Anticipating Fed Actions Recall that Carson Company has obtained substantial loa

Question

Anticipating Fed Actions
Recall that Carson Company has obtained substantial
loans from finance companies and commercial banks.
The interest rate on the loans is tied to market interest
rates and is adjusted every six months. Because of its
expectations of a strong U.S. economy, Carson plans to
grow in the future by expanding the business and by making acquisitions. It expects that it will need substantial
long-term financing and plans to borrow additional
funds either through loans or by issuing bonds. The company may also issue stock to raise funds in the next year.
An economic report recently highlighted the strong
growth in the economy, which has led to nearly full
employment. In addition, the report estimated that
the annualized inflation rate increased to 5 percent,
up from 2 percent last month. The factors that caused
the higher inflation (shortages of products and
shortages of labor) are expected to continue.
a. How will the Fed’s monetary policy change based
on the report?
b. How will the likely change in the Fed’s monetary
policy affect Carson’s future performance? Could it
affect Carson’s plans for future expansion?
c. Explain how a tight monetary policy could affect
the amount of funds borrowed at financial institutions
by deficit units such as Carson Company. How might it
affect the credit risk of these deficit units? How might it
affect the performance of financial institutions that
provide credit to such deficit units as Carson
Company?

Explanation / Answer

(a) Since inflation is increasing and the economy is at almost full-employment level, unless the growth is controlled, a positive output gap is on the verge which will see actual GDP exceed the full employment GDP, increasing prices further.

So, Fed will want to slow down the monetary growth by reducing money supply. Fed can reduce money supply by engaging in open market sale of government securities, or by increasing required reserve ratio and/or Federal funds rate.

(b) A reduction in money supply will increase the interest rate. A higher interest rate will make Carson's borrowing and debts more expensive to service. This will increase its existing debt-servicing burden in form of higher interest payments, reducing profitability. In addition, a higher interest rate will make new borrowings costlier, which will most likely make Carson postpone its investment-by-borrowing decisions. As a result its future growth will likely slow down (unless operating profit increase enough to cover the rise in interest expense).

(c) A tight monetary policy will reduce borrowing by deficit units who will find debt-servicing costlier (unless a deficit unit is desperate for funding).

A higher interest expense will increase the credit risk of the deficit units since chance of a default caused by higher interest burden will be higher.

As borrowing decreases, the lenders will be affected too, since their source of income is interest charged from borrowers. With lower borrowing by deficit units, the income and asset of surplus units (lenders) will be lower, therefore profitability will decrease.

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