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ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

9. The Money Market


1. What is Money? Money is the asset that can be widely accepted as a means of payment that can be readily used to make transactions. The functions of money o Medium of exchange It is used to buy goods and services It eliminates the need for barter and the double coincidence of wants. o Store of value It is a way to transfer purchasing power from the present to future. Is money a good asset to store value? Unit of account It provides the common unit for measuring how much something is worth.

Commodity money: something that has other important uses other than as a means of payment. Fiat money: something that serves as a means of payment by government declaration. o M1: Currency (cash in the hands of the public) + Checking account deposits + Travelers checks M2: M1 + Saving deposits + Time deposits + Negotiable certificates of deposits (NCDs) M1 + additional types of deposits that can fairly easily be turned into cash or checking deposits (near money)

To measure the quantity of money, government compiles several measures of the money stock. The two most important definitions (HK) are: o M1: Currency (cash in the hands of the public) + Checking account deposits + Travelers checks M2: M1 + Saving deposits + Time deposits + Negotiable certificates of deposits (NCDs) M1 + additional types of deposits that can fairly easily be turned into cash or checking deposits (near money)

2. Money Supply The money supply is controlled by the central bank o The Federal Reserve Board (Fed) in the U.S. (current Chairman, Ben Bernanke) o The Peoples Bank of China (PBC) in China (current governor, Zhou Xiaochuan) o The European Central Bank (ECB) in EU (current President, Jean-Claude Trichet) o The Hong Kong Monetary Authority (HKMA) in HK (current Chief Executive, Norman Chan)

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

The major functions of central banks: o Control monetary policy (i.e. money supply and interest rate) o Act as the lender of last resort to the banking systems o Other functions include issuing currencies, acting as a bank for commercial banks, check clearing, supervising and regulating the commercial banking industries. Money supply (Ms) is considered to be a policy instrument that the central bank can set precisely at any desired value. It implies that the supply of money is fixed and, in particular, does not depend on interest rate. o The money supply curve is vertical
Interest rate (r)

Ms

Money (M)

3. Money Demand Money demand is the amount of wealth that the household chooses to hold as money, rather than other interest-bearing assets. Liquidity of an asset: the ease with which an asset can be converted into the medium of exchange and used to buy goods and services Money is the most liquid asset. The money demand is the amount of money that people demand, which depends on: o Real income (Y) When total income increases, people make more purchases, more money is therefore needed for transactions. Price level (P) When the price level increases, people need more money for transactions, even if the amount of goods and services purchased remains the same. Interest rate (r) (paid on assets other than money)

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

The higher the reward for holding interest-earning financial assets, the less money will be held.

Interest rate (r)

Md

Money (M)

Other factors affecting real money demand: o Wealth If people becomes wealthier, some of the wealth may be held in the form of extra money holding Md increases when wealth increases. o Expected future inflation If people expect the price level to rise rapidly in the future, the will try to hold less money Md decreases when expected price level increases. Risk (of holding wealth in alternate assets) If the risk of alternative assets such as stocks and real estate increase, households will demand more money, which is safer. Md decreases when expected price level increases. Payment technologies Any technological development that alters how people make and receive payments, or the ease of switching between money and alternate assets (increases the liquidity of alternate assets). E.g. the invention of ATMs machines, debit cards (EPS) and credit cards. Md decreases.

4. The Money Market Equilibrium When the money market is in equilibrium, real money demand equals real money supply.

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Graphically, the equilibrium point can be determined by the intersection of money demand curve and money supply curve:
Interest rate (r)

Ms

r2 r* r1 Md

M*

Money (M)

Why is the economy in equilibrium when Ms = Md? o At r1: Ms < Md People will try to sell some of their interest-bearing assets (such as bonds) and concert them into money. It lowers the bond prices (because of higher supply) in the bond market, which means higher interest rate (yield). Why? Higher interest rate induces people to decrease money demand until it equates the real money supply fixed by the central bank.

Consider a bond with no expiration date (with a face value of $1000) that promise to pay you a fixed annual interest payment of $50 Suppose that the bond is initially sold in the market at its face value $1000, what is the interest rate (yield)? Interest rate (yield) = $50/$1000 = 5% Suppose that the bond is sold in the market at $950, what is the interest rate (yield)? Interest rate (yield) = $50/$800 = 6.25% Suppose that the bond is sold in the market at $1200, what is the interest rate (yield)? Interest rate (yield) = $50/$1200 = 4.17%
o At r2: Ms > Md People will try to convert some of their cash into interest-bearing assets (such as bonds). It raises the bond prices (because of higher demand) in the bond market, which means lower interest rate (yield)

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Lower return on holding other interest-bearing assets induces people to increase money demand until it equates the real money supply fixed by the central bank.

At r*: Ms = Md There is no tendency for people to change their money balance.

Isnt interest rate determined in the loanable funds market in the classical model? o Yes. In the long run, the interest rate equates the demand and supply of loanable funds. o However, the classical model ignores that the households continuously choose how to allocate their wealth between money and other interest-bearing assets. In the short run, the changes in the money market can move the interest rate away from the long-run equilibrium determined in the lonable funds market.

4. Money Supply and Interest Rate The central bank can affect the interest rate by changing the money supply o If the government desires a higher level of interest rate, it can be achieved by reducing Ms. o If the government desires a lower level of interest rate, it can be achieved by increasing Ms.

Interest rate (r)

Ms1

Ms2

r1

r2

Md

Money (M)

When media report on change in central bank policy, they often just say the central bank raised or lowered interest rate o In fact, central bank has used to the short-term interest rates as its policy instrument. o However, to set the interest rate, it has to change money supply to hit the target. o Therefore, behind the change in the interest rate are the necessary changes in money supply.

5. How Central Banks Control Money Supply?


So far, we assumed the central bank can control money supply precisely for simplicity. o How does the central bank control money supply?

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Can the central bank always control the money supply precisely in practice?

Recall that money supply includes both currency in hands and demand deposits. To answer these questions, we must first understand the role of commercial banking system in the money supply determination. o Commercial banks are private corporations that provide banking services to the public. Money Creation under fractional-reserve banking o Banking system creates money by making loans. When money is deposited into banks, banks only keep a fraction of the deposits as reserves, and lend out the rest of the deposits. Why banks lend money out and why they keep a fraction? Required Reserve ratio (RR): the minimum fraction of deposits the banks must kept in reserve, i.e. required reserves/total deposits.

Suppose $100 is deposited into bank A, and bank A is required to keep 10% of the total deposits as reserves and lends out the remaining. What would happen to Bank As balance sheet? Two types of assets that are particularly important in understanding the money creation process: Loans: A borrower gives the bank an IOU, a promise to replay a certain sum of money by a certain date. Reserves: a banks deposits with the central bank The most important liabilities for a bank are the deposits owed to the depositors. The central accounting principle is that the balance sheet is always balance: Shareholders equity = Total assets Total liabilities.
Bank As Balance Sheet Assets Liabilities and Net Worth $100 $900 Deposits $1000

Reserves Loans

Bank A immediately increases the money supply by $900 because money supply includes both cash and deposits. Bank A creates money.

The creation of money does not stop with Bank A. If the borrower uses the $900 to pay someone who then deposits the $900 in another bank, bank B. What would happen? Given a required reserve ratio of 10%, bank Bs excess reserve is $81. If bank B lends out all the excess reserves, its balance sheet becomes:
Bank Bs Balance Sheet Assets Liabilities and Net Worth $90 $810 Deposits $900

Reserves Loans

The process goes on and on. With each deposit and loan, more money is created.

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Although this process of money creation can continue forever, it does not create an infinite amount of money. Given RR = 0.1, the amount of money that the original $100 creates is: = $1000 = (1 RR) x $1000 = (1 RR) 2 x $1000 = (1 RR) 3 x $1000 . . . = [1 + (1 RR) + (1 RR) 2 + (1 RR) 3 + ... ] x $1000 = (1/RR) x $1000

Original deposits (reserve injection) 1st lending 2nd lending 3rd lending

Total Money Supply

Given RR = 0.1, the original $1000 reserve injection becomes $10,000 of money.

The total amount of new money created by a single dollar of initial reserve injection given the value of the reserve ratio (R) can be found:
M s ReserveInjection [1 (1 RR) (1 RR) 2 (1 RR) 3 ]
M s ReserveInjection 1 RR

where the multiple by which the maximum amount of new money (or deposits) can be created by a single dollar of initial reserve injection is called the monetary multiplier (m):
m 1 RR

Note that we must recognize that the definition of monetary multiplier emphasizes on the term maximum because the new money created can be smaller if: o Banks may keep actual reserves in excess to fulfill the reserve requirement. Excess reserves are the difference between the actual reserves and the required reserves. o Households and firms may hold some currency in hand instead of depositing all loans back to the banking system. The Instruments of Monetary Policy The central banks change the money supply by changing the reserves in the banking systems. o In U.S., the monetary policy is decided by the Federal Open Market Committee (FMOC) at meetings scheduled eight times each year. Tools of monetary policy: o Open-market operations o The required reserve ratio o The discount rate o The term auction facility (introduced in December 2007) o Interest on reserves (introduced in October 2008)

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Open-Market Operations o The purchases and sales of government securities (usually short-term) from or to commercial banks and the general public. To increase money supply: open-market purchases (i.e. buying securities) To decrease money supply: open-market sales (i.e. selling securities) o The open-market operation is the most commonly used instrument. Flexible in magnitude and timing The impact on bank reserve is prompt

Reserve Requirements o The change in the reserve requirement. To increase money supply: lower reserve ratio To decrease money supply: increase reserve ratio The Discount Rate o The discount rate is the interest rate the central bank charges when it makes loans to banks. To increase money supply: lower discount rate To decrease money supply: increase discount rate o The discount rate is infrequently used. Passive instrument

Interest on Reserves o It was introduced in October 2008 in the U.S. o The change in the interest on reserves. To increase money supply: lower the interest on reserves To decrease money supply: increase the interest on reserves Term Auction Facility o It was introduced in December 2007 in U.S. when commercial banks became reluctant to borrow from the central bank The action was in coordination with simultaneous and similar initiatives undertaken by the Bank of Canada, The Bank of England, the ECB, and the Swiss National Bank. o The Fed holds two auctions each month at which banks submit anonymous sealed-bid for the right to borrow reserves for 28-day (or 84-day) periods. Each commercial bank (generally with sound financial condition) is eligible to submit bid stating the amount they would like to borrow and the interest rate they are willing to pay. The submitted bids are then arranged in order by the willingness to pay (in terms of interest rate). The one with the highest willingness to pay will be able to obtain the loan it desires first, and then the second highest bidder will obtain the amount it would like to borrow, and so on, until the limited pool of fund is exhausted. The interest rate paid by all commercial banks is the same.

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

It is the bid of the last auction-winning bank.

To illustrate, suppose the central bank offers a sum of $10,000 in a term auction. Suppose the bids submitted by the commercial banks are shown in the following table in order:
Interest rate Bank A Bank B Bank C Bank D Bank E Bank F 15% 13% 10% 8% 6% 5% Desired amount of loan 2000 1500 5000 2500 1000 3000

In this case, banks A to C obtain the full amount they desire, bank D obtains a part ($1500) only. All the banks pay an interest rate of 8%.

Why term auction facility is useful? Anonymity Unlike lowering discount rate, which is rather passive, the term auction facility allows the central bank to lend out all the loans it desires. In terms of its impact on money supply, the mechanics of term auction facility is similar to that of open-market purchases (from commercial banks) and lower discount rate, all aiming at increasing the reserves of the commercial banks directly.

6. Monetary Policy Monetary policy: Control or manipulation of interest rates by the central bank designed to achieve a macroeconomic goal. Recall that the central bank can affect the interest rate by changing the money supply o If the government desires a higher level of interest rate, it can be achieved by reducing Ms.

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

If the government desires a lower level of interest rate, it can be achieved by increasing Ms.

Interest rate (r)

Ms1

Ms2

r1

r2

Md

Money (M)

Expenditure (E) Y=E

AE2 (for r = r2) AE1 (for r= r1)


Ca + Ip

A2 A A1 Y1 Y2 Y = A / (1 c) Income (Y)

To understand how the monetary policy works, we have to examine the connections between the goods market and the money market. The impact of an increase in money supply. o Increase in money supply lowers the interest rate o How would the decrease in interest rate affect the aggregate expenditure (AE)? Both autonomous consumption expenditure (Ca) and planned investment (Ip) increases when interest rate decreases. o Therefore, the equilibrium output level (Y or real GDP) would increase.

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ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

As an increase in money supply raises real GDP, it is called expansionary monetary policy. How about a decrease in money supply?

Note: So far in our analysis we basically focused on how a change in the money market affects the goods market via the change in interest rate. However, we have ignored the feedback effect from the change in income, which would affect money demand. (The connection between the goods market and the money market will be discussed in detail in the next topic.)

7. Interest Rate Targeting in Practice In the above discussion of monetary policy, we assume there is only one interest rate in the economy. In real world, there are many different interest rates. o Which one does the Fed (central bank) target? The Fed has chosen to target the federal (Fed) funds rate. o Day-to-day transactions rarely leave all banks with their exact levels of required reserves. o What can be done by the banks having temporary excess reserves? o What can be done by the banks failing to meet reserve requirements temporarily? o Banks with excess reserves therefore lend these excess reserves to other banks on an overnight basis as a way of earning additional interest with sacrificing long-term liquidity. The interest rate paid on these over-night loans is called the Fed funds rate.

Although the Fed funds rate is just an interest rate for lending among banks, many other interest rates in the economy will be affected when the Fed changes money supply. o For example, when the Fed funds rate falls, banks will find lending in the Fed funds market less attractive than before, and will switch to hold other assets, such as government bonds or corporate bonds. The increase in demand for these assets will increase their prices, leading to lower interest rates in the economy in general. Therefore, most interest rates usually move in the same direction in the economy.

Readings: Chapter 25 (excluding Appendix) 26 (The Appendix will be covered in the next topic)

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Money markets: Blocked pipes | The Economist

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Money markets

Blocked pipes
When banks find it hard to borrow, so do the rest of us
Oct 2nd 2008 | LONDON AND NEW YORK | from PRINT EDITION

Illustration by David Simonds

ANY good tradesman will tell you the importance of the bits of a house that you cannot see. Never mind the new kitchen: what about the rafters, the wiring and the pipes? So it is with financial markets. The stockmarkets are the most visible: as they soar or swoon, the headline-writers get to work. The money markets, however, are the plumbing of the system. Normally, they function efficiently and unseen, allowing investment institutions, companies and banks to lend and borrow trillions of dollars for up to a year at a time. They are only noticed when they go wrong. And, like plumbing, when they do get blocked, they make an almighty stink. At the moment, these markets are well and truly bunged up. In the words of Michael Hartnett, a strategist at Merrill Lynch, the global interbank market is effectively closed. The equivalent of a run on banks has been taking place, without the queues of depositors seen outside Northern Rock, a British mortgage bank, last year. This stealthy run has been led by institutional investors and by banks themselves. Many banks have had to be rescued by rivals or the state. This week the Irish government felt compelled to guarantee the deposits and some other liabilities of the countrys six largest banks. Surviving banks have become ultra-cautiousjust taking things one day at a time, says Matt King, a strategist at Citigroup. The effect has been most dramatic in the overnight rate for borrowing dollars. Bank borrowing costs reached 6.88% on September 30th, more than three times the level of official American rates, while some were willing to pay a remarkable 11% to borrow dollars from the European Central Bank (ECB). Banks have become so risk-averse that they deposited a record 44 billion ($62 billion) with the ECB on September 30th even though they could have earned more than two extra percentage points by lending to other banks. It was the last day of the quarter and, for balance-sheet reasons, banks were particularly keen to have cash on hand. (Overnight rates fell back on October 1st, but one-month rates rose further, indicating that the crisis had not eased.) In the absence of private-sector lenders to banks, central banks have become vital suppliers in the money markets.

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1/29/2011

Money markets: Blocked pipes | The Economist

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With the help of the ECB, the Bank of England and the Bank of Japan, the Federal Reserve agreed to lend a further $620 billion on September 29th (see article). That package, though of similar size to the Bush administrations $700 billion bail-out plan, did not need congressional approval or attract public opposition. But central banks can only do so much. In particular, they tend to lend for short periods and then only against collateral with a high credit rating. That still leaves banks with the problem of financing their more troubled assets, an issue the Bush administrations plan was designed to solve. The money markets difficulties began in July 2007, when two Bear Stearns hedge funds revealed the damage done to their portfolios by subprime mortgages. Since August of that year, central banks have been intervening to keep them functioning, with a series of schemes like Americas Term Auction Facility. But the collapse of Lehman Brothers, followed by the long series of rescues in Europe and America, seems to have brought the money markets close to breakdown. Even immediate passage of the Bush plan would not solve all their problems straight away, because it would take time to put the plan into place. Why do these markets matter? First, the rates on loans paid by many consumers (adjustable-rate mortgages, for example) and companies are set with reference to the money markets. Higher rates for banks mean higher rates for everyone. Second, if the markets are blocked for more than a week some companies may find it hard to get any finance at any price. That could mean more bankruptcies and job losses. Third, more banks could go bust if the blockage continues, making investors even more risk-averse. The downward spiral would take another turn. We are at the juncture where more widespread and permanent support is required to restore confidence in the banking sector, say analysts at the Royal Bank of Scotland (RBS). Without it, the banks will be aggressively trying to contract their books and will be unable to provide credit to retail and corporate clients. So it is safe to say that, until the money markets behave more normally, the financial crisis will not be over. And until the financial crisis is over, the global economy may not recover.

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Liquid dynamite First, the problem. It is widely assumed that central banks set the level of interest rates in their domestic markets. But the rate they announce is the one at which they will lend to the banking system. When banks borrow from anyone else (including other banks), they pay more. Every day, this rate is calculated through a poll of participating banks and published as Libor (London interbank offered rate) or Euribor (Euro interbank offered rate). Normally, these are only a fraction of a percentage point above the official interest rates. But that has changed dramatically in recent weeks (see chart 1). Take the cost of borrowing dollars. On October 1st banks had to pay 4.15% for three-month money, more than two percentage points above the fed funds target rate. In theory, three-month rates could be that high because markets are expecting a sharp rise in official rates. But that is hardly likely, given the depth of the crisis. Instead, the width of the margin reflects investors worries about the banks, not least because so many have faltered so quickly. Three months is now a long time to trust in the health of a bank. In addition, banks are anxious to conserve their own cash, in case depositors make large withdrawals or their money gets tied up in the collapse of another bank, as with Lehman. One way this risk aversion shows up is in the Ted spread (see chart 2), the gap between three-month dollar Libor and the Treasury-bill rate. After being as low as 20 basis points (a fifth of a percentage point) in early 2007, the spread is now 3.3 percentage points. In other words, the relative cost of raising money for banks has risen 16-fold in the past 18 months. Indeed, some banks argue that Libor and Euribor understate the full extent of the increase in banks borrowing costs.

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1/29/2011

Money markets: Blocked pipes | The Economist

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According to John Grout of the (British) Association of Corporate Treasurers (ACT), banks have started to talk to companies about invoking the market disruption clause in loan contracts. This would allow them to replace the two benchmarks with the real cost of their funds, which they say would be higher. (Companies usually pay Libor or Euribor plus a margin that depends on the riskiness of their finances.) One company, Hon Hai of Taiwan, an electronics manufacturer, says its banks have already invoked the clause. This affects only debt facilities that have already been set up. Mr Grout says that when companies are negotiating new loans with banks, they are being asked to accept rates based on Libor plus a quarter of a percentage point. Unsurprisingly, the ACT is unimpressed with this tactic, since Libor is calculated from data supplied by the banks themselves. Companies do not have to borrow from banks; they can raise money from the markets by selling commercial paper, a type of short-term debt. For much of this year, that was an attractive option. The preference of investors for debt issued by non-financial companies made commercial paper a source of cheap finance. But in recent weeks even this has become more difficult. The volume of commercial paper outstanding fell by $61 billion to $1.7 trillion in the week ending September 24th. And investors are unwilling to lend for long: AT&T, a big American telecoms company, said on September 30th that the previous week it had been unable to sell any commercial paper with a maturity longer than overnight. The volume of assetbacked commercial paper maturing in four days or less ballooned from $32 billion a day to $104 billion during September (see chart 3), while the amount maturing in 21 to 40 days fell by 63%. Where there is doubt about a companys finances, it inevitably has to pay a higher rate. Worries about GE, one of Americas most prestigious companies, pushed up the premium on its credit-default swaps and made raising short-term debt dearer. According to the Wall Street Journal, the rate on its commercial paper had gone up by two-fifths of a percentage point. That might not sound much, but GE has $90 billion of paper outstanding, so it faced an extra interest bill of $360m a year. On October 1st the company announced a $12 billion public share offering and a $3 billion injection from Warren Buffett, a leading investor. Why has commercial paper lost its shine? The explanation seems to lie back in the authorities willingness to allow Lehman to collapse. That move, designed to warn the markets that the authorities took moral hazard seriously, has had some unintended consequences.

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Fund of surprises The most severe was the loss imposed on the Reserve Primary fund, a money-market fund. Such funds invest in short-term debt and offer investors higher rates than on bank deposits. But they also aim to repay their customers at par. Because it had bought Lehman debt, the Reserve Primary fund was forced to break the buck (that is, to repay less than 100 cents on the dollar), only the second such instance in the industrys history. This caused a crisis of confidence in money-market funds. Prime funds, which offer slightly above-average rates in return for higher risk, have lost about $400 billion out of $1.3 trillion in the past few weeks, as investors have switched to funds based on government debt. In turn that has made other funds more cautious and led them to steer clear of bank loans and commercial paper. Buried among the many recent American regulatory initiatives was a scheme to insure money-market funds against failure. That scheme may have halted a stampede by retail investors out of the industry, but it has not restored the level of confidence of two months ago and new deposits do not qualify.

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1/29/2011

Money markets: Blocked pipes | The Economist

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At the same time as they are struggling to raise money from outsiders, banks may face more claims on their capital. In the good times they promised to provide back-up loans to companieswhich they thought would never be asked for. On some estimates, the value of these promises is $6 trillion. But with the commercial-paper market tightening and the economy deteriorating, more companies will be asking banks to keep their word. Indeed, companies already seem concerned that banks will be unable to maintain promised loan facilities. So they are using those credit lines earlier than expected, in case they vanish. A prime example is Duke Energy, an American utility, which recently drew down $1 billion from a credit agreement. Chris Taggert of CreditSights, a research group, foresees a funding blitzkrieg by high-yield borrowers tapping their banks for cash if the mayhem does not abate. Theres a vicious-spiral element to the inability of companies to roll commercial
Illustration by David Simonds

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paper, says Ajay Rajadhyaksha, a fixed-income strategist at Barclays Capital. Those that have back-up lines of credit with banks are increasingly drawing on them. This is hurting the banks, and making money-market funds even queasier about buying bank debt, and so on. CreditSights notes that it has become more common for companies to call on these loans amid fears that bank lenders may not be able to honour commitments in the future. Several of these companies, including General Motors, have cited the uncertain state of capital markets when asking for their money. Goodyear Tire & Rubber said it was drawing down its loans because some of its cash was locked up in, of all places, the Reserve Primary moneymarket fund. Whatever the reason, the possibility of more calls from their corporate clients is another factor behind the banks desire to hold cash. That will mean any company without a back-up facility may struggle to raise new loans. Luckily, most companies are not as exposed as they were when the dotcom bubble burst. Nevertheless, plenty of carmakers and retailers have mountains of debt or a strong need for cash. Then there are companies that underwent leveraged buy-outs. The private-equity groups that bought them may have been counting on refinancing their debts soon. A lack of access to capital is sure to make companies cautious. Your ability to plan for investment is obviously affected, says Randall Stephenson, chairman and chief executive of AT&T. In addition, higher finance costs will eat into profit growth, a fact that seems yet to be recognised in buoyant forecasts for 2009. The equity market is going through the slow process of realisation that a large proportion of earnings growth over the last 25 years was due to the falling cost of money, says Kit Juckes, an economist at RBS.

Poloniuss revenge Consumers have been going on a greater debt binge than companies and the impact on them may be more immediate. In particular, they may face higher mortgage and credit-card rates. Some may be denied new credit altogether. The last survey of senior loan officers by the Federal Reserve was back in July. Even then 65% of banks were tightening their lending standards on credit cards, up from 30% in April. Consumers had not felt the effects by then: credit-card lending rose by 4.75% in the year to July, although other types of credit barely grew at all. Mortgage costs have also been rising for those with variable-rate loans. On September 30th, American adjustablerate mortgage rates were 6.13%, according to Bloomberg, compared with 5.92% at the end of August and less than 5.5% in the spring. In Britain three leading lenders raised rates by half a percentage point in the week to September 26th. And Moneyfacts, an information group, says the number of buy-to-let mortgages (used by private landlords)

http://www.economist.com/node/12342237/print

1/29/2011

Money markets: Blocked pipes | The Economist

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has fallen 85% over the last year. These effects might teach voters that punishing the banks for their follies is sometimes cutting off their noses to spite their faces. At some point Main Street will realise it lies on the same road as Wall Street, says Mr Juckes. It is not too difficult to imagine bank failures leading to job losses, further falls in house prices, bad consumer debts and further bank losses. We may already be at the point where corporate fear and conservatism are baked in: even if things start to improve for the banks, companies have seen how bad things can get, and that can prove lasting, says Torsten Slok, an economist at Deutsche Bank. So there is a risk theyll continue to hoard cash and mistrust banks for quite some time. That is the kind of spiral which the Bush administrations plan was designed to avoid. Relying solely on ad hoc rescues of individual banks would only make investors more nervous about the banks that remain. The financial plumbing would stay bunged up. Unless something is done to unblock it soon, there will not just be a nasty stink in the markets. There will also be an unholy mess in the wider economy.
from PRINT EDITION | Briefings2

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http://www.economist.com/node/12342237/print

1/29/2011

The Fed's big announcement: Down the slipway | The Economist

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The Fed's big announcement

Down the slipway


Quantitative easing is unloved and unappreciatedbut it is working
Nov 4th 2010 | WASHINGTON, DC | from PRINT EDITION

EVEN before the Federal Reserve unveiled its second round of quantitative easing (QE) on November 3rd, critics had already denounced it as ineffectual or an invitation to inflation. It cannot be both and it may not be either. The announcement of QE2 was hardly breathtaking. The Fed said it will buy $600 billion of Treasuries between now and next June, at about $75 billion a month, although it also said it could adjust the amount and timing if need be. That was about what markets expected but far less than the $1.75 trillion of debt it bought between early 2009 and early 2010 in its first round of QE. Yet QE2 seems already to have exceeded the low expectations it has aroused. Since Ben Bernanke, chairman of the Fed, hinted at it at Jackson Hole on August 27th, markets have all done exactly what they should (see chart). Under QE the Fed buys long-term bonds with newly created money. This lowers long-term yields and chases investors into riskier, alternative investments. The real yield on ten-year, inflation-indexed Treasury bonds has fallen from 1.05% to 0.5%, a result of relatively flat nominal yields and a rise in expected inflation. The yield on their five-year cousins is negative (see Buttonwood). Share prices are up by 14% in the same period. Lower yields make the dollar less appealing: it has duly fallen by 5% against the Japanese yen, by 9% against the euro and by 5% on a trade-weighted basis. You can declare QE to be a success already, says one hedge-fund economist. Whether this translates into real activity remains a question-mark. But the question of whether the mechanism would work has been answered. With a bit of a lag, these easier financial conditions are supposed to boost

http://www.economist.com/node/17417742/print

1/29/2011

The Fed's big announcement: Down the slipway | The Economist

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growth through three channels. First, lower real yields spur borrowing and investment. This channel is bunged up: many households cannot borrow because their homes have fallen in value and because banks are less willing to lend. But the remaining two channels remain open. Higher share prices have raised household wealth by some $1.4 trillion, which will spur some spending. And the lower dollar should help trade. American factory purchasing managers reported a sharp jump in export orders in October and a drop in imports. Macroeconomic Advisers, a consulting firm, reckons that the Fed will eventually buy $1.5 trillion of debt under QE2, and that this will raise growth next year to 3.6% from 3.3% without QE. Thats not exactly overwhelming: the firm thinks the Fed would have to buy $5.25 trillion of bonds to achieve the equivalent of a 4% federal-funds rate, which is what the economy needs. The Fed will not do that for fear of unknown consequences, among them the response of Congresss newly empowered Republicans. In a Bloomberg poll, 60% of self-identified tea-party supporters favoured overhauling or abolishing the Fed. Could QE work too well and drive inflation expectations to dangerous levels? The odds arent zero, says Don Kohn, a former Fed vice-chairman, but theyre small. Theres more risk that expectations could rise once credit loosens up and spending accelerates. That, however, would be a signal that the Fed has succeeded; it can then tighten policy. Other countries complain that QE is merely bringing them overvalued currencies and bubbly asset markets by pushing investors to seek higher returns elsewhere. But that may be unavoidable given their divergent growth paths. Both India and Australia raised interest rates this week despite rising currencies. A damaging round of beggar-thy-neighbour currency interventions cannot be ruled out. But the Bank of Japan, after intervening directly to weaken the yen in September, has struck upon a more benign response. It had been scheduled to release details of its own QE at a regular policy meeting in mid-November but moved the date forward to this week. Analysts suspect this was to counteract upward pressure on the yen because of the Feds move. If central banks all print money in unison, and dont mop up excess liquidity, then the result could be a worldwide monetary fillip. QEs benefits should not be over-egged. Nor should they be dismissed.
from PRINT EDITION | Finance and Economics

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http://www.economist.com/node/17417742/print

1/29/2011