Monetary Trends 

Abstract: The financial market disturbance last summer and autumn had numerous symptoms and effects. Stock prices (as measured by the Dow Jones industrial average) fell almost 20 percent between July 17th and the end of August. Prices and issuance of quality commercial paper temporarily dropped. Bonds from emerging markets in Latin America and Asia tumbled in value, and debt rollover temporarily came to a near standstill. A panicky flight to quality led to a large increase in the prices of on-the-run Treasury securities, even relative to previous issues of like Treasury securities. The same shift in investor preferences toward safe assets led to increases in quality spreads among corporate bonds. While each of these facets was important and telling, an indicator based on stock market volatility would perhaps provide a more general barometer of financial market uncertainty. Large quality spreads and flights to quality reflect heightened repayment risks, which are signs of more acute (or idiosyncratic) trouble than increased uncertainty regarding the earnings potential of large corporations as a group. The implied volatility from options contracts on the Standard and Poor’s 100 (S&P 100) index, which includes the country’s largest companies, is one barometer of stock market volatility. According to standard options-pricing theory, every determinant of an option’s price is observableexcept the expected volatility of the price of the underlying asset over the option’s life. From options prices and the other observable factors, one can infer the market’s implied volatility of the price of the underlying asset. Using the trading prices of options on the S&P 100, the Chicago Board Options Exchange (CBOE) estimates the implied volatility corresponding to a hypothetical at-the-money option with one month to expiration. (An at-the-money option has a strike price equal to the current price of the underlying asset.) The CBOE calls this estimate the volatility index (VIX). VIX is a forecast of how turbulent the S&P 100 index will be in the coming month. When expected volatility rises, put options, which give the older the right to sell stocks at a prespecified strike price, b come more expensive. Thus, when VIX is high, portfolio managers must pay a premium to hedge the values of their investments with options. In other words, the price of portfolio insurance rises. The accompanying chart shows how VIX reflects financial market uncertainty across time. The stock market crash of October 1987, the Gulf War buildup of 1990-91, the Russian debt default in August 1998, and Brazil’s recent currency devaluation in January 1999 all increased expected stock market volatility. The highest volatility in the 1986-98 period occurred right after the October 1987 crash. The chart indicates how infrequently the VIX is more than 50 percent higher than its average level. Thus, the financial market disturbance in autumn 1998 created a very tumultuous degree of uncertainty by historical standards, even if it did not match the titanic event of 1987. —Michael J. Dueker

Abstract: The Treasury began issuing inflation-indexed notes in January 1997. These Treasury Inflation-Protected Securities (TIPS) provide a market-based measure of inflationary expectations.1 Investors value TIPS as an inflation hedge. The Treasury values them as a source of funds that can reduce interest outlays when the inflation premium in non-indexed securities is higher than actual inflation over the maturity of the security. The Fed values them as providing another measure of expected inflation. A total of $47 billion of the new notes have been issued, with 5-, 10-, and, most recently, a 30-year maturity. On April 15, the Treasury issued $8 billion of the latter, which can be stripped to create inflationindexed zero-coupon derivatives with maturities up to 30 years. Even the Fed has accumulated some TIPS. As of April 30, 1998, it held $2.45 billion of inflation-indexed U.S. government securities valued at original face amount. In addition the Fed had received $27 million of compensation that adjusts for the effects of inflation on the principal of these securities. Fed holdings represent less than 5 percent of TIPS held by the public and a minuscule fraction of the FedÕs roughly $450 billion portfolio of government securities holdings. Future inflation will determine whether the returns on the inflation-indexed securities turn out to be higher than returns on non-indexed nominal notes of comparable maturity. As shown in charts on page 11, 10-year indexed Treasury notes in mid-June were selling for an inflation-adjusted return of about 3.7 percent compared with about 5.5 percent on a non-indexed note of the same maturity. The 3.7 percent real return to investors incorporates expectations of future real rates and prospective tax liabilities because the compensation for inflation paid to holders of TIPS is taxable. In acquiring inflation-indexed securities, the Fed has purchased some insurance against the effect of inflation on its earnings. Such protection is reasonable for private investors who perceive future inflation risks, but what about for a central bank? Fed purchases of indexed bonds may have helped establish this fledgling market, but do its holdings of inflation-indexed securities interfere with their usefulness in providing a market measure of inflation expectations and inflation risks? Also, does the Fed lose inflation credibility by holding such securities? The answer to such questions is probably not. One reason is that any extra earnings the Fed gets by holding TIPS are transferred to the Treasury. Another reason is that the Fed does not actively trade any longer-term issue including the new inflation-protected securities. Therefore, its holdings of longerterm issues simply represent claims on the federal government against which the Fed has issued currency and bank reserves, the total of which comprise the monetary base. Even though the Fed holds a lot of long-term government debt and now some inflationindexed debt too, as long as such securities are not actively traded, Fed holdings of such securities would not exert a direct influence on the price, quantity, or composition of federal debt held by the public. By implication, Fed holdings of TIPS need not distort information about expected inflation coming from the market yields of these inflation-protected securities.

Abstract: During the first eleven months of 2001, the Federal Open Market Committee (FOMC) announced ten reductions in its target for the federal funds rate. Each of the announcements also included a statement about the discount rate. For example, the November 6 announcement that the federal funds rate target was being lowered by 50 basis points to 2 percent also noted that “In a related action, the Board of Governors approved a 50 basis point reduction in the discount rate to 1-1/2 percent.” In fact, changes in the discount rate have been identical in timing and magnitude to changes in the federal funds rate target since mid-1999. The accompanying figure shows that the perfect onefor-one movement between these two key interest rates is a fairly recent development. During the late 1980s and early 1990s, the federal funds rate target deviated from the discount rate by varying magnitudes, with the discount rate changing less frequently than the intended federal funds rate. Nevertheless, the announcements accompanying discount rate changes often explained that changes were made simply to keep the discount rate aligned with market interest rates. The discount rate has not always had such a passive role in the conduct of monetary policy. During the 1960s and 1970s, for example, the discount rate often served a signaling function: Changes in the FOMC’s objective for the federal funds rate were not publicly announced at the time, and the visibility of discount rate changes made it a useful tool for communicating major changes in policy. During the years when the Fed used a nonborrowed reserve operating target for conducting monetary policy (1979-82), the spread between the federal funds rate and the discount rate was highly variable as changes in reserve demand were accommodated by fluctuations in discount window borrowing. That operating regime was succeeded by one in which the Fed ostensibly targeted the amount of borrowed reserves, amounting to a procedure for manipulating the spread between the funds rate and discount rate. Under the current operating procedure, the federal funds rate is the direct instrument of policy, with the discount rate and the very low average level of discount borrowing having little or no significance in the conduct of monetary policy. Given the reduced importance of the discount rate in the Fed’s conduct of monetary policy, there have been proposals to dramatically alter the nature of the discount window. Some have suggested that the discount rate be adjusted automatically with changes in the federal funds rate or other market rates. Other proposals have even suggested the elimination of the discount window altogether. The surge in borrowing following the September 11 terrorist attacks demonstrated, however, that the discount window can perform a crucial stabilizing function, providing temporary liquidity in times of crisis. Moreover, the evolution of the Federal Reserve’s operating procedures has shown that the importance of policy tools can change over time. While the discount rate has little independent significance in the present context, it may again sometime in the future.