Question

Carson company has obtained substantial loans from finance companies and commercial banks. The interest rate on loans is tied to market interest rates and is adjusted every six months. Because of its expectations of a strong US economy, Carson plans to grow in the future by expanding its business and making acquisitions. It expects that it will need substantial loan-term financing and plans to borrow additional funds through loans or by issuing bonds. It is also considering stock to raise funds in the next year.

Given its large exposure to interest rates charged on its debt, Carson closely monitors Fed actions. It subscribes to a special service that attempts to monitor the Fed’s actions in the Treasury security markets. It recently received an alert from the service that suggested the Fed has been selling large holdings of its Treasury securities in the secondary Treasury Securities market.

1. How should Carson interpret the actions by the Fed? That is, will these actions place upward or downward pressure on Treasury Security prices? Explain.
2. Will these actions place upward or downward pressure on Treasury yields? Explain.
3. Will these actions place upward or downward pressure on borrowing interest rates? Explain.

Answer 1

Answer to (a):

If the FED or Federal Reserve Board wants to stimulate the USA Economy ,then it can use open market operations to purchase Treasury securities held by Banks thereby increasing the money supply in the market.Similarly: if the FED wants to reduce inflation, then it can do so by selling Treasury Securities to Banks in the open market operations.

Here, the selling of the treasury securities by FED implies a decline in the demand for Treasury Securities.Simultaneously: selling of Treasury Securities in the secondary market leads to a fall in the money supply .This fall in money supply will cause an upward pressure on the Treasury Securities Yield which will lead to a decrease in the price of the Treasury Securities(there exists an inverse relationship between the yield of Treasury Securities and Price of Treasury securities ie:: a rise in yield will  cause fall in price).Thus in simple terms: selling of Treasury Securities by Fed increases the supply of Treasury Securities and this supply will exceed the demand for it and hence there will be a downward pressure on the price of Treasury Securities.

Answer to (b):

As already discussed above:selling of Treasury Securities by FED in the secondary market will lead to the supply of Treasury Securities exceeding its demand and thereby reducing the money supply which puts an upward pressure on the yield of Treasury Securities.

Answer to (c):

An upward pressure on the yield of Treasury Securities will lead to an upward pressure on the interest rates also with more pressure being there on the short term interest rate .This will also lead to a fall in the long term inflation.