Yield curves as a leading economic indicator
There are several reasons, which indicate that the gradient of the yield curve shows a probable future downturn. Contemporary monetary policy has a noteworthy influence on the yield curve extension, therefore on actual activity over the subsequently several quarters. An increase in the short rate tends to reduce the pace of actual growth in the near term and to squash the yield curve. Prospects of actual interest rates and potential inflation enclosed in the yield curve appear to have a vital function in the forecast of economic action. It is evident that the yield curve is a very effective tool for forecasting prospective financial and economic circumstances. However, other variables also predict the economic outcomes other than the yield curve, for instance trends in stock prices. Economic analysts deem that anticipations concerning prospective dividend streams determine stock prices. Consequently, this trend influences and dictates on the future economic status of a nation (Estrella & Mishkin, 1997).
Tools that the Federal Reserve policy makers use to influence the money supply and interest rates
Monetary policy refers several strategies by which central banks influence the supply and accessibility of money, in addition to the interest rates. The Federal Reserve is in charge of monetary policy In the U.S. Central banks for instance the Federal Reserve can apply contractionary or expansionary policy instruments to influence a country’s money supply. Expansionary monetary policy raises money supply. For example, banks can loan much of their obtained deposits if the Federal Reserve lessens reserve obligations. Since a low rate prompts banks to maintain fewer reserves since it costs less to borrow funds to cover deficits, a decrease in the discount rate has parallel outcomes. On the other hand, contractionary policy tools decreases money supply. Central banks mostly undertake these procedures to lessen inflation. Contractionary strategies comprise rising the discount rate and augmenting banks’ reserve obligations. The former makes it extra expensive for banks to fall short of reserve obligations, forcing them to employ reduced lending while the latter decreases the amount of money accessible for loaning. These measures render borrowing more expensive since they increase interest rates (Hal, 2011).
One strategy through which the Federal Reserve policy makers can control money supply is by altering the reserve obligations of banks. It is evident that small alterations in the amount can lead to enormous modifications for available money, which could impose severe implications on the economy. For this reason, policy makers do not use this strategy often. Consequently, the Federal Reserve just modifies the reserve obligations under intense circumstances. Similarly, there are just not sufficient dollars on margin, relative to the fiscal foundation, to make a noteworthy distinction in the money supply. Due to this, the Federal Reserve does not often alter the Federal call percentage for the stock market. In addition, the loans attainable by banks are often rather higher than the discount rate the Federal Reserve charge. This is probably the major reason why financial analysts still refer to this discount rate as a discount loan. In general, it appears that banks ought to borrow as much as they can from the Federal Reserve and then raise profits from reducing their interest expenditure. If the Federal Reserve reduces or raises the discount rate, banks become aware that they are altering monetary policy consequently increasing or reducing their rates. On the other hand, banks often borrow from other banks that have cash overflows if they require money to cover temporary liquidity predicaments (Options A to Z, 2007).
The other strong tool that the policy makers use to influence money supply and interest rates is open market operations. This strategy involves the buying and selling of government bonds in the open market. In this regard, the Federal Reserve pays for treasury bonds with cash and obtains bonds from banks or investors if they purchase them in the open market. Moreover, they deposit this money into banks thereby increasing the money supply. This strategy clearly indicates that the Federal Reserve increases money supply. Consequently, when there is increased money supply, the value of the money reduces thereby reducing interest rates. This again indicates that the Federal Reserve lowers the interest rates. The Federal Reserve is also in a position of raising the interest rates. They can clearly do this by selling there bonds in an open market. By so doing, the banks and investors will tend to hold the bonds while they release cash for them. Consequently, this causes a reduction in the money supply, which reduces its value, thereby increasing the interest rates. This indicates that the open market operations utilize a reverse strategy, which either increases money supply thereby lowering interest rates or reduces money supply thereby raising the interest rates. This is far much the most easy and rational toll for controlling money supply and interest rates.
The relationship between short and long-term interest rates as the time to maturity of the debt increases
Monetary policy can control the gradient of the yield curve in relation to the interest rates. Short-term interest rates increases due to a stretched monetary policy. The intention of the increased short-term interest rates is causing the lessening of the inflationary pressures. Consequently, there is expectation that there would be a strategy to ease lower rates once these pressures fall down. This means that due to the stretching, short-term interest rates increases. On the other hand, long-term interest rates seem to symbolize longer-term anticipations and increase by less than short-term rates. However, one consequence of increased short-term interest rates is that there is sluggishness in the economy and squashing of the yield curve. On the other hand, the long-term interest rates move in the opposite direction from time to time. This indicates that both long-term and short-term interest rates may lead to an inversion of the yield curve if persistent. Occasionally, long-term rates go down devoid of an apparent concurrent movement in short-term rates, an occasion that might also give rise to an inversion (Estrella & Trubin, 2006).
Long-term interest rates are superior to short-term rates since evasion might become possible in the distant future if the borrower obtains several bad shocks and builds up debt. In addition, Long-term interest rates are higher due to the risk premium on prospective alterations in evasion likelihood. On the other hand, during increased debts and reduced income, evasion is probable in the near future therefore, interests become high. Furthermore, long-term interest rates increases by a lower margin compared to the short-term interest rates. This is because the borrower’s probability of paying back might increase over a stretched time scope if there are several good shocks and reduction in debt. In addition, interest rats are very dynamic and the gap between short-term and long-term rates fluctuates considerably over time. In this regard, when interests are low, long-term rates become normally higher than short-term rates. Conversely, when the extent of interests’ increases, the difference between short-term and long-term spreads seems to contract and at times overturns (Arellano & Ramanarayanan, 2010).
If the Federal Reserve follows either an expansionary or a contractionary policy, what will be the effect on bonds?
The decision of issuing bonds in a certain period by a company highly reflects the contractionary and expansionary monetary policies by the Federal Reserve. Due to these measures, a borrower undergoes continual income shocks and can issue short and long period bonds. The borrower can evade on debt at whichever particular time, but experiences expenses of doing so. These expenses arise due to omission from global financial markets and reduced income. In equilibrium, defaulting appears to arise in high-debt, reduced-income periods, when the rate of debt repayment overshadows the rates of evasion. In effect, bond prices reimburse for the anticipated loss from evasion and for risk premium (Arellano & Ramanarayanan, 2010). In the case of the major department store chain, the management will have to issue their bonds now if the Federal Reserve is following an expansionary policy. This is because expansionary monetary policy leads to reduction in interest rates. Consequently, this renders bonds less striking in relation to equities, thus leading to increase in the price of equities. When interest rates are low due to expansionary monetary policy, less risk-susceptible borrowers are many among those requiring loans. In effect, lenders become more eager to loan, increasing both venture and yield. In addition, Expansionary monetary policy raises bank deposits and bank reserves thereby augmenting the amount of bank loans obtainable. Consequently, this increase in loans will lead to an increase in investment and probably consumer expenditure (Mishkin, 1996).
On the other hand, the management of the chain store should issue the bonds after one year if they feel that the Federal Reserve is following a contractionary policy. This is because a contractionary monetary policy will likely augment the borrowing price of companies that have to finance their working capital. In the short run, such short-run raises in financing the production cycle becomes partially the burden of consumers. Consequently, this “cost channel” controls the reduction in demands subsequent to the shock and effects in higher, instead of lower costs. In addition to this, a rise in the relative issuing of long-term bonds might reduce the costs of all bonds, even short-term bonds, whose supply reduces. The perception is that alterations in supply affect the term formation by changing the market prices of the risk factors. These risk factors are general to every bond due to the lack of arbitrage. There are diverse channels through which contractionary monetary policy reduces surplus stock market returns. Moreover, a contractionary monetary shock will cause a rise in inflation. This will only happen if the Federal Reserve has some confidential data concerning future inflation, or if their shocks increase the borrowing price of companies (Goto & Valkanov, 2002).