THE MOST POWERFUL CORPORATION IN AMERICA
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. Brief History Of The Federal Reserve.
2. Tools The Fed Uses To Influence Rates.
3. How Fed Actions Impact Your Life.
4. Changing Rates Without Changing Rates.
5. Will The Fed Raise Rates This Week?
Federal Reserve Board Chairman Alan Greenspan is an American icon. It is said that when Greenspan gets a cold, it sends shivers down the markets’ backs. Like that old E.F. Hutton commercial, when Alan Greenspan talks, people listen. The markets hang on his every word. However, it is important to note that Mr. Greenspan merely communicates the actions and policies of the Federal Reserve. The real power is held by the Fed’s Board of Governors.
While Congress can affect the economy through changes in taxation, tariffs, employment law, etc., these items require passage by both the House and Senate and signature by the president. The Fed, however, can have just as much effect on the economy, if not more. That’s why the Federal Reserve Board is among the most powerful organizations in American government.
From time to time, I get e-mails from readers that make it evident that some people do not understand how the Fed works. In this issue, we’ll explore how Alan Greenspan and the Federal Reserve Board impact our lives, in more ways than you might realize. We’ll also look at what tools they have to change monetary policy and what impact that has on the economy. Also, we’ll see how they sometimes change rates without really changing rates.
A Brief History Of The Federal Reserve
First, a brief history of the Federal Reserve Board (the “Fed”). Since a detailed history of the Fed is, well, boring, I’ll give you the Reader’s Digest version. In the early years of this great country of ours, there were periods of financial instability, especially in relation to banking. At one time, there were over 30,000 different “currencies” in the US as currencies could be issued by almost anyone, including many businesses.
The various currencies were valued differently, and some were backed by silver or gold, and some by other things like bonds. There was also a problem with banks and liquidity. It wasn’t uncommon for banks not to have adequate funds (cash) available to honor all of their customers’ withdrawals. Obviously, this led to great uncertainty among the people and instability in the banking system.
Thus, after some wrangling in Congress, they finally agreed on and passed the Federal Reserve Act on December 23, 1913. It essentially established a decentralized central bank in order to standardize and stabilize the monetary system. It set up a central headquarters in Washington, DC, with 12 Reserve Banks strategically located in the larger cities across the country. The seven members of the Board of Governors of the Federal Reserve are appointed by the president and confirmed by the Senate. The Fed Chairman (currently Alan Greenspan) is also appointed by the president.
While created by the Federal government, the Fed operates as an independent corporation. The Fed’s stockholders are made up of nationally chartered banks and some state banks, but these banks cannot trade the stock and do not control the Fed.
The Federal Reserve has many functions. Perhaps most importantly is the Fed’s control over monetary policy. There are several things the Fed can do that can influence things like consumer demand, which in turn can fuel or slow down the economy. More about this later.
Another function the Fed has is to regulate other financial institutions. It establishes rules and procedures that banks must follow. It supervises them to make sure they are acting properly. This gives consumers confidence in the banking industry. The Fed also serves as the “bank’s bank” as the lender of last resort.
The Fed also acts as the US Government’s bank. The checking account of the US Treasury is at the Federal Reserve, which needless to say, is the largest checking account in the world. It also distributes money printed by the Treasury and sends paper currency to the banks as needed.
Finally, you may be interested to know that the Fed receives no funding from the Federal government. Instead, it pays its own way with interest earned from investments in government securities, loans to banks, and various other charges for services provided to member banks. Any excess of income over expenses is remitted to the US Treasury.
Tools At The Fed’s Disposal
As stated above, perhaps the most important thing the Fed does is control the monetary policy that impacts the economy on many different levels. This includes, to varying degrees, how fast our economy grows, the unemployment picture, inflation and even international trade.
Changes to monetary policy are affected primarily through the Federal Open Market Committee (“FOMC”), which is the group that basically decides how much to raise or lower interest rates. This elite group is made up of the seven members of the Federal Reserve Board, plus the 12 Reserve Bank presidents. However, only five of the Reserve Bank presidents get to vote. The president of the New York Federal Reserve Board is a permanent voting member, and the other four voting members are selected from the other Federal Reserve Banks for one-year rotating terms.
The FOMC currently meets eight times per year, at five to eight week intervals. During their meetings, they review the current state of the economy and the economic indicators including the Consumer Price Index, the Gross Domestic Product and Housing Starts, just to name a few. The FOMC also uses various proprietary indicators which are the subject of interest and debate. Based on their expectations and forecasts for the future of the economy, they decide what monetary policy to implement.
The Fed basically has three tools it uses to implement monetary policy changes. The first is open market operations. This is the buying and selling of US Treasury and Federal agency securities in the open market. This is perhaps the most effective tool the Fed uses. If the Fed wants to increase the flow of money and credit, it buys these securities, thus adding money or liquidity to the economy; this is often referred to as “adding reserves.” If it wants to reduce the flow of money and credit, the Fed sells these securities, thereby taking money or liquidity out of the economy; this is often called “draining reserves.”
The Fed also controls the interest rate on “Fed funds.” The Federal funds rate is the interest rate on overnight loans between banks. Banks frequently borrow and lend money among themselves, most commonly to satisfy the reserve requirement. The Fed funds rate is also a key element in determining the interest rates on many different types of loans made by banks to businesses. It is the Fed funds rate, currently at 1%, that the Fed is expected to raise this week.
Another way the Fed affects monetary policy is through the use of the discount rate. This is the rate at which the Fed loans money directly to banks and other depository institutions, on a short-term basis. The discount rate also affects the interest rates that banks charge their customers. At present, the Primary Credit discount rate is 2%.
Here is where I sometimes see confusion, in that some people think the Fed funds rate and the discount rate are the same thing. It’s not hard to understand why some people are confused, since most news media only report that the Fed raised or lowered “short-term rates,” but not which ones. Just be aware that when the news media talks about the Fed raising or lowering rates, they are usually talking about the Fed funds rate.
Another way the Fed affects monetary policy is through reserve requirements. The reserve requirement is the amount of money banks must legally hold in reserve for their customers’ deposits with their bank. This rate usually ranges from 3% to 10%. The higher the reserve requirement, the less money banks have to loan to customers. When the reserve requirement is lowered, the banks have more money to loan to their customers.
The bottom line with all of these policy options is that they impact the amount of money available to be lent, or liquidity. When interest rates are lower, people and businesses tend to borrow more, which means spending increases, which in turn stimulates the economy. When the reserve requirements are lower, more money is available to be loaned by the local banks in their community, which again stimulates spending. This in turn stimulates economic growth.
If the economy is growing at too strong a pace, demand tends to outstrip supply and prices rise, thus increasing inflation. In the late 1970s, inflation was out of control, and the Fed has been in a continuous battle to control inflation ever since. If the Fed funds rate is increased this week, as is widely expected, it will be precisely because the FOMC believes inflation is on the rise again, which it is. In May, the Producer Price Index jumped 0.8%, which was the largest gain since March 2003.
How This Impacts Your Life
You may not realize just how much the decisions of the Fed impact your life. Of course, there are the obvious ways – like the interest rate you pay for your home mortgage, or the interest you earn on your money market account.
But what about variables like the money your employer borrows? The lower the interest rate, the more profitable the company is, which in turn could keep your job safe. Borrowing can also help a company expand, which creates more jobs, or at least makes your job more stable. This can increase profitability, which in turn can lead to bigger raises or bonuses for you. Increased money supply also usually equates to increased consumer spending, which often leads to higher corporate profits.
As noted above, the Fed also attempts to keep inflation under control. This affects us all, since we are all consumers, and we all want to see that the cost of the goods and services we purchase doesn’t rise too rapidly. This is really important, especially if you are on a fixed income or Social Security. Higher prices usually lead to lower spending.
The Fed’s actions also often have a huge impact on the stock markets. When Alan Greenspan makes a speech, or gives testimony before Congress, you can bet the markets are hanging on his every word. Sometimes you can see the markets react as he speaks. When he says something perceived as positive, the markets go up, and if he says something perceived as negative, look out below.
Since most of us are invested in the stock markets in one way or another, the impact of the Fed’s decisions can be very significant. Many of our financial fortunes go up or down with the stock market. Consumer spending also tends to increase when the markets are higher.
Of course, the impact on bonds can be even more dramatic. As we all know, when interest rates rise, bond prices drop, and when interest rates drop, bond prices rise. If you’re invested in bonds or bond funds, you’ve no doubt felt the impact of the Fed rather directly.
Interest rates on most bonds have already increased in recent months, and many bondholders have lost money. Hopefully you took my advice last year and lightened up on your bond holdings, especially Treasury bonds.
Changing Rates Without Changing Rates
Sometimes the Fed can actually change interest rates without really changing rates. For example, at the last FOMC meeting on May 4, the Fed left short-term interest rates unchanged. However, in their post-meeting statement, they dropped previous language that said the Fed “can be patient” about raising rates. They added new language that said the Fed policy can be tightened but “at a pace that is likely to be measured.”
That statement caused rates on most bonds to rise, as noted above. The same is true of periodic public statements made by the Fed chairman and the various Fed governors and Reserve Bank presidents. The result is, the Fed can move interest rates without formally changing the Fed funds rate.
Bond and interest rate markets are often like the stock market. They move not so much on what happened today, but on what they think will happen in the future. So, by the time the actual rate hike comes, the markets have usually already priced it in.
As this is written, the bond markets are priced for a quarter point hike in the Fed funds rate this week. If the Fed decides to hike the rate by a half point, then we can expect bond prices to react negatively.
Will The Fed Raise Rates This Week?
The Federal Reserve will announce on Wednesday whether or not they will raise the Fed funds rate for the first time in over four years. As noted above, virtually everyone expects the Fed to hike its short-term rate by a quarter point, or maybe even a half point. The increase is widely expected given that the economy has been growing at a strong pace and inflation is starting to creep up. The other reason is that the election is coming up, and they don’t want to raise rates too close to the election.
However, there is no guarantee that the Fed will take this action. While Greenspan and company do not want to ignore inflation, they also do not want to stall the current economic expansion. Just recently, durable goods orders unexpectedly fell –1.6%, and the first quarter GDP report was adjusted down to 3.9% from 4.4%.
On the other hand, other economic reports such as industrial production and new home sales still show robust economic growth. Will the fear of inflation beat out two negative economic reports? I guess we’ll all find out on Wednesday.
If the Fed decides to not raise the Fed funds rate, look for some volatility in the stock and bond markets. Analysts will scurry around trying to figure out the reason for not raising rates. They could interpret the lack of action as the Fed’s opinion that the economy is not out of the woods yet. Or, they could come to the conclusion that the Fed is accommodating the Bush administration with an easy money policy through the election.
Alan Greenspan and the Fed’s decisions impact all of our lives in many ways. They work to achieve a delicate balance between promoting economic growth and controlling inflation. In the Fed’s view, too much of either is not a good thing. You no doubt remember the late 70’s and early 80’s when inflation was out of control, and interest rates were sky-high. That’s something the Fed doesn’t want to be repeated.
Currently, short-term interest rates are at the lowest levels in more than 40 years. As noted above, the Fed funds rate is at 1%; four years ago, it stood at 6.5%. The Fed slashed rates repeatedly in an effort to stimulate the economy in the face of the recession that unfolded in late 2000 and 2001, and then even more when the 911 attacks hit the economy hard. It appears to have paid off as now the economy is growing at a strong pace, perhaps too strongly in the Fed’s view.
Where do rates go from here? Well, that all depends on how strongly the economy grows in coming months, and what the rate of inflation is. The Bank Credit Analyst (my very best source for economic and interest rate forecasts) believes that the Fed funds rate will rise to 3-4% over the next two years. They expect the Fed to move very slowly in raising rates.
That all depends, of course, on what happens with the economy and inflation. If the economy continues to grow at a rate above 4%, the Fed will raise rates faster. The same will be true if the inflation rate accelerates on the upside, which remains to be seen. If on the other hand, the economy slows down significantly, the Fed will stop raising rates. But keep in mind, even if the Fed increases rates a point or two over the next year or so, interest rates still will be at very low levels as compared to the ‘70s and ‘80s.
Remember when investing in bonds, the short-term bond funds tend to be less volatile, but they also tend to have lower rates of return. The long-term bond funds are more volatile, but the rates of return are generally higher in the long run.
Of course, another way to invest in bonds is with professional management through an advisor like Capital Management Group. They invest in diversified high yield bond funds. These tend to be less sensitive to interest rate fluctuations than government bond funds, though they have greater credit risk. Capital Management Group has an outstanding performance record - CLICK HERE to take a look at their actual results. Past results are not necessarily indicative of future results.
Very best regards,
Gary D. Halbert
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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.