Professor Paul Palley's
          Economics Seminars

The marketplace, the interaction of supply and demand, determines the prices that will be charged and consumers will pay for a good or service. This point is well understood, but there are many times in which the prices consumers are willing to pay is not as well understood as it should. We know that these pricing decisions made by consumers are based on their perception of the utility they expect to derive from that product, but we can focus further on this point. More specifically, many people determine the price they are willing to pay based on their perception of the value of the attributes or characteristics of the product. The models that are built to better understand these pricing decisions is called “hedonic pricing models” and what we learn from them helps with marketing efforts and to better understand current and future consumer behavior.

Consumers can be very discerning about the prices they are willing to pay for many goods and services. In line with this, this focus will often be on the characteristics and attributes of the product. A case in point is that of housing. Prospective buyers will assess price based on the value they assign to the size of the home; size of the lot; the number of bedrooms and baths; whether or not it comes with a pool; the age of the home; and several other factors as well. When people determine the price they are willing to pay for a car the focus will fall on the make and model of the car; the reliability of the car; the resale value of the car; the style; fit; and finish of the car; etc. What these two products have in common is that they are expensive and the demand for these products tends to be very price elastic. In other words, the consumer is very sensitive to changes in the price of the product. In addition, the consumer is willing and able to shop and compare prices.

The same holds true also for less expensive products and the ramifications of this is that demand becomes more price elastic and profit margins become thinner. The firm needs to create other profit centers in order to overcome this. For example, the automobile manufacturer makes a significant amount of money through its financing arm. Another applicable example of a less expensive product is the personal computer and laptop computers. Consumers can very easily use the Internet and other media resources to better understand the capability of different hardware and software components of these computers, and the prices of these components, in order to make decisions related to the value of these products. In addition, a firm like Dell which facilitates the consumers’ efforts to build and price their computers online furthers the education of consumers. The impact of this is that demand becomes more price elastic as the consumer learns to comparison shop and better understands the value of the attributes of these products, and profit margins becomes thinner.

What should a firm do about this? The process I described can’t be stopped. Instead the firm needs to build increasing amounts of value into their products that are the result of innovation, quality enhancements, and improvements in capability. The firm needs to develop and market related products that are profit centers that the consumer values relatively highly. Finally, the firm needs to build systems that facilitate innovation and value enhancement with the understanding that the consumer is always adapting and loyal to only their desire to enhance the value they derive from the goods and services they consume.

Since September 2007, the Federal Reserve has cut the federal funds target rate a full percentage point from 5.25% to 4.25%, but the immediate results for the economy have not been perceived to be positive. The problem is the Federal Reserve’s inability to unfreeze debt markets, especially the markets in which large financial institutions lend money to each other. The source of this problem is a lack of confidence in the balance sheets of lending institutions, and the genesis for this is the breakdown of the mortgage markets and the complex securities constructed from these mortgage loans. The result is that some are predicting that a recession is set to happen; others argue that the economy is in recession; and there are analysts who are predicting only slow and sputtering economic growth for this year. Either way, the economy will be at best weak during the first half of this year and this has raised questions about the effectiveness of the Federal Reserve, but the better questions are related to how the macroeconomy and financial markets in the world today affect the Federal Reserve’s ability to successfully implement its monetary policies.

It is not surprising that the cuts in the target for the federal funds rate detailed above have not had immediately positive impacts on the economy as it is well known that there are lags between changes in monetary policies and responses by the economy. What is interesting is that the Federal Reserve’s use of its discount window hasn’t been effective either. Finally, the effectiveness of the “term auction facility” recently implemented by the Federal Reserve and foreign central banks remains to be evaluated. Two auctions are planned for January and further auctions in February have not been announced at the time that this article was written (see http://www.federalreserve.gov/ for further details).

The problem with the Federal Reserve’s discount window it that it is not used. It is generally perceived to be the place desperate banks go to borrow, and as a result healthy banks do not use it and instead they borrow money from other banks to meet short-term liquidity needs and pay the federal funds rate rather than the discount rate. This negative perception of the discount window may also carryover to the “term auction facility” limiting its effectiveness. On the other hand, it has been suggested that coordinating this effort with other central banks may lead to the success of the “term auction facility”, but that will have to be evaluated over time. This also illustrates a point, as seen with this case and the Federal Reserve’s coordination of monetary policies with foreign central banks in the past, the Federal Reserve does not act in a vacuum and it increasingly must consider the actions of other central banks when it implements its policies.

The fact of the matter is that the Federal Reserve is not the all powerful fixer it has been advertised to be and this is due to a number of important developments; financial markets are really very complex interrelated global markets that are transnational rather than simple markets open for central bank intervention; the United States is not as dominant financially as it used to be and more coordinated central bank policy moves are now required; the Federal Reserve has also been criticized for not acting to “pop” the stock market bubble of the 1990s and real estate market bubble of the recent memory. The mortgage market breakdowns that resulted from “liars’ loans”, teaser-rate mortgages, and poor lender and borrower due diligence, indicated a need for the Federal Reserve to step up its regulation of the lenders it can regulate but it did not, and holes in its regulatory authority indicated a need for further statutorily approved regulatory authority were not filled.

It must be further noted, though, that to a great extent the Federal Reserve is a victim of its own prior success, especially when combined with the successful inflation fighting of foreign central banks. In part, the lower inflation rates seen in recent memory is the product of successful inflation fighting monetary policies. These policies reinforced with the understanding of the meaning of monetary policy rules geared around the relationship of short-term interest rates with the inflation rate and economic growth, or on the other hand inflation targeting policies, carried out by foreign central banks are also very important. The result is lower inflation rates and lower long-term interest rates. This success, combined with the way globalization has increased world wide competition and facilitated more efficient supply chains. Plus, technological developments have increased productivity and as a result lowered the cost of doing business. These and other developments lead to lower current and expected inflation rates and as a result lower long-term inflation rates. Further contributing to lower long-term interest rates is the availability of funds held by societies that save a much larger percentage of its income than the United States and nationally controlled funds supported by oil and other resource sales. These factors, combined with the large amount of United States Treasury securities held by foreign investors has reduced the impact of independent Federal Reserve policy initiatives when it seeks to raise market interest rates through its policies.

There have been a number of changes in commercial banking that have also reduced the effectiveness of the Federal Reserve in its efforts to successfully implement its monetary policies. These include deregulation; the fewer number of commercial banks that exist today; technology; complex financial modeling; and asset securitization. Bank deposits are relatively small today and this makes changes in reserve requirements by the Federal Reserve as a monetary policy tool largely ineffectual. The cumulative impact of this is that banks are more likely to facilitate credit rather than hold onto loan assets. The mutual fund or another institutional investor, investment bank, corporation, or large foreign investment interest can often be the real provider of credit. This fact requires a much broader focus on an array of sources of funds in order to understand why the financial markets function as they do, and how the Federal Reserve’s monetary policies impact the economy.

It is well understood that the effectiveness of the Federal Reserve’s monetary policies can be undermined by two facts; the Federal Reserve does not control the willingness of people to borrow money and it does not control the willingness of banks to lend money. That being said, the above points in this piece raise a list of changes in the financial markets that all need to be considered when we try to understand the impact of Federal Reserve policies on short-term and long-term interest rates, and the economy. The complexity of the financial markets indicate that the Federal Reserve will increasingly face new and more complex challenges, and the public and financial markets will need to adapt to this new understanding of the Federal Reserve’s place in the equation.

Biography:

Paul Palley manages Palley Economics Seminars and is a practitioner faculty member for the University of Phoenix where he teaches graduate and undergraduate economics and statistics courses.