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Mechanics of Finance: The Federal Reserve

M A N AG I N G T H E M O N E Y S U P P LY
MILKEN INSTITUTE CENTER FOR FINANCIAL MARKETS N AT I O N A L P R E S S F O U N D AT I O N T U E S D A Y, J A N U A R Y 1 4 , 2 0 1 4

Overview
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Introduction

Crises and Fed Actions


Impact on markets Global Action and Impacts

Tapering

2 5 10 21 30

Monetary policy and the federal funds market


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Normal Operations
Interest rates
Interest rates

Quantitative Easing
Bank Reserves Supply

Tighten

Ease

Bank Reserves Supply Fed funds rate Bank Reserves Demand


Bank Reserves Demand

Quantity of Bank Reserves

Quantity of Bank Reserves

QE zone

Source: JPMorgan, Milken Institute

Alternatives to QE
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Floor System
Interest rates

Corridor System

Quantity of money

Bank Reserves Supply Deposit rate Bank Reserves Demand

Lending rate
Ff rate Deposit rate

Bank Reserves Supply

Bank Reserves Demand

Quantity of Bank Reserves

Quantity of Bank Reserves

Excess money is soaked up at central banks borrowing facility

Borrowing and lending facility used to ensure target rates stay in the corridor

Source: JPMorgan, Milken Institute

Overview
5

Introduction

Crises and Fed Actions


Impact on markets Global Action and Impacts

Tapering

2 5 10 21 30

Fed Balance Sheet


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Source: ISI Group

Composition of Feds Balance Sheet


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Sources: Federal Reserve, Milken Institute

The Fed has engaged in Quantitative Easing repeatedly


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Sources: Federal Reserve, Milken Institute

Federal Reserves earning remittances to U.S. Treasury


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US$ billions 100

Federal reserve annual distributions to the U.S. Treasury

80

60

40

20

0 1952 1958 1964 1970 1976 1982 1988 1994 2000 2006 2012

Source: Federal Reserve

Overview
10

Introduction

Crises and Fed Actions


Impact on markets Global Action and Impacts

Tapering

2 5 10 21 30

Has the U.S. policy rate been kept too low for too long?
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Sources: Federal Reserve, Bloomberg, Milken Institute

U.S. economy is still below its potential output trend


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Real GDP (US$ billions, 2005=100)

15,000 Potential real GDP 14,000 13,000


12,000 11,000

Real GDP

10,000 2000

2002

2004

2006

2008

2010

2012

Sources: U.S. Bureau of Economic Analysis, Federal Reserve Bank of St. Louis

Employment To Population Ratio


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64%

63%

Employment to Population Rate %

62%

61%

60%

59%

Employment growth is flat


58.6%

58%

Source: Bureau of Labor Statistics

Unemployment
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Unemployment rate
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10

7.0%
6

0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Bureau of Labor Statistics

Housing Stats Have Improved


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But have a long way to go

2,800
2,500

Housing Starts SAAR Thousands

2,200

1,900 1,600 1,300


1,036,000 Avera ge 1,472,000

1,000 700

400

Source: US Department of Commerce

U.S. private capital formation has not been picked up


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Net private fixed asset stock, four-year percent change at an annual rate (%), index, 2005=100
5

0 1951 1957 1963 1969 1975 1981 1987 1993 1999 2005 2011

Sources: U.S. Bureau of Economic Analysis, Milken Institute

Real treasury yield has turned negative in some recent periods


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10

U.S. real 10-year treasury yield, percent


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-2

-4

-6 1957

1961

1965

1969

1973

1977

1981

1985

1989

1993

1997

2001

2005

2009

2013

Sources: Federal Reserve, U.S. Bureau of Labor Statistics

Relationship between Treasury yield and Feds buying Treasury securities


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US$ trillions

Percent

2.0 1.6 1.2 0.8 0.4 0.0 2005

10-year Treasury yield (%, RHS)

QE1

QE2

QE3

6
5 4

3
Fed holdings of Treasury securities (US$ trillions, LHS)

1
2009 2010 2011 2012 2013

2006

2007

2008

Sources: Federal Reserve, Milken Institute

Yields on U.S. high-yield bond hit record low


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25

20

15

Yield, %
10
5 0 1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

Note: BOFA MLUS High Yield Master II Index

Source: Datastream

Total U.S. credit market debt


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Debt to GDP ratio (2012): 3.5+
60 4 3.5 Debt to GDP Ratio 1991 1998 2005 2012 Debt to GDP Ratio US $ trillions 3 2.5 2 1.5 1 10 0.5 0 1949 1956 1963 1970 1977 1984

50

40

30

Debt to GDP ratio (1950-1980): 1.5

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Total credit market debt owed

GDP

Sources: Federal Reserve, BEA

Overview
21

Introduction

Crises and Fed Actions


Impact on markets Global Action and Impacts

Tapering

2 5 10 21 30

Central bank target interest rates remain low


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Policy interest rates, percent
7

United Kingdom
6

United States
3

Eurozone
2

Bank of Japan

0 2007

2008

2009

2010

2011

2012

2013

2014

Source: Bloomberg

Emerging market central bank target rates


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16

Policy interest rates, percent Brazil Russia

14

12

10

China India

0 2007

2008

2009

2010

2011

2012

2013

Source: Bloomberg

Expansion of balance sheets of major central banks


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Source: Bloomberg

Central bank assets vs. GDPs of worlds largest economies


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18 16 14 12
US$ trillion

10 8 6 4 2 0 United States China Japan US Federal Reserve Germany France United Kingdom European Central Bank

Sources: Federal Reserve, IMF, December 2013

Output is still below the pre-crisis level in many major countries


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Real GDP (Q1 2008=100)
110

105

U.S. Germany

100

Japan. U.K.

95

90

Italy

85

80

U.S.

Germany

Japan

U.K.

Italy

Sources: Bloomberg, Milken Institute

Inflation may be worryingly low


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Sources: Datastream, Milken Institute.

Decline in government bond yields in major advanced countries


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10-year Government bond yield (%)


6
US Germany UK Japan

0 1/9/2006

1/9/2007

1/9/2008

1/9/2009

1/9/2010

1/9/2011

1/9/2012

1/9/2013

Source: Bloomberg

Equities rally in 2013


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Equity indices in major countries

Note: U.S. (S&P 500), Eurozone (German DAX), UK (FTSE 100), Japan (Topix)

Source: Bloomberg

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Introduction

Crises and Fed Actions


Impact on markets Global Action and Impacts

2 5 10 21 30

Tapering

Bernankes taper talks scared the market


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Source: Bloomberg

Summer 2013
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Roadmap to tapering
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Projected monthly pace of Fed asset purchases Projected size of Fed balance sheet

Sources: Federal Reserve, JPMorgan