(50 points total) The two tables below show the response of various interest rat
ID: 1208680 • Letter: #
Question
(50 points total) The two tables below show the response of various interest rates to previous FOMC statements. The first Table shows the response to the Dec 16, 2016 FOMC statement where the Fed got off the zero bound by raising rates. The second Table shows the response of various interest rates to the most recent meeting when the FOMC decided not to change interest rates. please answer the questions below.
Table 1
Table 2
a)(10 points) We are focusing on the reaction of the 1-year, 2-year, and 3-year Treasury constant maturities to the FOMC statement of Dec 16, 2015. What was the reaction, in basis points, of the 1-year, 2-year, and 3-year interest rates to the Dec. 16 announcement (compare to Dec 15, the day before the announcement) and how do these changes relate to the change in the federal funds rate (top row) between Dec. 16 and Dec. 17? Explain why there was such a large difference in the movement of the Federal Funds rate relative to the other 3 interest rates.
b)(10 points) We now focus on the reaction of the 1-year, 2-year, and 3-year Treasury constant maturities to the most recent FOMC statement of March 16, 2016. What was the reaction, in basis points, of the 1-year, 2-year, and 3-year interest rates to the March 16 announcement (compare to March 15, the day before the announcement) and how do these changes relate to the change in the federal funds rate (top row) between March 16 and March 17? Explain why there was such a large difference in the movement of the Federal Funds rate relative to the other 3 interest rates.
c)(10 points) The first line of a WSJ article we discussed in class that was written the night of Wednesday, March 16, 2016 is below:
The Federal Reserve eased monetary policy on Wednesday, and the global economy is safer for it.
Explain exactly how the Fed eased monetary policy on Wednesday, March 16, 2016. Are your results from part b) consistent with easier monetary policy? To support your answer, what happened to the one year interest rate expected one year from now - our notation is i12e.
d)(10 points) Regarding the lessons learned from the research on forward guidance, did the Fed employ the lesson learned from the research following their March 15 - 16, 2016 FOMC meeting? Why or why not - explain. What was the lesson learned and how exactly did we learn the lesson on forward guidance?
e) (10 points) Now draw a graph with time on the horizontal axis and interest rates on the vertical axis - you need to have 3 different interest rates on the vertical axis (we did this in class). On the graph, clearly label the period of the 'zero bound', the period associated with the move in December of 2015, and the period after the hike at the April 2016 meeting (we assume another 25 basis point at their April meeting). Make sure you label your graph completely including the horizontal axis representing time and the vertical axis representing interest rates. Explain why the federal funds rate will change when the Fed changes interest rates.
Explanation / Answer
1) An interest hike has opposite effect on bonds. Bonds and interest rates have an inverse relationship. As interest rates increase, bond prices generally fall. As interest rates fall, bond prices go up. Bonds generally pay a stated interest rate, also known as a coupon rate. New bonds are issued in relation to the current prevailing interest rates.Demand increases for bonds with the higher interest rate. This reduces the demand for bonds with lower rates and decreases its price also but in turn increases its yield.
The Fed’s policy has a more direct impact on short-term government debt whose yields are highly sensitive to changes in the fed-fund rate. For example, the yield on the two-year note traded near 1% before policy and highest since May 2010. Market expected the yield to rise if the Fed raises interest rates on Wednesday. However it was argueed that the yield has nearly doubled in the past two months and if the Fed signals that further tightening will happen at a very slow pace, some may book profit from their short bets on the two-year notes.
2) In the March statement, Fed turned out to be dovish and didn't raise the interest rate on the back of weaker oil prices as well as weak global economy. Any further rise by Fed would have seen sell off in riskier global equities and higher demand for safer US treasuries. Further recent meltdown in Chinese market also weighed on the minds of policy makers.
According to the dot plot, which shows where each participant in the meeting thinks the Fed funds rate should be at the end of the year for the next few years and in the longer run, policymakers now foresee two, rather than four, modest increases in their benchmark short-term rate during 2016.
Thus, Fed officials forecast that the federal funds rate will reach 0.88% by the end of 2016, 1.9% by the end of 2017, and 3% by the end of 2018—lower than the December 2015 forecasts.
this is the reason for subdued sentiments in the bond market and 1-3 year treasuries seen higher losses in yield.
3) In late 2014, the Fed began signaling that the era of unusually easy monetary policy, conducted through bond buying and commitments to keep interest rates near zero, was coming to an end. That policy had encouraged investors to take risks, what traders call “risk on.” So its approaching end logically meant “risk off.” Capital fled emerging markets and junk-rated companies such as shale-oil producers, the dollar rose and stocks stopped rising. Plunging oil prices and doubts about China were certainly drivers of the risk-off shift, but the cautious Fed was always in the background.
The Fed’s move is seems to be co-ordinated because it comes after the world’s other three most important central banks acted similarly. In January, the Bank of Japan cut rates into negative territory. Last month, the People’s Bank of China reduced reserve requirements, freeing banks to lend more. Last week, the European Central Bank cut rates further into negative territory and expanded its bond-buying program.
4) The Fed signaled in March policy not only that the path to higher rates would be lower, but so, too, would the resting place. The median of officials’ estimate of the long-run federal funds rate dropped to 3.25%, from 3.5% in December and 4% two years ago. This is not actually encouraging: it means Fed officials think a deep-seated shortage of investment and spending are holding down the demand for loans and thus the “equilibrium” interest rate that keeps the economy at full employment.
At full employment any further expansion will lead to stagflation and while employemnt is at the full but Fed noted that wage growth is still slow. Further, it had taken care of global impact while giving guidance as rate hikes will not be good for alredy fragile economy, any faster rate hike will only worsen the situation.
In January the Fed wanted to see if the market turmoil reflected changing fundamentals. It did; growth in commodity exporting countries from Canada to Brazil has been set back. The International Monetary Fund expects to downgrade global growth this year. Weaker global growth, said Fed Chairwoman Janet Yellen, is a key reason officials now expect the U.S. to grow just 2.2% this year, down from 2.4% in December.
Second, as Ms. Yellen herself noted, markets have stabilized in part because investors expected the Fed to tighten more slowly. The burden was on the Fed to ratify those expectations.
Markets had reached the same conclusion long ago; it’s why long-term Treasury yields persist near 2%. Fed officials are coming around to the market’s way of thinking, and in the process making it less likely they will push rates up so far that the economy sinks back into recession.
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