TO READ: as part of my education

Bond Basics: Characteristics
Reading The Balance Sheet

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The Fed and Lowering Long-Term Interest Rates

How does the Fed lower long-term interest rates?

  • The Federal Reserve owns about $1.7T in US treasury securities (e.g. bonds issued by the federal government), which is about a trillion more than they owned before the quantitative easings of 2008 and 2010.
  • When the Federal Reserve starts buying longer term US treasury securities, this obviously increases the demand for those securities.
    • Note that US treasury securities include: Treasury Bills, Treasury Notes, Treasury Bonds. All of  these are fixed income securities and so they yield some predetermined constant amount on some predetermined schedule.
  • As demand for securities goes up, so does their price.
  • And if the price of a fixed-income security goes up (say, from X to X+k) then its relative yield (yield amortized over the cost of the security) decreases.
    • Say a given Treasury bond is going to pay $30 every 6 months for 30 years. If we buy that bond for $X then our yield per dollar invested (i.e. relative yield) will be higher than if we buy it for some amount >$X. Because the yield itself (the amount we’re earning) is fixed.

(($30 * 2 * 30)/$X) > (($30 * 2 * 30)/($X+k)).

What happens when long-term interest rates go down?

  • The interest rates of many other securities (not issued by the federal government) are pegged to the Treasury interest rate. When Federal interest rates go down, then all such securities will have lower rates of return (since they will earn less interest than when the rates were higher).
  • This will cause investors to seek other investment vehicles, which have higher rates of return, e.g. stocks. This will cause stock prices to rise, which will cause consumers’ stock portfolios to increase in value, which will make consumers feel wealthier and consequently spend more.
    • This is called “the wealth effect”.
  • Also, when long-term interest rates decrease, that means credit is cheaper, which encourages more borrowing and could encourage more hiring.
  • This whole cascading effect is intended to stimulate the economy (by stimulating spending).

Other things the Fed might do to stimulate the economy

There are limitations to what can be accomplished by lowering interest rates. After all, if there aren’t credit-worthy borrowers (to take out the loans) or businesses willing to take advantage of low-cost loans (due to uncertainty about the future) then further lowering interest rates (by itself) is unlikely to produce stimulative effects.

  • The Fed could also decrease the interest rate it pays to banks on the banks’ excess reserves. That might cause banks to look elsewhere (somewhere with higher returns) to park that money.
  • Or if the Fed raises the target for inflation that might encourage folks to spend more now since their money will be worth less (relative to the cost of goods) later.

Some other notes

Interest rates of long-term treasuries are at historical lows (point: not much further to drop)

  • The yield for a 10-year Treasury note:

  • The yield for the 30-year U.S. Treasury bond:

* The yield for the 30-year U.S. Treasury bond generally has declined since the early 1980s. Note that there is no data for yield for 2003, 2004, and 2005 because the U.S. Treasury had suspended issuing 30-year bonds during those years. Source: Federal Reserve Board.

Source: Nearly Out of Tricks, Fed May Pare Longer Rates

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Quantitative Easing

What is it basically?

An “expansionary monetary policy”: that is, a policy that attempts to increase the size of the money supply, typically with the goal of lowering interest rates. Lower interest rates encourage (1) investors to look for higher yield places to park their money (e.g. riskier investments, such as stocks) and (2) borrowers to borrow (because money is so cheap). These twin side effects are intended to stimulate the economy.

As discussed elsewhere, the Fed controls some set of interest rates (e.g. the federal funds target rate); many other (private sector) interest rates are pegged to those controlled by the Fed. In particular, the US Prime Rate is typically (since 1994) three percentage points above the federal funds target rate. The US Prime Rate “is used by many banks to set rates on many consumer loan products, such as student loans, home equity lines of credit, car loans and credit cards.”

There are some interest rates, however, that are not directly related to the federal funds target rate (or are more loosely correlated) and so if the Fed wishes to lower these rates, they have to use different tactics. Applying quantitative easing – targeted toward purchasing private sector assets (e.g. bank bonds) – is one such technique.

How do you do it?

The central bank (e.g. the Federal Reserve) buys assets (e.g. US Treasury Securities) from the government or from the private sector (insurance companies, pension funds, banks, non-financial firms) by crediting the account of the seller (e.g. the private bank’s federal reserves account). In this way, the central bank didn’t literally print more money but it did in effect create money out of thin air by exercising its ability to credit one account without debiting another. Not only does this inject more money into the economy but it also frees up the seller to redeploy that capital elsewhere (for example, lending it to other institutions or to consumers).

  • The Bank can create new money electronically by increasing the balance on a reserve account. So when the Bank purchases an asset from a bank, for example, it simply credits that bank’s reserve account with the additional funds.” Source: The Bank of England: Quantitative Easing
  • See also: Understanding The Federal Reserve Balance Sheet
  • What’s a federal reserves account?
    • Insert link here, when new section on federal reserves accounts is done.
  • E.g. recent US quantitative easing
    • In 2008, the Fed doubled its holdings of US Treasury securities – from approx $750B (in 2007) to approx $1.5T (in June 2011), now $1.7T.
      • This included $600B in Mortgage Backed Securities (MBSs) (presumably from Freddie Mae and Fannie Mac). It also bought bank debt and treasury notes.
    • In 2010, the Fed bought another $600B in Treasury Securities; this was referred to as QE2.

Why do you do it?

Lowering interest rates is one of the key tricks for stimulating the economy (as described here). If interest rates are already sufficiently low OR if lenders still don’t want to loan money, then central banks (e.g. the Fed) do QE in order to lower interest rates that are not otherwise under the control of the central bank (e.g. interest rates of securities that are not pegged to the rate of US Treasury securities).

  • However, “economists [have] warned that quantitative easing may be of limited use when the problem is a lack of demand, rather than of liquidity — that consumers and businesses were uninterested in spending in the face of high unemployment no matter how much cheap money is around.” Source: Times Topics: Quantitative Easing
  • The cost of borrowing is not the problem,” said Paul Ashworth, chief United States economist at Capital Economics. “The problem is that there are not creditworthy borrowers, and that businesses don’t want to invest because they’re concerned about the economic outlook.” Source: Nearly Out of Tricks, Fed May Pare Longer Rates
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How much is the US debt and what is it comprised of?


Total US Debt

All told, the total US debt is about:

$55T ~= $16T (personal) + $21.4T (corporate) + $2.5T (state/loc) + $14.7T (nat’l gov’t)

 Which includes:

  • [$16T] Personal debt held by Americans
    • [$13.56T] Mortgage debt (including non-residential mortgages)
    • [$2.48T] Consumer debt (including car loans, credit card debt)
  • [$21.4T] Corporate debt, including
    • [$14.1T] The US financial sector debt
    • [$7.3T] Non-financial business debt
  • [$2.5T] State and local government debt
  • [$14.7T] Federal government debt

Breakdown of the US national debt

The US national (federal government) debt is currently just under $14.7 trillion dollars (see also: The Debt to the Penny and Who Holds It). The amount of debt changes every year by the size of the budget deficit (increase!) or surplus (decrease!). The $14.7T is comprised of:

  • [~$10.06T] Public debt: Securities issued by the federal government and held by the public (investors, the Federal Reserve, foreign, state, and local governments)
  • [~$4.64T] Intragovernmental debt: Securities issued by the federal government which live in accounts administered by the government.
    • What? Government account securities
    1. Federal Housing Administration
    2. Federal Savings and Loan Corporation’s Resolution Fund
    3. Federal Hospital Insurance Trust Fund (Medicare)
    4. Social Security Trust Fund

Not included in that $14.7T…

The national debt figure does not include:

  • Fannie Mae and Freddie Mac obligations: together these accounted for about $5T in September 2008.
  • Fannie Mae and Freddie Mac buy mortgages from lending institutions (such as your local bank) so that those institutions can be “freed up” to issue more mortgages or otherwise loan more money.
    • But are these obligations actually guaranteed? No.
      • Freddie Mac securities are not funded or protected by the US Government and they carry no government guarantee of being repaid.
      • Freddie Mac states, “securities, including any interest, are not guaranteed by, and are not debts or obligations of, the United States or any agency or instrumentality of the United States other than Freddie Mac.”
      • There is a widespread belief that Freddie Mac securities are backed by some sort of implied federal guarantee and a majority of investors believe that the government would prevent a disastrous default.
    • Source:
  • Guaranteed obligations:
  • Unfunded obligations: Not included in the national debt are the obligations (under law) for payments the US government must make to Medicare, Medicaid, and Social Security.
    • [$7.7T] Social Security
    • [$38.2T] Medicare and Medicaid
  • The cost of these programs far exceeds tax revenues for the next 75 years.
  • The Medicare payouts already exceed the tax revenues intended to pay for Medicare. Similarly, social security payouts for a given year already exceed payroll taxes for that year.
  • With the baby boomers nearing retirement (and redemption of their Social Security retirement payments), that these liabilities are unfunded looms large and imminent.

Over the years: US national debt versus GDP

Below picture is over a longer time horizon (starting from the 30s)… but with less precision on the actual value of the ratio; also, this graph stops at 2010.

The below graph is over a shorter time horizon (than the above); note that this graph doesn’t include the spike in the 40s, which was related to WWII spending (I assume!). Also, this includes current and near-term debt-to-GDP ratios (inching toward 100%).


Over the years: international government debt versus GDP

How does the US debt-to-GDP ratio compare to that of other countries? (Lower is better!)

See also:

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