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The Most Powerful Corporation In America

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
October 30, 2007

The Most Powerful Corporation In America

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 Cut Rates Tomorrow?

Introduction

The Federal Reserve Bank’s Open Market Committee (FOMC) will decide tomorrow, October 31, whether to cut interest rates a second time this year.  On September 18, the last time the FOMC met, the members voted to cut the Fed funds rate from 5.25% to 4.75%, and in a surprise move they also cut the discount rate from 5.75% to 5.25%.

On this day before the Fed’s next interest rate announcement, analysts are pretty much split with about half expecting another cut and about half expecting the Fed to stand pat at least until the next policy meeting on December 11.  My guess is that the Fed will cut again tomorrow, but perhaps by only a quarter point.

If the Fed cuts rates by more than a quarter point tomorrow, this will likely be a sign that the FOMC believes the housing slump and the subprime mortgage troubles are worse than we think.  Likewise, if they do not cut rates tomorrow, it will be a sign that the Fed believes the subprime meltdown is under control.

In this week’s E-Letter, we explore the very influential Federal Reserve Bank, how it is organized and how it works.  I’ll explain how the Federal Reserve Board and the Fed chairman 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. The Fed is a mystery to many people, so hopefully this discussion will help.

The Fed Chairman Is An American Icon

None can deny that Alan Greenspan became an American icon in his position of Federal Reserve Board Chairman for 18 years, just as Paul Volcker became an American icon before him.  Greenspan retired as chairman of the Fed on January 31, 2006 and was replaced by the current chairman Ben Bernanke.  Although Greenspan has been retired from the Fed for almost two years, his recent book tour showed that there are still many who value his input and opinions. 

While Greenspan is still an American icon, he is not without his detractors, and it remains to be seen how history will judge him.  He railed against “irrational exuberance” in the stock markets in the late 1990s, but then opened the floodgates of liquidity that many feel helped to fuel the tech stock bubble, and we all know how that came out.  Some say he helped bring on the 2000 recession and a bear market in stocks by raising interest rates too high in an effort to fight inflation, at a time when many felt that inflation was not a serious problem. 

Mr. Greenspan has now passed his mantle on to Ben Bernanke, the next icon, and the jury is still out as to how closely he will follow the Greenspan model.  However, just as under Chairman Greenspan, it is important to note that Mr. Bernanke 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 the signature of 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 America.   Let’s take a look at how the Fed really works.

A Brief History Of The Federal Reserve

First, a brief history of the Federal Reserve Board.   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 frequent periods of financial instability, especially in relation to banking.  At one time, there were thousands of different “currencies” in the US, since 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 an independent 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 Ben Bernanke) 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 important 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.

According to the latest Federal Reserve Report to Congress, payments to the US Treasury in the form of interest on Federal Reserve notes totaled just over $29 billion in 2006, up from $21.5 billion in 2005.  The payments equal net income after the deduction of dividends paid and of the amount necessary to equate the Reserve Banks’ surplus to paid-in capital.

Tools At The Fed’s Disposal

As stated above, perhaps the most important thing the Fed does is to set and control monetary policy which, in turn, impacts the economy on many different levels.  This includes, to varying degrees, how fast our economy grows, the employment picture, inflation and even international trade. 

Changes to monetary policy are effected primarily through the Federal Open Market Committee, which is the group that 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.  The latest FOMC meeting is being held today and tomorrow. 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 the housing and construction industries, just to name a few.

The FOMC also uses various proprietary indicators which are the subject of much interest and debate. Based on their expectations and forecasts for the future of the economy and inflation, they decide what monetary policy to implement.

The Fed has three basic 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 Fed 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 and consumers.  It is this key rate that receives so much media attention.

As noted above, some analysts (including BCA) expect the Fed to lower the Fed funds rate again tomorrow.  However, there are also plenty of analysts and forecasters that believe the Fed will hold the Fed funds rate steady at 4.75%.  One way or the other, we’ll know by tomorrow afternoon.

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.  You may recall that the Fed surprised everyone by cutting the discount rate to 5.25% in September in order to help stabilize financial markets as the subprime mortgage debacle spread.  

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 easy 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.  As a general rule, the discount rate is usually around 1% higher than the Fed funds rate, although currently the Fed funds rate is 4.75% and the discount rate is 5.25%.

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. Conversely, when the reserve requirement is lowered, the banks have more money to loan to their customers. 

The Fed rarely changes the reserve requirements, with the last change occurring in April 1992.  One reason that this tool is not used very often is that changes in the reserve requirement make planning difficult for lenders, and any increase imposes a cost on them.  Thus, the Fed generally does not change the reserve requirement when there is an alternative way of achieving the same policy result.

The bottom line with all of these policy options is that they impact the amount of money available to be loaned, 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 lowered again tomorrow, as some expect, it will be because the FOMC believes inflation is less of a threat than a sluggish economy.  As discussed above, it may also be a sign that the Fed is still very concerned about the housing slump and the stressed credit markets.

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, generally speaking, which in turn could keep your job safe. Borrowing can also help a company expand, which creates more jobs, and may make 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 a growing economy and 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 can lead to lower spending.

The Fed’s actions also often have a huge impact on the stock markets.  Just as with Alan Greenspan, when Ben Bernanke 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.

It was often speculated that Alan Greenspan intentionally chose to speak in such a way as to avoid telegraphing the Fed’s future intentions.  In a recent “60 Minutes” television interview promoting his new book, Greenspan laughed at some of the clips he was shown from his speeches and discussed why he thought it necessary to speak in such a confusing manner.  While Bernanke started out speaking more clearly, he may revert back to Greenspan’s obfuscation model if the markets start to anticipate the Fed’s next move based on his comments.

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, which has a direct affect on the economy. 

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.

Changing Rates Without Changing Rates

Sometimes the Fed can actually change interest rates without really changing the actual Fed funds rate or the discount rate.  How can this happen?  Simple, with the power of the Fed’s post-meeting statements.  Following each FOMC meeting, the Fed releases an official “statement” that typically includes an indication of what bias it may hold.  If there is a bias that inflation is a problem, it could mean higher Fed funds rates in the future.  If the bias is toward a sluggish economy, just the opposite might happen. 

Thus, the action of the bond markets can actually raise or lower the general level of interest rates based on anticipation of the Fed’s next move.  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 sometimes move interest rates without formally changing the Fed funds rate or the discount rate.

Bonds and interest rate markets in general are often like the stock market.  They frequently 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 or cut comes, the financial markets have usually (but not always) priced it in already.

Will The Fed Cut Rates Tomorrow?

As noted above, the Federal Reserve will announce tomorrow whether or not they will lower the Fed funds rate a second time this year. As noted above, many believe another rate cut is necessary to keep the economy on track and help stabilize the credit markets.  Others, however, believe the larger-than-expected cut of 50 basis points in September was enough to stabilize the credit markets. 

The Fed’s decision tomorrow will be highly sensitive, regardless of what the decision is – whether to leave rates unchanged or to cut again.  For one thing, we get the advance report on 3Q GDP at 8:30 EST tomorrow morning.  If you recall, GDP for the 2Q rose at an annual rate of 3.8%, which was well above expectations.  There is little doubt that the economy slowed in the 3Q, perhaps significantly.  However, the advance estimates of tomorrow’s GDP report are actually more positive than I have been expecting.  The pre-report consensus is that GDP rose by around 3% in the 3Q.  I expect the number to be lower than that, but we’ll see.

The point is, the Fed will see the GDP report before they have to make the final decision whether to cut rates again or leave them unchanged this time around.  If the GDP report is 3% or higher, this could influence the Fed to leave rates unchanged.  If the GDP report is below 3%, this could influence the Fed to cut rates again.

Another key issue on the minds of the FOMC members is the continued slump in the housing market.  Almost all of the housing and construction data since the Fed’s last meeting on September 18 have been negative.  The credit markets continue to have problems, and trust among lending institutions remains a serious concern.  The fallout in subprime mortgages is not over.  These housing and credit issues could well influence the Fed to cut rates tomorrow, as I believe it should.

As I noted last week, BCA believes that inflation will surprise on the downside over the next year, despite soaring oil and food prices.  They believe that the housing slump will be more than enough to negate the increases in energy and food.  Here is a recent quote from BCA:

“The cyclical tendency of the world economy is leaning toward disinflation or deflation, not inflation.  The reason is simple. The bursting of the U.S. real estate bubble is a deflationary shock whose disinflationary impact will continue to be felt in the global economy… This is because asset price deflation often precedes a period of economic weakness, which in turn restrains the business sector’s pricing power.”

It has long been believed that certain members of the FOMC read BCA.  If so, BCA’s view that inflation is not going to be a problem over the next year or so may be yet another influence that tips the Fed toward cutting rates again tomorrow.

Conclusions

Over the years, I have heard from dozens of clients and readers who believe the Federal Reserve is a vast conspiracy with far too much power.  While there may be some truth to that, the Fed is what it is.  It is arguably the most powerful corporation in the US, maybe the world.  Its primary mission is to use monetary policy to promote economic growth, keep inflation under control and serve as lender of last resort to the banking system.

In addition to influencing the level of interest rates, the Fed is continually conducting open market operations by buying and selling US Treasury and Federal agency securities.  And the Fed sets the reserve requirement for banks.  All of these actions can serve to stimulate the economy or slow it down.

Whether the Fed elects to cut interest rates tomorrow remains to be seen.  Whatever the decision is, there will almost certainly be a reaction in the bond markets – one way or the other.  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.  And bonds can be just as volatile as stocks, sometimes even more so.

For years clients have asked me to find a professional bond trader that goes both long and short.  Earlier this month, I introduced you to Hg Capital Advisors and their Long/Short Government Bond Program.  They invest in Treasury long bond index mutual funds, and seek to deliver short-term capital gains.  Since 30-year Treasury bonds are sensitive to interest rate fluctuations, this gives Hg Capital the potential to capture gains from these movements in interest rates. 

The Long/Short Government Bond Program has an outstanding performance record - CLICK HERE to take a look at their actual results.  The minimum to invest is $50,000.  This program is not suitable for all investors, and past results are not necessarily indicative of future results.  Call us at 800-348-3601 for more details, or click on this LINK to access our online request form.

Wishing you profits,

Gary D. Halbert

SPECIAL ARTICLES

Politicians create problems, then ‘solve’ them.
http://www.realclearpolitics.com/articles/2007/10/political_solutions.html

Liberals vs. the First Amendment (Fairness Doctrine)
http://www.opinionjournal.com/diary/?id=110010795

The Legacy of the Bush Administration?
http://victorhanson.com/articles/hanson102407.html

 


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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.

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