Chapter Nine: The Personality of the Fed

Ipek Kazan

Raegen Richard

Jon Greenwald

The Federal Reserve

• Regulates nation’s money supply

• The only American institution with the ability to create money

• Interacts with the federal government and international policymakers.

• U.S. Economy: Family

Fed: The Head of the family

The Personality Of The Fed• The personality of the Fed reflects the

personality of its chairman• How to get to know the Fed?- Get to know its chairman- Learn to listen to the Fed’s public statements- Watch Fed’s daily operations- Pay attention to Fed’s attitudes (anti-inflation

and pro-growth)- Watch how the Fed handles stress

Understanding The Chairman’s Activities

• Examine the economic goals of the president

• Watch the foreign exchange market’s treatment of the dollar

• Consider chairman’s professional background

The Chairman’s Job

• 2 Main goals: low inflation and modest but consistent economic growth

• Enough money to keep economy growing

• Prevent excessive inflationary intoxication

• Walk the line between economically sound and politically expedient

Public Statements

• Discount rate statements– Whenever discount rate changes, the Fed issues a

statement.

• Federal Open Market Committee Meeting Minutes– Published in Federal Reserve Bulletin

• Humphrey-Hawkins Reports– Chairman addresses Congress in February and July.– Reports are televised on C-SPAN and analyzed in

major newspapers.

Body Language (Daily Market Operations)

Look at daily market operationsPurchase or sale of U.S. Government securities

• Typically done between 11:40-11:45 A.M.• Thursday operations important:

- The first day of the bank statement week

- Fed can maximize its impact on reserves

Changing Attitudes can occur

• Dire inflationary trend

• Deep economic recession

• Foreign exchange crisis

• Domestic financial crisis

• New Fed Chairman takes office

Fall of 1979

• Monetarist Approach to Central Bank management– Monitoring and regulating money supply

became main concern– Tight monetary policy caused deep recession

of 1981 and 1982– Curbed high interest rates and rapid inflation

of late 70’s and early 80’s

Crisis Investing

• When major corporate bankruptcies occur– Fed is lender of last resort to maintain

efficiency• Investments perform well during this time

• Penn Central Bankruptcy– $82 million outstanding as commercial paper– Occurred on border of Ease-Off and Plunge

phases

Crisis Investing Con’t.

• Penn Central Con’t.– Optimal Investment Response

• Take position in stocks and bonds

– Bankruptcy and GM strike pushed economy into the Plunge phase

– Created major bull markets for stocks and bonds

• Yields on ten-year Treasury Notes fell over 50 basis points (favorable)

• NYSE index rose 13.4 percent

Crisis Investing Con’t.

• Franklin National Bank Insolvency (1974)– Fed lent whatever was necessary to pay off

maturing deposits (totaled $1.7 billion)

• Problem occurred between Ease-Off and Plunge– Optimal Investment Response

• Take position in stocks and bonds

– Yield on ten-year Treasury Notes fell 100 basis points

Crisis Investing Con’t.

• Hunt Silver Crisis– Silver collapsed and interest rates increased

• Defaulted on margin calls on the Comex

– Occurred in the middle of a minirecession– Optimal Investment Response

• Extend maturities on bond investments• Move to financial instruments• Yield on ten-year Treasury Notes fell 350 basis points• S&P rose 10 percent• Gold didn’t do so well

Crisis Investing Con’t.

• Lombard Wall-Drysdale Double Crisis– Both went bankrupt– Large investment positions with small capital bases– Occurred during Plunge phase of 1982– Optimal Investment Response

• Increase investments in longer term debt instruments and stocks

– Ten-year Treasury Note dropped 300 basis points– S&P index rose over 35 percent

How To Respond

• Do not panic

• Go for quality

• Reassess your big picture

• Investment reaction should relate to the phase of the cycle where the crisis occurs

Crises In The Future

• Why Crises lie ahead– Frequency and severity of inflationary cycles

• Due to more speculative habits

– Banking system not as solid as it used to be• More loans to high risk creditors

Chapter Ten: Two Well-Known Interest Rates and How They Work

A Tale of Two Over-rated Rates

• The Federal Reserve Discount Rate– A bank’s cost to borrow reserve funds directly from the

Fed’s Window

• The Federal Funds Rate– A bank’s cost to borrow reserve funds from another

bank in the system

• “…both the discount rate and the Federal funds rate are valuable BUT NOT crucial to reading the Fed and responding with a sound investment strategy. The real answer lies in the monetary base, the basic money supply and velocity which I explain in the next two chapters.” (emphasis added)

The Discount Rate• Deceiving and Perceiving

– Media Hype – The discount rate does not directly steer the

economy or interest rates

• Changes in the discount rate do affect the economy and interest rates, but there are many other significant elements in play

Three Varieties of Rate Changes

1. Leading– Discount rate cut causes a decline in interest

rates and economic stimulation• May 1985 cut led to a 14% decline in Treasury yields

and an 18% increase in the DJIA by year’s end

2. Lagging– The Fed may use the discount rate to support

monetary tightening or easing• December of 1982: markets saw a seventh consecutive

rate cut as unnecessary because economic recovery was well underway and other rates actually rose in early 1983

Three Varieties of Rate Changes

3. Missteps– The Fed may take a series of increases or

decreases too far and then need to reverse suddenly

• July of 1980: cut from 11% to 10%. Concurrently, increases in interest rates, the money supply, inflation, and the economy continued. In September the Fed had to return the discount rate to 11%.

Three Varieties of Rate ChangesWhat do you see?• Examine the statement that

accompanies the change– The Fed may say it is trying to bring

the discount rate in line with the market.

• Watch the response of other rates

– There may be abiding interest rate moves in the same direction

• Observe the momentum of the overall economy

– Discount rate changes are effective at dampening and stimulating

• The Fed’s discount rate changes often lag other indicators and are preceded by missteps

The Federal Funds Rate

• The Fed funds rate is not a good leading indicator of monetary policy– Many factors outside of the Fed’s control can

impact the rate

• It is a good indicator of where monetary policy stands– The Fed can influence through its supply of

reserves

• Look at weekly or monthly averages and analyze to see if there is movement away from a trend

THIS IS THE ENDTHANK YOU FOR YOUR ATTENTION