Good Essay About Financial Markets And Institutions
1.0 The money market and its transactions
The money market is the center of credit exchange in the United States and around the world. It is where businesses (local and global), governments (local and global), and individuals (local and global) borrow or lend short-term credit instruments usually for a term of 1 to 120 days (Kidwell & Peterson, 1987). Instruments include the U.S. Treasury securities (e.g. Treasury bills), negotiable certificates of deposit (time deposit), commercial paper (short-term unsecured promissory notes), banker’s acceptances (time drafts), and repurchase agreements (sale of short-term security or collateral). However, the U.S. Treasury bills are the dominant money market instrument for long decades. Money market participants include commercial banks, the Federal Reserve System, the U.S. Treasury, dealers in U.S. securities, and corporations.
Money market transactions are called ‘open market transactions’ because they are both impersonal and competitive, involving wholesale transactions mostly involving at least $1 million (Kidwell & Peterson, 1987). Its most important economic function is the provision of an efficient system for economic units (e.g. the US and global economies) to adjust their liquidity positions. It allows for an efficient timing of cash receipts and cash expenditures in perfect synchrony. If, for instance, the French government has surplus U.S. dollars in its central bank, it can temporarily purchase U.S. Treasury bills for a predetermined period of, say, 120 days, after which they can use it for their expenditures; instead of keeping these idle cash in the central bank vaults.
This market is highly valuable to global economies as it offers low default risk, short-term to maturity, and high marketability or liquidity, allowing governments to manage their liquidity efficiently.
2.0 The most important interest-rate factor in today’s economic environment
Based on the third quarter 2014 results, the US real GDP increased at an annual rate of 5.0 percent primarily reflected positive contributions from PCE, nonresidential fixed investment, federal government spending, exports, state and local government spending, and residential fixed investment (Mantaloni, 2014). This acceleration came under a 2014 annual inflation rate of 0.8 percent (US Inflation Calculator, 2015).
Malkiel (2015) identified five of the most important determinant factors in the magnitude of the US interest rate: (1) the strength of the economy and the willingness to save; (2) the rate of inflation; (3) the riskiness of the borrower; (4) the tax treatment of the interest, and; (5) the time period of the loan. Factor 1 appears to be under control and Americans are motivated savers. Factor 2 is also well under control at less than one percent. Factor 3 is a discretionary factor that is lender-specific. Factor 4 is given in most interest earnings. Factor 5, however, is highly important due to the increased variability influence of time on interest rates. The current problem is not about controlling interest rates but in effectively predicting its behavior in the long term for investment risk management purposes.
3.0 Dynamics and value of interest rate forecasting
Predicting interest rates are inherently difficult because their behavior is highly volatile and nonlinear (Ju, Kim & Shim, 1997). The primary issue in forecasting interest rates lies upon the relative precision between forecasting models. Whether it is a central bank or a market-based forecast, Goodhart and Lim (2011) noted that, by most “econometric standards,” their predictive ability is good only over the first quarter from the date of the forecast. Once beyond the end of that first quarter up to the end of the second quarter, the predictive value is not only poor but already without value; although significantly better than the no-change tenor of random-walk forecast. Beyond the sixth month, the forecast becomes utterly useless. These forecasts become strongly and significantly skewed upward or downward from the actual subsequent path of interest rates.
The problem with the use of time series comes from the sampling categorization into “up,” “down,” and “flat” periods, which pose difficulty as they are always not self-evident (Goodhart & Lim, 2011). Short-dated series, however, are relatively easier to use due to the ex post timing of their turning points.
Nonetheless, the benefits of interest rate forecasting, especially by the central bank, includes the provision of projective reference interest rates for market participants from which they can design their investment plan in the short- and medium-term (Walker, 2009). It also expresses the central bank’s understanding of the economy and how it anticipates its future actions in response to forces affecting interest rates, such as inflation and unemployment. .
4.0 Federal Reserve history and American economic roles
The severe financial crisis of 1907 highlighted some serious shortcomings of the national banking system. It lacked a flexible (“elastic”) currency supply, failing to meet increased money demand as the economy expanded or even during seasonal high demands (Kidwell & Peterson, 1987). It followed a system of pyramiding of money reserves wherein smaller country banks may deposit only to large city banks for their seasonal cash reserves, which resulted to cash squeeze and forced reduction in bank credit during seasonal massive withdrawal of such cash reserves. It also lacked an efficient national payment system (no central check-clearing and no collection mechanism). Instead thousands of individual banks cleared their checks through an elaborate and cumbersome banking network where the cost of transferring funds between regions was high and accompanied with long delays in clearing checks. Many banks redeem off-town checks at discounts instead of at par.
The passage of the Federal Reserve Act in 1913 corrected some of these shortcomings, allowing the Federal Reserve System (FRS) to expand and contract the national money supply as the economic need demands, lend money to banks as a last resort in times of financial crisis, instituted an efficient clearing and collecting system for checks nationwide, and a more vigorous supervision of the national bank system. This time the FRS can provide the national supply of U.S. currency effectively eliminating financial panics during high economic demands. It can issue new bank notes at its discretion to maintain elasticity of money supply. Consequently, it successfully stabilized the U.S. economy, contributing also to the stabilization of other global economies.
5.0 Current US monetary policy
Current policy of the Federal Reserve System for 2014 indicates a more improved accommodative stance in managing the US monetary supply and expected to be so for a considerable time after the asset purchase program ends. The current interest rate for federal funds will be at 0 to 0.25 percent and contingent with an unemployment rate of above 6.5 percent, inflation rate of up to 2.2 percent in the next one to two years, and a stable long-term inflation expectation (Federal Reserve System [FRS], 2014
Moreover, the FRS (2014) has scaled down its large-scale asset purchases, and slowly winding down further based on economic developments on a monthly basis. It continued purchasing mortgage-backed securities (MBS) and long-term Treasury bonds at $40 billion and $45 billion per month, respectively. It proceeded to reduce asset purchases, contingent with public announcements that it will continue in a measured rate contingent with its outlook for the labor market and inflation and its assessment of the costs and efficacy of such purchases, to $30 billion per month for MBS and $35 billion per month for Treasury bonds.
Disclosing these to the public has the effect of stabilizing the long-term expectations as well as fostering price stability in an environment of moderate interest rate. This policy is expected to promote stronger economic recovery in the US as an outcome of its maintenance of the declining pressure on longer-term interest rates. In effect, it will support continued US company expansion locally and offshore in the long-term. Consequently, it promotes optimum employment potential, aimed at maximum rate possible, even before major economic instabilities; supports mortgage markets and heightens its already accommodative policy to broader financial conditions.
An expanding and stable US economy increases international trade as more funds increases at home due to moderate and stable interest rates and around 2 percent inflation. Oversees lenders also will be encouraged to purchase Treasury debt securities, and with potential overflow into corporate bonds, as the inflation rate move towards the maximum target of 2.2 percent.
6.0 Strategic financial objectives
The FRS currently aims to adjust the below 2 percent inflation rate to a maximum of 2.2 percent in the future, based on future economic developments. This objective sets up the interest rates, and subsequently the coupon rates, to increase in the future, making investment in the medium- and long-term U.S. Treasury bonds currently highly attractive. As the FDS continued cutting down on its purchase of Treasury debts, increasing upside pressure on the interest rates is already in progress. The indicators to closely watch, though, to time the purchase of US debt securities are inflation rates and their immediate impact on interest rates and coupon rates. The current downside development in the world oil price (e.g. crude oil futures dropped 5.2 percent in New York) also eased up inflation pressure in the U.S., making near-term interest rate unlikely (Kruger & Walker, 2015). However, a low inflationary environment creates risks for the ongoing effort towards economic recovery, keeping still an upside pressure on interest rate as far as FRS monetary policy is concerned. Thus, buying longer-term US Bonds remained exciting.
Board of Governors of the Federal Reserve System. (2014, February 11). Monetary Policy
Report, Washington, DC: Federal Reserve System.
Goodhart, C.A.E. & Lim, W.B. (2011, June). “Interest rate forecasts: A pathology.”
International Journal of Central Banking, 7(2): 135-171.
Ju, Y.J., Kim, C.E. & Shim, J.C. (1997, December). “Genetic-based fuzzy models:
Interest rate forecasting problem.” Computers & Industrial Engineering, 33(3-4): 561-564. DOI: 10.1016/S0360-8352(97)00193-9.
Kidwell, D.S. & Peterson, R.L. (1987). Financial Institutions, Markets, and Money,
3rd ed. New York: The Dryden Press.
Kruger, D. & Walker, S. (2015, January 6). “U.S. 30-Year yield is lowest since 2012 as oil
damps inflation.” Bloomberg.com. Available at: http://www.bloomberg.com/news/2015-01-05/global-bond-yields-approach-record-low-of-1-29-as-euro-falls.html
Malkiel, B.G. (2015). “Interest Rates.” The Concise Encyclopedia of Economics. Available
Mataloni, L.S. (2014, December 23). “GDP News Release.” Bureau of Economic Analysis.
Available at: http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
US Inflation Calculation. (2015). “Current US Inflation Rates: 2004-2015.” US Inflation
Calculation. Available at: http://www.usinflationcalculator.com/inflation/current-inflation-rates/
Walker, M. (2009, May 13). The Publication of Interest Rate Projections by the Central
Banks of Norway and Sweden. Stanford: Stanford University.
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