Allen Cring Productions in association with the Emergent Light Studio presents
the Illinois State Collegiate Compendium, Academic Lectures in Business and Economics.
This is Business Finance, FIL 240 for spring semester 2024.
Today, interest rates. A few things to do before we start the fun.
First things first, we're going to have a look at the markets as uninspiring as they are.
Right here. So, for you, obviously, this is a bear day, but it is not a giant bear day.
It just started out down and it's just been winding around.
As you can see, the Dow is down 13 hundredths of a percent.
The S&P 500 down about a quarter of a percent. And the Nasdaq is down about three quarters of a percent.
Typical, the riskier the portfolio, the more magnified the effects of positive or negative news.
And it's just not really anything in particular that is a glaring problem.
It's just that the markets are in one of those grouchy moods today.
And it's just going to be that way for a while.
Now, let me find my way over here just a second.
The oil has found its way back into that trading band between 72 and 79, as I would have expected it to.
It poked its head above 79 briefly and then it just chickened out and went back down, as I would have expected it.
Because there's nothing really major going on in world oil markets.
Gasoline prices at that 77 level, they'll probably, you'll see gasoline maybe about 340 a gallon.
And it won't go down much from there until you get closer to the 72 end of that, the lower end of that range.
As you can see, even gold's down, trying to work its way back down to $2,000 an ounce.
So there's kind of a malaise in the market.
And the bonds, they have gone up.
So there's a little bit of selling in the, well, okay.
The bond yields are up, which means bond prices are down, which means that investors are selling bonds.
Now, you've got to remember that relationship because I oftentimes ask a question on a midterm about that.
If you see this happening, what does that mean?
If you see the bond yields rising, which of the following does that mean is happening kind of thing?
But nothing really major.
It's up about four basis points, the yield is.
So it's going in the wrong direction.
We'd like to have it going down because that means interest rates in general will be going down.
And that is what we're going to talk about today and a little bit on Monday as well.
Over on the other side of the planet, Nikkei, it started out down and it just kind of stayed there down.
There wasn't anything that really had it upset.
It just was in a grouchy mood.
Same way with later, the London market was started out down and it just stayed down there,
floating at about three quarters of a percent down for the day.
So that would say, that tells us that there was some negative news that started markets off today,
and that just was about the only news that happened.
Nothing moved the markets from that grouchy.
Although you see the S&P 500.
Matter of fact, all of these in the United States had a little bit of a bear, a bull run there about midday,
and then the bears came back in and slapped it back down to where it had been before the bull run.
Nothing big about any of that.
Really quickly, and I may have mentioned these before, but we'll see a couple.
Now, I had mentioned on Monday, Rivian, and I want to update that one.
Their earnings are not announced until after the market closes today.
So what you're seeing here is probably an expectation that they're going to have an announcement
of earnings that were below what they said they would be.
That's the only way I could interpret this.
Now, if they come out and they say the earnings were below what they said they would be,
that won't do much to the market.
The market will just sit there and see that's what we expected.
But if they come out in surprise and say the earnings were better than we thought,
then you'll see tomorrow Rivn will pop up in price.
We don't know that one way or the other right now.
I've shown you this before, but let me go back over here.
The VIX is a measure not of stock prices exactly, it's a measure of volatility in the market.
And volatility tends to lower, too much volatility that lowers equity prices.
So as you can see, the VIX is up today, and the VIX is volatility.
And the volatility is volatile today.
Notice how the VIX is actually not a traditional market.
It starts at a much earlier hour.
So you see that the VIX volatility index would say volatility was relatively stable,
and then there was a spike in volatility, and then the volatility in the market dropped down,
spiked again.
So it is a whipsaw of a measure.
It moves around a lot.
And the higher the volatility, in other words, the greener, the more volatility.
But boy, when the volatility is volatile, that's another story entirely.
Let me show you something else.
I brought this up before, just to emphasize that securities markets are not always just stocks and bonds.
They can be other animals, like ETFs or something.
Here is if you are generally bullish on the markets, but you don't have details of what stocks are going to go up,
what stocks are going to go down, but you have a general sentiment of bullishness,
you might consider something like TQQQ.
Now, this is actually a bullish or bearish measure.
Notice ProShares QQQ, TQQQ, is a bullish.
You would take a position in this if you were generally bullish,
but you didn't have your hands on any stocks that were really going to be the winners in the bull market.
You would go with TQQ.
And as you can see, the markets are bearish today, so TQQQ is down.
On the other hand, suppose that you are a bear.
That would be SQQQ.
And there are others.
Don't get me wrong.
These are not the only ones.
But SQQQ is a bear.
And as you can see, the markets are bearish today, and SQQQ is up.
So these are the kinds of investments that you can take on if you are not wanting to get into the details of the analysis of some stock or something,
but you just have a more general sentiment of bullish or bearish markets.
And as you can see, they follow the bull bearer behavior of the equities.
The equities today are bearish.
SQQQ is making money today.
And if you were bullish tomorrow, well, you'd flip over to TQQQ and ride it and hope that the markets were up,
because you'd be up because the markets are up.
That's just sort of a quick run-through on some of the investments that are out there to make.
Now, I wanted to go on.
Before I get into the main lecture today, I did want to do one quick thing with Canvas here.
I have augmented that spreadsheet that I showed you.
And I still got a couple of questions on, can we use Excel quiz or exam?
I expect you to.
I don't want you to try to do it with just tables, for heaven's sakes.
The Excel is what we use in the business world right now.
We still use financial calculators kind of sometimes, but Excel is where I want your skill set to be,
hence why I have a for-credit assignment, a required assignment.
You've got to show me that you get certified in Excel.
But here in 240, let me show you something here.
I upgraded this one, files, spreadsheets.
Now, that present value and future value.
Now, I already showed you all about that, but I'm going to just show you one little addition to it.
And you should start getting comfortable with using it right away.
Because if I give you a quiz, let's say on Monday, and I'm not saying I'm going to give you a quiz on Monday,
but if I gave you a quiz on Monday, again, I'm not saying I am, but I'm not saying I'm not.
You might want to have this to answer some of the questions, the math questions.
And if you know how to use this, use the Excel templates and build them to your own desires,
you will be surprised at how useful they are to you.
Now, one thing that I had wanted to make sure was that this one in the middle, payments on a loan.
I'm not saying I'm going to ask that on the quiz on Monday.
I'm not even saying that I'm going to have a quiz on Monday.
But if I had a quiz on Monday, and I'm not saying that I would have a payments on a loan on Monday on that quiz,
but here's how you get the payments on a loan.
Now, the first thing that you would want to do here is, and I've got some down here at the bottom that I told you you should try to do,
but it's actually kind of daunting creating this.
It's not a typical Excel thing.
But anyway, suppose that you decide that you want to get a six-year loan, monthly payments, and an APR of let's say 5.89%,
and you're going to borrow, remember you have to put in a negative, you're going to borrow, let's say,
I was looking at an Outlander, which was outlandishly priced at $38,000.
Okay, now we've got, there's your payments right there.
Know how to, look at the formula though, because there will be a time when I will anticipate that you can write these formulas,
create them yourself, and that's what those learning assignments are, Excel learning assignments are, is learning how to do this.
However, I did want to put in how you find the balance on a loan.
Let's say that this loan is six years.
Well, how much will I still owe after four years?
See how easy that was?
Now, if you look up at the top, look at the formula, that does not look right.
I actually, okay, Excel does not have a native balance formula.
I was thinking of another spreadsheet that used to be around.
Excel does not have a balance equals BAL, open parentheses, and do that.
You actually have to kind of trick Excel into doing it.
Let me explain what's going on here, and I'm doing this so that you begin to get that sense of what we call the architecture of Excel formulas.
I'm actually going to call up a future value.
Well, you find the payments, starting with the present value, the PV there.
Well, we're going to do a future value, and then this first thing that I'm doing here is the rate,
which would be the APR divided by the number of periods per year, 5.89 divided by 12, which would be D4 divided by D3.
That's going to be a typical thing in a lot of formulas for loan payments and stuff like that.
Well, that doesn't seem too odd, but now the D16 times D3.
Well, there's 12, the number of periods in a year, and D16 is the 4.
So, in other words, I'm saying find out what happens after four years.
And then I'm saying, if you have already paid $627.80 in each of those periods, how much is left after that?
And then the D7 says, well, that's your present value, which you started paying down.
And then the D8 is just telling it that it's an ordinary annuity.
But so what it's doing is it's actually sitting at the beginning and then saying,
how much is left after I've paid 48 of those payments on the loan?
The future value starting at time zero, after I've paid that many payments at that interest rate per period,
what is the future value remaining at four years or 48 months, it would be.
So it's not something that I would expect almost any of you to be able to create on your own.
And that was why I finally I thought, no, I'm going to have to do this one custom.
And then it's now in yours.
So you want to download the latest one. I've put this in there for you to use.
So anything that you would need for payments on a loan, you've got right here in Excel, in this template.
You've also got the present value of annuities, well, annuities.
You've got the future value of annuities.
You've got all of them right there for you, for whatever needs you would have.
And that's worth gold. But you do have to know how they work.
You have to know how the formulas function and where you put the numbers.
But if you can master that, then you can do anything that I would ask on an exam
as far as present values of annuities, future values of annuities, and all of that kind of stuff.
And in fact, they'll even do lump sums for you as well.
But I won't go into that too much. I'm not going to ask about that on a test or a quiz.
But there you go. And also, of course, you get your effective rates too, which is fair game.
I could say, what was the effective rate on this loan that I described?
So it's all there for you to use.
This is the 21st century, and I want you to get used to using Excel as the tool
for getting numerical answers, regardless of whether you're in finance or some other subject.
So that's that.
No, I don't want to say that.
Okay. There you go. That's all there is to that.
Now, the lecture today is on interest rates.
Now, I caution that there is a point in this lecture where I go through some history,
and that I could hold you to that on an exam, a little bit of it.
And in that history part, there is one place where I use some appallingly foul language,
quoting historical figures who were involved in this cycle of interest rate increases and decreases.
And the purpose of this is to illustrate the formulas that I'm going to give you.
And they're not hard formulas. They're kind of silly formulas today, anyway,
as well as I'll save until Monday.
But this gives you a context, historical context, for what has happened in the last couple of years.
The same thing as what I'm going to describe happened starting at the end of the 1950s
and rolling to the beginning of the 1980s.
You saw it happen, except it happened in kind of more compressed time, this time a lot more compressed,
because the last cycle of this lasted probably about 18, 20 years.
This one, we went through the whole cycle in a compression of maybe about, total of about 7 to 8 years.
So, fortunately, the lessons that were learned from the first pass were applied this time, rather masterfully.
But here's the thing, and I said this the last time, there is no such thing as the interest rate.
There are a number of interest rates. There's the interest rate on a credit card,
the interest rate on a car loan, on a home mortgage loan,
the interest rate that a AAA grade corporation would pay on its borrowings, the coupon as we call it.
There's the interest rate that would apply for all kinds of different loans that a bank would make.
The loan, a personal loan you'd get would have an interest rate.
The loan that a very large credit worthy company would get would be a lower rate called the prime rate or the bank rate.
So, a lot of interest rates.
So, this R is the abstraction. They are all built from a set of blocks.
Now, the first thing that we have, it's the substrate.
Now, this is actually a hypothetical.
We have interest rates that are very close to this first one.
It's called the risk-free rate.
And we designate it as R sub F.
We can't see the real one, the actual risk-free rate.
Like I said, we have some interest rates that are very close to it.
They are what we call proxies.
It has no risks in it whatsoever.
The one that we often use is a one-year treasury bill yield,
because it's so close to being risk-free that it practically is the risk-free rate.
But again, that's an actual rate, and risk-free is the theoretical underpinning of it.
But inside of the risk-free rate are two pieces.
And we cannot see these.
We can use econometrics, one of my field specializations many years ago,
to tease out estimates of these two pieces of it.
But they are still kind of like, we can't really see them.
Well, it's very much like what happens in quantum physics.
We have a hard time seeing a proton and seeing what's in it, what we call quarks.
We can't see those at all.
So it's that same kind of, we know they're there because we know the effects that they have,
and we know a lot about them, and we can estimate a lot about them.
So the first part of the risk-free rate is what we call the real rate of return.
That's just old-fashioned economics.
Supply and demand, the supply of and demand for money.
Where those two cross, that would be the risk-free rate.
That would be the real rate.
The actual underlying opportunity cost of money, if you will.
It is a real rate.
Now, to turn that into a nominal rate, what we see with our eyes,
we have to put in inflation and inflation.
Now, the book correctly describes it, but they use IP, the inflation premium.
That's not exactly correct.
It's the expected inflation premium.
Inflation means nothing.
It's there, it irritates the hell out of us.
But what in finance, what in your financial dealings,
whether you are someone borrowing money or you are getting a wage increase,
it's the expectation of inflation that is all that matters.
And that's the one that is difficult.
Let me explain.
I'm picking on the front row people all the time.
Okay, madam, I've decided I'm going to hire you full-time for my company.
Now, okay, I'm going to start you at $100 a week.
That's right, I'm a giver.
$100 a week.
Okay, so you start working for me and your annual review comes.
You come into my office and I say,
well, you've been a darn good employee, fine employee.
I am so glad to have you with us.
I'm going to give you a raise.
Well, I see that inflation last year was 2%,
so I'm going to raise your wage 2%.
Now, get back to work.
Okay, you leave.
Okay, you come back the next year for your annual.
And I say, you're still doing so fabulously.
I see that inflation was 4% last year,
so I'm going to give you a 4% raise.
Now, get back to work.
Well, now in the third year, you come back to me and I say,
well, I'm still so happy to have you as an employee.
And I see inflation last year was 6%,
so I'm going to give you a 6% rise.
And you say, stop it right there, fat boy.
You called me fat boy?
What is wrong with what I am doing?
Do you see the fundamental problem with what I'm doing?
Yeah.
You see, what I'm doing is I'm paying you for what has already happened,
the inflation that has already eaten your paycheck.
That has nothing to do with what's going to happen next year.
Now, if it's gone 2-4, and the next one might be a 6,
then what you would probably say is, no, no 6.
I want 8, because I want to compensate for the inflation that is going to hit me.
Not what has already happened.
So that's the whole point of expectation of inflation.
No bank, no trading bond market, nothing like that is ever going to correct
for inflation that is already there.
They will want to correct for what is coming down the line.
You walk on a railroad track, a train hits you.
Nah, nah, ding, ding, ding, ding.
Well, you know, that's already happened.
You don't care.
You're not going to look at that train and say, damn you.
You're going to look back there and, oh, I think there's a train coming.
That's the one you're going to run from.
You can't run from the one that's already happened.
That's the thing that I'm getting to here.
Expected inflation drives markets, not the CPI, the PPI, and all of those.
No one in his right mind is going to put an inflation premium in.
That's what has already happened.
They'll put in the inflation that they expect to happen next.
When I make you a loan on a house, if I'm a banker,
I am going to adjust that interest rate up to compensate for what will happen
to the erosion of the balance, not what has already happened
because nothing already happened.
So that's why that expectation of inflation is what will drive the nominal risk-free rate.
So going on from there, though, this part is crucial,
and it is what has driven actually the economy and the politics
and the election of presidents in the past.
It was that risk-free rate and those two pieces in it.
That's why we know they are there.
We see their effects, and some of those effects can be pretty catastrophic, dynamic effects.
So here's where it comes into the historical, and then I get to the part for you.
Now, the historical part, I'm sorry to say, happens probably before your parents,
starts at least, before even your parents were born.
God, it happened in my lifetime, which really bothers me.
Your grandparents, if you have grandparents, might remember some of this,
but the problem is that never do you have the general population understand it.
That's what we're doing here in college, is we are making you the ones who do understand it
so that you can manage it, you can see what will happen under different scenarios,
and so that you can lead instead of being part of the masses who have their own ideas,
silly as they may be.
But unfortunately, if you don't lead strongly, you will be overrun by the idiots, the conspiracy theorists,
the people who are not educated.
I hate to sound like an elitist, but that's what we are.
We have to provide the technical knowledge to keep things on track,
and give them their bread and their circuses.
Let me start this out.
1950s, it was a good time in the United States.
The president for most of it was Dwight Eisenhower,
some I would say the last of the moderate Republican presidents,
general in World War II, general and all that,
very well-disciplined man, good man, from everything that has been said about him.
Now, he had overseen a steadily growing, it wasn't spectacularly growing, but a steadily growing economy.
He was conservative in the sense that he rejected cry after cry from the Republicans
for tax cuts as far as the eye could see.
He rejected the progressives and the liberals who were calling for a strong commitment
to helping the poor, civil rights and all that.
He kept things on a very steady course,
that kind of no crazy stuff on either side of the political spectrum.
For better or worse, he was that way.
But now he was to be replaced in the 1960 election because he'd finished his two terms.
And the two candidates that were vying for the presidency were Eisenhower's vice president,
a harder right conservative named Richard Milhouse Nixon.
And on the Democrat ticket was this brash, East Coast, Irish Catholic, World War II hero,
just a very fine consummate man named John F. Kennedy, John Fitzgerald Kennedy.
And the election kind of went, the country was ready for new, ready for change.
Kennedy was a brash, he dressed beautifully, he was a handsome man.
His wife Jacqueline Kennedy was just a consummate kind of person
and knew, she knew all of the fashion stuff and she was always in the best of the social circles.
And John, he knew all the entertainers of the time, Sinatra, those kinds of people.
Rumors later were that he even had an affair with some actress named Norma Jean.
Marilyn something, I think you knew her as.
But he won and that began what we call the era of Camelot.
Jackie took people on a live tour of the White House, redecorated in the best tapestries of Paris.
John Kennedy was brash and forward looking.
He said, we will put a man on the moon by the end of the decade.
And of course all the rocket scientists said, that's funny, wait, you're serious, are you kidding?
And he also started pressing for much more, much stronger action in what he considered to be a war on poverty.
We had won World War II, we had beaten the Nazis and we'd beaten the Japanese Imperial Army.
We could win any war we damn wanted to.
And he saw the poverty at home as a war.
He started working on getting legislation passed for something called the Civil Rights Act, of all things.
But he was also fiercely anti-communist.
So he started sending advisors to this backwater shithole in Southeast Asia called Vietnam.
He was going to do it all. We could do it.
We were Americans, my God.
Well, everything starting to move forward.
We had a good tax base.
We had 70% top marginal tax bracket for the rich.
We had business activity, so there were plenty of tax revenues coming in.
People paid their taxes and all of that was great.
So everything was moving forward.
And it's key here.
The Federal Reserve just did its thing.
Printed money at the real growth rate of the economy so that there wasn't inflation or deflation.
Everything was moving fine.
Until this place in Dallas in November of 1963, when a lone gunman ended Camelot.
And Kennedy's vice president, Lyndon Johnson, took over.
Now, Lyndon Johnson was a blue dog Democrat.
In other words, a conservative redneck from Texas.
And of course, there was a lot of sense that he was going to change the direction.
As a matter of fact, where I lived, there was celebration.
There were church bells that rang when Kennedy was killed.
There was such happiness that that liberal Catholic was gone.
And old Lyndon was going to take over.
Lyndon Johnson was the kind of conservative you would have expected him to have a white sheet in his wardrobe closet.
But something odd, see, Johnson was a vicious politician.
He was a survivor in the politics of Texas.
He wasn't afraid of getting what he wanted done.
And he would say, we're going to do this because Jack wanted it.
Well, the first thing on the agenda was to get the Civil Rights Act passed.
Now, all those old blue dog Democrat friends of his, well, they figured he's going to be on our side.
We're going to stop that damn thing.
Well, he didn't.
Now, let me give you a little background on Johnson.
When he was running for Senate, he actually, the story goes that in one case he had an opponent that he wanted to defeat.
So he told his campaign manager to start a rumor that his opponent was a pig fucker.
And those were his words.
You tell, I want you to get out the word that he is a pig fucker.
Well, Linda, he ain't no, I know a rule, he ain't no pig fucker.
His wife's a little chunky, but you don't understand.
I don't care if he is or not.
I want to make him deny it.
And that was the way Johnson played politics.
He was vicious.
So when those blue dog Democrats didn't want to pass the Civil Rights Act of 1964, well, he brought them in one by one,
and he explained exactly what he would do to them if they didn't.
And so we had the Civil Rights Act of 1964 that forbade discrimination on the basis of race, creed, national origin,
all of that stuff, because that's what Jack wanted.
And Johnson prosecuted anything Jack wanted, including the war on poverty.
The projects went up in Chicago and L.A. and everywhere else.
And on the other side, food stamps, welfare massively increased.
The butter.
But he also went hog wild in Vietnam.
We dropped iron on that little piece of backwater country like no one had ever seen, even in World War II,
in carpet bombings like Dresden.
We just laid waste to that country because Jack wanted it.
He was not going to let communism spread through Southeast Asia.
And all of this cost money.
Lots and lots of money.
And so the Federal Reserve began to accommodate the policies.
They printed money.
So as they printed money, money supply and the price of money, this would be the real interest rate.
Supply and demand.
Well, what the Federal Reserve under Johnson and his successor Nixon did was they increased the supply of money,
which brought down the real interest rate.
And so we had a stimulative period of economic growth.
The long term was another story because excess money is the only thing that creates inflation.
So you have this real and you have the expected inflation premium.
And together they make the R.
So at first the real rate was going down, the expected inflation premium didn't go anywhere,
and so the risk-free rate was falling or low.
Very stimulative to business activity.
Now that would have been the end of the story, except that eventually it will create inflation.
But as it was beginning to build that expectation of inflation, Richard Nixon resigned in 1974.
So this was before he resigned.
In 1973, an event on the global stage caught us rather badly.
The idea that we can hide from the world and ignore our responsibilities is a glaring lie with just this one example.
You see, after World War II in 1947, we pushed for the charter of a country called Israel.
So it would be a haven for the survivors of the Holocaust and worldwide Jewry,
both the ancient Jews and the Ashkenazis and others of the Jewish faith, Israel.
Well, that pissed off the Arabs and through the time after 1947,
they made some attacks on Israel trying to knock it down and end it.
Never worked.
But they decided in 1973, enough is enough, and so they amassed an ungodly force and it attacked Israel.
And Israel defeated that force in three days. Three days.
Kicked their asses.
Instead of driving Israel into the sea, they ended up wiping out half of their military capabilities.
The Arabs did.
And then that set them off.
They saw, hmm, I wonder why this country is so able to defeat us.
Oh, it's the United States.
Aren't they the same ones who slobber all over themselves for our oil?
Well, we're just going to turn off that oil.
The so-called OPEC, Oil Producing and Exporting Countries, oil embargo.
They shut it off.
Instantly, we didn't have a whole lot of oil.
Gasoline prices went through the sky.
I was old enough, I remember the lines going clear out to the interstates,
waiting for a couple of gallons of the gasoline that were available.
It was insane.
Anger.
So what did the Fed do?
The Fed just cranked up the money supply, what we call monetizing the price shock.
Printed money hand over fists.
Now, sir, if you are angry at me, you're a typical political, you're a voter, and you're angry at me.
Boy, you piss me off.
And I pull out a lot of money I handed to you, are you going to be so mad?
You're going to be, oh, you're cool, man.
That was what they did.
They printed money to monetize so people had more money in their pockets so they could afford these higher prices.
Nixon also put on wage and price controls, which was an insane idea.
But anyway, so more money.
So what was happening here was that the real interest rate was dropping because of the excess supply,
but expected inflation premium was beginning to build.
Now, it was still not too bad.
Interest rates were still, the real interest rate dropping was more than a counterbalance for the building expected inflation.
But that one lasts long.
Because every time we printed money, the expected inflation started to build a little more,
so the Fed would print more money to drive down the real rate to counterbalance the expected inflation premium going up.
Eventually, it got to the point where the real interest rate couldn't get down much further,
and expected inflation was really beginning to build.
Well, we had to stop inflation.
President Nixon resigned in 1974, and his vice president, Gerald Ford, took over.
Now, Gerald Ford was a moderate Republican, very likable guy, kind of in the news media.
They made him out to be a little bit goofy.
He was very tall, and he kept hitting his head on low ceilings and things like that.
But he recognized that there was a problem with inflation.
His solution was to get people to stop raising their prices.
He called it whip inflation now, win.
And they even printed up tens of thousands of buttons people could wear.
Win, whip inflation now.
Well, of course, it's not going to solve it, just saying some logo, some jingle.
And as the decade wore on towards 1976, the Fed was still trying to counterbalance this building expected inflation premium,
but interest rates were still pulling upward because expected inflation premium was going up faster than the real rates could go down.
And so Ford was the, he ran for president in 1976.
He lost to a man named Jimmy Carter.
Now, Jimmy Carter was a Georgia peanut farmer, but he was also a nuclear physicist.
He understood what was happening.
I mean, a lot of people, others did, Ford did too.
He knew what, but he, even Carter didn't want to address what had to be done at first.
Carter replaced the whip inflation now with his version.
He called inflation the moral equivalent of war.
Now think about the acronym, moral M equivalent E of O war W. Meow.
Well, that didn't go over too well.
Of course, he understood what was going on.
By 79, the risk-free rate was spiraling upward.
Expected inflation and the observed inflation were skyrocketing.
So that risk-free rate going up, that slowed down the economy to a point where it was almost stagnant.
And the rising inflation was there too.
The term that they used at the time was stagflation, a stagnating economy with inflation.
So Carter knew what had to be done.
He appointed a new chairman of the Federal Reserve, a man named Paul Volcker.
Tall Paul, he was 6'3", 6'4", something like that, 250, 270 pounds.
He smoked foul cigars and he didn't care what anyone thought of him.
The stories were that he would even blow his cigar smoke in people's faces if they annoyed him.
And he was there to turn this mess around.
So what did he do?
He clamped down the money supply.
He crushed it, which of course brought the real rate skyrocketing.
The real rate skyrocketed like this.
But no one believed him.
Ah, yeah, other Fed chairman have said that too.
So they kept embedding bigger and bigger expected inflation premiums.
So the risk-free rate and every rate that is based upon the risk-free rate was going through the roof.
Home mortgages, 25%.
The coupon on AAA corporate bonds, 20, 22%.
Everyone was just angry.
And so he was defeated in the 1980 election.
And he was replaced by a gentleman who was a former governor of California.
Also he had been a Western movies actor and a spokesperson for cigarettes.
His name was Ronald Wilson Reagan.
By the time he was in office for a year or so, finally expected inflation was beginning to wither away.
You see, the markets are not going to believe that inflation is going away just because politicians said it was.
They'd heard that story for years.
Volcker went in there and he knew what he'd have to do.
He'd have to put his throat on the economy.
And he'd just have to hold it there until he got the answer he wanted to the question, who's your daddy?
He strangled the economy down and the Congress and Reagan passed a tax cut in 1981, a very heavy tax cut.
And the economy began to recover in 82, 83, and into 84.
But it was all because of Volcker crushing the money supply years before.
People blamed Carter for what had happened.
And he was the inheritor.
Ford was, Nixon was, hell even Johnson to a certain extent was.
He was the inheritors of a process that they couldn't stop because they didn't have the political will to kill that expected inflation premium before it grew into a monster.
So when it finally had to be done, it really hit the economy hard in 79 and 1980.
So there you are.
That's where we come.
Now let's reel forward to the 2010s.
We came out of a terrible crisis in 2008.
We were really not back on the road to groveling out of it until maybe 2011 or so.
But we got back on track.
Fed growing the money supply responsibly.
The taxes staying at a controlled level so that we had a knowledge of what was going to be, what interest rates were going to be.
What confidence was building in the economy.
And then that was in the term of Barack Obama.
And then in 2017 after the next president, Donald Trump, was elected, they passed a massive tax cut, which of course destroyed the revenues of the government.
So the government had to start borrowing money.
Demand for capital by the government started rising.
And of course if the demand for money rises, then the price of money rises.
So there we go.
The Fed at first refused to accommodate this by printing extra money until the president threatened to fire the board of governors, or at least the chairman.
Whether he could have or not is legally speculative.
But they started printing money.
Especially because the economy was beginning to slide into a mild recession in 2019.
And so the president demanded that the Fed monetize that recessionary force.
Print money to make the recession go away.
And that would have been enough, except that then we had COVID.
And we had all of the COVID checks being printed so people didn't get kicked out of their houses.
And all of the PPP loans to make businesses be able to stay in business even though they were locked down.
Print money.
Create money out of nothing.
And so here we went back into the cycle again.
At first this brought interest rates down because you're printing money, giving money to people who don't have money,
giving money to businesses that can't generate revenues.
So of course the risk-free rate was going down.
And at first expected inflation premium stayed pretty level.
But as that new extra money began to soak into the economy, well, expected inflation premium started to go up.
And as that went up, the inflation we see started going up.
Fortunately this time the Federal Reserve acted very quickly.
This was what was happening in the last year and a half.
The Fed clamped down the money supply, just started draining that liquidity back out of the economy, and we got back on track.
Now inflation and expected inflation premiums are going down.
And there you go.
The same process except that this time we took the steps necessary in a much shorter timeframe than we did in the 60s to 70s cycle.
And we did quite well this time, all things considered, killing off.
We still got some expected inflation.
You still see companies raising prices.
You still see interest rates abnormally high.
But they are draining out as the markets begin to be convinced that that excess liquidity is being clawed back out of the economy.
And it's still a process though.
Let me show you something here.
Now these are Treasury yield rates.
These are actually our proxy, the one year Treasury yield is our go-to proxy for the risk-free rate.
So let me show you starting let's say 2022.
And I want to do all of 2022 so you can see what was happening.
Do you see how low rates were in 2022?
Look at that, 0.2, 0.4 percent.
But look what happens.
Do you see as the Fed begins to drain the liquidity, do you see that column right there?
See what's happening to the interest rate?
That is what I was drawing there.
They're clawing the liquidity out of the economy.
As the supply of money goes down, the price of money, spank me Jesus, that's the risk-free rate, is going up.
All through 2022.
And of course everyone's yelling and screaming, look at what's happening to the interest rates.
Well yeah, this is how we stop it.
Clear to the end of the year, you can see that it was they were drawing that liquidity out of the economy.
Now let's go to 2023.
And this is where data is our greatest ally.
You can question, well I don't like your theory, it sounds wrong to me.
I read on a web page where it was these aliens that were doing it.
No, we're using actual real life data to see what's going on.
Well let me apply 2023.
Okay, look at, see the interest rates?
Notice how they begin to come up and slowly begin to slow, calm down again as the year goes along.
But the Fed was holding steady with the money supply.
Do you see how they're somewhat stable?
Beginning, the Fed was beginning to loosen up as it saw the first evidence that the expected inflation premium was falling.
Now we come back to the current year here.
We'll come here to 2024 and we'll see that at this point the Fed is holding pretty steady right now.
Waiting to make absolutely sure that the fire is out.
They're not going to loosen up too much because expected inflation is like a burning house.
Even after you don't see the fire, it can still be sitting there under the surface.
And we see it.
I mean we're still seeing some prices that are going up these days.
And that's just how it is.
So we've got, the Fed is going to probably hold the throttle on the money supply until we're sure that the markets have taken out that expected inflation premium.
They will.
They'll learn.
They'll stop overpricing.
And other companies will beat them because they won't keep jacking up their prices.
It's the normal cycle of business.
But understand this.
One little side note here.
One little side note before I go on.
Interest rates have their effect on the economy in actually not a complicated way.
Now one thing to keep in mind, and you can check this yourself with those present value of annuities.
As the interest rates rise, the present value of future expected cash flows falls.
There is an inverse relationship, which you, I could very easily ask you on a true-false question on a quiz or an exam.
Interest rates going up lowers the present value of future expected cash flows because you're discounting them at a lower rate.
Okay, so let me do this here.
Suppose that we have a company that is considering four projects.
A, B, C, and D.
And let's put the ROIs, oh, let's just do three.
ROIs on A, B, and C.
So let's say that the ROI for return on investment for project A is 6%.
The ROI on project B is 10%.
And the ROI on project C is 15%.
Now suppose that the cost of capital, let's call it R, is 5%.
Well, we're certainly going to take project C because it returns 15% for a cost of 5%.
So absolutely.
Okay, we're also going to definitely take project B.
It costs us 5% to make 10%.
Hell to the yeah.
Even project A.
We're going to take it because the cost of capital is 5%, we make 6%.
We're greedy, we'll take it, sure.
Absolutely.
Now what happens though if the cost of capital rises to 8%?
Well, we'll still take project C because it costs 8% to make 15%.
Sure we will.
We'll certainly take project B because it costs 8% to make 10%.
But project A, it costs 8% to make 6%.
We're going to reject it.
Now suppose that the cost of capital goes to 12%.
Well, we'll still take project C because 12% to make 15%, sure.
But project B is gone.
It costs us 12% to make 10%, no.
And hey, it's absolutely out of the question.
We pay 12% to make 6%.
Do you see two things are happening?
One is pretty obvious.
Rising interest rates kill off company projects.
Which means that the company doesn't make as much.
It doesn't have all of that employment that would come from all those new projects.
This is how the economy slows down.
It's just a direct result of the cost of capital are going up.
There's a subtler effect here too.
Remember that the greater the risk, the greater the expected return?
Notice how as the interest rate is going up, this company is being backed into a corner of risk.
It can't take the low risk, low return projects to counterbalance the high risk, high return projects.
It is being forced to take only what you would call an old football terminology, the hail marries.
The ones that are long passes hoping for a win.
Hence why we start getting more bankruptcies.
Because companies are being driven to take riskier projects and not have counterbalancing lower risk projects
in the portfolio of capital investments.
So you see this is that driving force.
That's why interest rates, we don't want them to be going up.
We don't want them to be going down so low that we light the fires of inflation.
But we don't want them going up because they throttle off the economy.
Sorry, every time doors open anymore I get a little nervous.
You know, active shooters and all.
Yeah, of course my ass is right up here at the front so I'll be the first one gone.
While you guys say see you later, Prof.
Times are so strange anymore.
Anyway, but look, you understand what I'm getting at here is that we really care in business about interest rates.
And that's why we have all of this stuff in this chapter before we go any further about interest rates.
Now the thing though is, as I said, if all interest rates were the risk free rate, I put these wrong.
Correct this in your notes.
R sub F is R sub real.
If all that mattered was the risk free rate, if every interest rate was the risk free rate, then we're done with it.
We can go home.
But unfortunately, only a very short term treasury bill would be even close to the risk free rate.
No default possibility and all that kind of stuff.
However, in the real world, we have this ginormous thing called the risk premium.
It has three pieces to it.
And those three pieces act in each in its own way, the risk premium.
Each one has its own size in a given interest rate.
Now the three of them are, the first one is the default premium, R sub D, the default premium.
This is the extra scratch in an interest rate in the event that the borrower doesn't pay it off.
Now think about it, a home mortgage loan would have a pretty small default premium.
Here's why.
The bank could get the house.
The bank will get the house if the owner defaults, if the borrower defaults.
So in other words, the risk of a big loss is not very much.
So the default premium on a loan that is collateralized is always going to be lower than the rate on a loan that is uncollateralized.
In fact, you ever see those credit card rates, those insane credit card rates?
The big reason is the default premium because so many people default and the lender, the credit card company, doesn't have anything it can take from them.
It can't.
So that's the first one.
The second one is the maturity premium, R sub M.
If interest rates go up or they go down during the life of a loan, that's adverse to the banker.
So the longer a loan is, the more chance that interest rates are going to go somewhere that the banker doesn't want.
And it's actually a principle from physics.
If you ever see gas or anything coming out of a small area, it expands as it goes further out.
This is the same thing.
The risk of something adverse happening with interest rates is more for longer-term loans.
If a bank lends money for, let's say, a year, interest rates aren't going to probably go anywhere.
They'll get back what they expected to get back.
But a 30-year interest rate could be somewhere way different from what the lender thought they would be.
So the maturity premium gets bigger as time goes on.
So a 30-year loan would carry a much larger maturity premium than a five-year car loan would.
The last one is the illiquidity premium.
Surprising as it may seem, banks aren't really in the business of long-term loans.
On a given day, a large bank might make 1,000 mortgage loans.
At the end of that day, they're going to dump those into what's called the secondary mortgage market.
Fannie Mae, Freddie Mac, Jenny Mae, they package those and they sell them.
They just get rid of them.
That's not the bank's business.
Now, they will get a nice little fee for processing the loan payments and making you think that your bank holds your loan.
But those loans are somewhere else.
The easier it is for a lending institution, a financial intermediary, to get rid of a loan,
the more liquid the loan is, the lower the illiquidity premium is.
So in other words, car loans, a bank's stuck with those usually.
So those will have a higher illiquidity premium than a mortgage loan will.
That's enough for one day, and we'll finish this on Monday.
That's all I have for you.
I thank you.