 2011, 2012) All had same goal: increasing lending & spending Animated Yield Curve: Zero Lower Bound (ZLB) (Traditionally?) Target FFR can t go below 0 Fed s target for Federal Funds Rate was in the range of percent Fed was at zero lower bound Why do I say Traditionally? Because other countries have broken ZLB and Fed officials unofficially ponder whether Fed will eventually do so, too Why is zero no longer a lower bound? Original Phillips Curve A.W. Phillips used U.K. data for Found: tradeoff between unemployment and wage inflation Story: Bargaining power 2

3 Phillips Curve (U.S. version) Tradeoff between unemployment and price inflation Phillips Curve Story: Bargaining power Change AD change output change demand for labor change wages change costs of production change prices This shows the menu of choice Phillips Curve 3

4 Movements Along vs. Shifts If aggregate demand changes (which of course then changes GDP, employment, and unemployment), move along Phillips Curve If prices change for some reason other than change in AD, shift of Phillips Curve 4

5 1. Change in inflationary expectations 2. cost shocks ( supply shocks ) 3. change in labor productivity growth Most recent statement (Sep 2016) Information received since the Federal Open Market Committee met in July indicates that the labor market has continued to strengthen and growth of economic activity has picked up from the modest pace seen in the first half of this year. Although the unemployment rate is little changed in recent months, job gains have been solid, on average. Household spending has been growing strongly but business fixed investment has remained soft. Inflation has continued to run below the Committee's 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation remain low; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months. 5