Re: moore on term structure

[Warren Mosler <mosler@xxxxxxxx>]

Basil Moore wrote:
>
> Warren
>
>         Your statement that the CB could commit itself to keep the overnight
> rate fixed for 10 years is exactly the point I was trying to make. Fixing a
> LT rate requires that expected Av ST rates over the period must equal the LT
> rate??  Whenever this is not satisfied, there will be arbitrage opportunities?
>
>         So the CB is constrained in a different way in directly setting the
> LT rate, than it is in directly setting the ST rate???
>
>         Basil

Basil,

Not exactly.  Let me use an example.  Suppose the CB decides to
peg the lt rate by making a market in a 10 year Tsy., say, the
(hypo) 6% of 10/15/07.  Say it decides to be 100 bid and 100 1/8
offered.  There is no technical problem buying or selling unlimited
amounts at that price.

Now, to your point, suppose the cb also pegs the fed funds rate at
5%.  One might think the arbs would then buy the 10 year at 6% and
finance it at 5% day to day?  Or, perhaps, finance it for 5 years
if the five year rate is 5.5%, etc.?  Financing it for 10 years at
6%, of course, is a wheelspin.  Notice first that the 'unfinanced'
or 'back end' of the transaction (the last five years in the 2nd
example)
implies a 'forward rate' in excess of 6%.  In fact, the implied
rate of each three month segment could be readily calculated from
the 'yield curve.'

The question is, are the arbs at risk buying the 10 year and financing
it for something less than 10 years?  In this case, I would say yes.
The risks include:

1.  The Fed could raise the short term rate to, say, 7%, at which time
the arb could sell the 10 year at a 1/8 point loss, or continue to carry
it at a cost of 1% per year.

2.  The Fed could change the 10 year price it wishes to peg, say to 99
bid 99 1/8 offered, and then raise the short term rate to 7%.  The arb
would then either pay a 1% negative carry until the short term rate
changed
or sell the 10 year for a 1 1/8 point loss.

3.  etc.

Anyway, I don't see pegging the 10 year as described as creating a risk
free situation, anymore than any non-flat yield curve does anyway.

Japan is a bit like that now.  You can buy the 10 year at something like
1.75% and finance it for the first three months at .50%.  The BOJ is
supporting
the 10 year sector, though not formally pegging it, with continuous
purchases.
Of course, should the BOJ change policy, you would have a lot of
downside!

If the Fed also announced the long peg was good for 10 years, that is a
different
story and would result in a free ride for the arbs.


The other option was the cb announcing only that it would leave the
overnight
rate at, say, 5% for 10 years regardless of economic circumstances,
etc.
if this was deemed a legal responsibility, market participants would not
let
the 10 year rate to deviate much from 5% without any state intervention
in that
sector.  To my knowledge, no cb has used this option, probably because
of a
perceived loss of control.

It is interesting that in Japan with a .5% rate has virtually no growth,
and
and much of Europe with 3.3% rates has record unemployment and very
little
growth.  Turkey has 9% growth, and has had high growth for many years,
with
interest rates and inflation well over 75%.  I am not saying rates are
not
a factor.  I am asking just how important they are relative to other
macro factors?
I am sure that when Turkey becomes 'fiscally responsible,' either under
IMF
influence (pressure) or in an attempt to join the EU, they will look
like
the rest of Europe- low inflation, low rates, low growth, and high
unemployment.
Greece and Italy are recent examples.

Warren