I was emailed this article by a friend. In it the author, who alleges to be a former investment banker, “spins” the Federal Reserve’s current involvement in the US economy to lead readers into believing that we’re currently witnessing one of the largest financial conspiracy theory’s in modern history.
I had planned to respond to his email privately and then figured I might as well use it as an opportunity to blog about my understanding of the financial system and to clarify how the Fed is currently using their tools to stimulate the economy.
So here we go from the top:
*What is the Fed responsible for?
Their job is threefold- 1) maintain price stability (i.e. low inflation) 2) promote full employment & 3) sustain economic growth.
*How do they go about doing this?
They effectively have three tools- 1) Federal funds rate (impacts short-term interest rates) 2) Open Market Operations (buy/ sell securities) & 3) Margin requirements (sets level at which investors can leverage security purchases)
*Currently, what is the Fed most concerned with?
Under the current economic environment the Fed’s main concerns are improving employment & economic growth. Inflationary pressures are not a concern at the current time.
*How are they going about improving employment and economic growth?
They are using two primary strategies right now. First, they have cut the Federal Funds Target Rate down to 0-.25%. As a result short-term interest rates on lines of credit and revolving credit are very low which they hope will stimulate businesses to borrow money to invest in their companies and to entice consumers to borrow money to spend on consumer goods.
Second, they are engaging in open market operations. This is when they purchase securities from the open market. It helps to stimulate the economy because they exchange money for securities. The money increases the supply of money in the economy and drives down interest rates by creating additional demand for these securities and by increasing the supply of money in the economy. The most well known operation that the Fed is currently engaged in is the TALF program which I blogged about last November. It was later expanded and can be credited for keeping mortgage rates near historic lows throughout 2009.
Each of these initiatives are designed to increase liquidity in the economy, which drives interest rates lower, and increases investment and consumption.
*Has the Fed been secretive in their initiatives?
Far from a conspiracy the Fed has been more than transparent in their action. The TALF made headlines news when it was announced and in last week’s monetary policy meeting the Fed clearly announced that they had already discontinued the purchase of US Treasury securities and would discontinue the purchase of mortgage-back bonds early in 2010. This is not a secret.
*As the author addresses in the article, how are their actions going to impact security prices?
When the Fed engages in open market operations they create substantial demand for the fixed-income securities that they are buying. As a result, the value of the asset increases and the yield decreases (which is how bonds work). Therefore, when the Fed leaves the market when their open market operations are discontinued it is likely that interest rates will move higher which will in turn push the value of existing fixed-income securities lower.
Because fixed-income securities with low coupons are more volatile than securities with higher coupons (all else being equal) we do expect these securities to take a hit. But is this really detrimental to the “small investor” as the author suggest?
I would argue no. First off, keep in mind that if the “small investor” was buying fixed-income securities during this crisis they probably owned fixed income securities headed into this crisis as well. The values of their holdings rallied as the Fed began their open market operations in late 2008. In fact, mutual funds which hold long US treasury positions were some of the top performers from 2007 to current.
Second, income investors who buy bonds under a buy-and-hold strategy have probably determined that the coupon payments they receive are sufficient to satisfy their cash-flow needs. When rates rise the value of their underlying bond will decrease. But, so long as the coupon is still being paid they shouldn’t care because the income will not be impacted.
Lastly, for growth investors who are concerned about capital appreciation the solution is simple right now. Don’t purchase long-term government notes or bonds. Instead, use shorter duration bills and bank products to make up the portion of your portfolio that you hold in fixed income securities. As rates rise, you will then be able to re-invest the principal into higher yielding assets.
*Since the Fed is effectively creating money right now through their open market operations won’t that lead to hyper-inflation later on?
This is one of the most hotly debated topics in financial circles right now. It is true that we find ourselves in a unique situation. The Fed has never been in a position where they’ve created this much money. And as I blogged about a month or so ago, according to Irving Fisher’s Equation of Exchange it is possible that as the economy improves the expanded money supply could lead to significant inflation if the Fed is unable to unwind the liquidity in time.
However, the Fed claims that they have the tools to unwind the money supply in time using tools such as reverse repurchase agreements to prevent rapid inflation. In fact, the Wall Street Journal reported back in October that they were already testing these tools to be sure they were prepared.
In summary, fundamentally the Fed is doing nothing different today than they’ve done in the past. The difference is that they are using their tools on a much larger scale than they’ve employed in the past. As with any action their is a reaction and the Fed will need to be cognizant of the long-term implications their policy decisions have. But for now, I think preventing the economy of falling into a deep recession is their biggest goal.