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Posts Tagged ‘interest rates’

Auction Theory and LIBOR

An article in The Economist argues that a little auction theory might solve some of the British Bankers’ Association (BBA) current LIBOR problems:

Some of LIBOR’s failures also have echoes in auctions. Traders at involved banks are accused of aligning their LIBOR estimates in an attempt to affect the final rate. They were able to cross-check what others had done, since the BBA makes individual estimates public. These traders had, in effect, formed a “bidding ring,” analogous to a sort of cartel that is familiar to observers of auctions.

Fortunately, a variety of economists have researched how to break bidding rings.  Their findings suggests that, in addition to relying on actual data (instead of estimates) and creating penalties for false bidding, the LIBOR system would benefit from a few changes focused on the weaknesses of bidding rings:

Once banks’ LIBOR bids actually have some commitment value, the system should focus on the weaknesses that auction cartels are known to have. The cartel-enforcement problem would be more acute if the BBA increased the number of submitting banks and kept those bids private. The entry of outsiders should be actively encouraged, by allowing other lenders to banks (money-market funds, say) to submit estimates, too.

What can Eeyore and Tigger Teach Bernanke About Monetary Policy?

What can Eeyore and Tigger tell us about the current state of monetary policy?  A lot.  At least that’s the argument that Betsey Stevenson and I make in our new column for Bloomberg View.

The Fed is now engaged in the game of “forward guidance”—they’ve announced that they anticipate keeping interest rates at zero, until late 2014—and hope that it will shape the recovery.  But what effects will this announcement have?  To figure this out, let’s visit two of the greatest ever Fed Chairmen: Eeyore and Tigger.

Operation Twist 101

Given the confusion about Operation Twist, here’s an explanation.
What is Operation Twist? Basically the Fed can’t reduce short-term interest rates any further—they’re already at zero. So they want to reduce long-term interest rates instead. They do this by buying long-term bonds. When you buy more of something, you raise the price. And when you raise the price of a bond, you lower the interest rate. So what the Fed is doing, is lowering long-term interest rates.
How does the Fed pay for these bonds? With QE1 and QE2, the Fed effectively just printed the money. (They “expanded their balanced sheet.”) Instead, they are selling short-term bonds, and using the proceeds to buy the long-term bonds. Now selling a bunch of short-term bonds will—usually—lower their price, raising short-term interest rates. That’s why people call this “Operation Twist”—it should “twist” the yield curve—lowering long-term interest rates (which is what matters when you buy a house, or when a firm borrows to buy new machinery), but it also raises short-term interest rates.
Raising short-term interest rates is a bug, not a feature. But fortunately, this time, the effect on short-term interest rates will be small. Why? The Fed has already committed to keeping short-term interest rates near zero for the next couple of years. And so given this commitment, the 2-year bond will also be close to zero.

The Latest from the Brookings Panel

I’m back from my favorite conference of the year—the Brookings Papers on Economic Activity. It was a terrific line-up of papers. And to call the discussion lively would be an understatement. (Full disclosure: David Romer and I are the co-editors.)
While a close reading of technical research papers is my idea of a good time, I’m told not everyone is wired this way. So I went into the studio to record a very simple summary of my thoughts on the papers. You won’t quite get the whole two days of economic policy wonk-ery, but this video is a start:

Interpreting the Fed: How Did it Lower Rates This Time?

I’ve found a lot of the recent discussion about the Fed to be, frankly, confused. So I thought it worth trying to put the issues into a broader context.
Read the Fed’s latest statement, and you’ll see many of the themes I’ve talked about recently. They’ve learned that the economy is not only weak, but that—as I’ve been forecasting for some time—“economic growth so far this year has been considerably slower than the Committee had expected.” Turn to the labor market, and they somewhat dryly note “a deterioration in overall labor market conditions.” And while they won’t use the word double dip, they do note that “downside risks to the economic outlook have increased.” Also, “inflation has moderated.” So there’s plenty of room for them to try to goose the economy. But how?