Understanding The Fed & Its Policies
What Every Investor Needs To Knows

Regardless of the state of the U.S. economy, there is no bureaucracy more integral to our nation’s stability than the Federal Reserve System. Yet, for an agency which wields so much power in determining the direction of economic and financial policy, investors know little—and perhaps understand less—about who the Federal Reserve is, what they do and how they operate.

What is the Federal Reserve System?
Founded by Congress in 1913 by the Federal Reserve Act, the Federal Reserve System is the central bank of the United States. Overseen by a board of seven members who are appointed by the President and confirmed by the U.S. Senate, the Federal Reserve operates Reserve Banks in twelve geographic divisions of the county. The Federal Reserve Banks serve as the operating arms of the central banking system.

Why was the Fed established?
Following the Panic of 1907, during which equity markets collapsed and numerous banks experienced runs by their depositors, the Federal Reserve Bank was established as a lender of last resort to forestall financial panics. Specifically, the Federal Reserve Act’s stated purpose was to “Provide for the establishment of Federal Reserve banks, to furnish an elastic currency, to afford a means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”

It is worth noting that nowhere was any specific mention made of maintaining price stability, economic growth or active participation in economic stabilization activity (bailouts). Much of what the Fed is now known for, at the time of its creation would have been unconceivable. The last mandate “for other purposes” has resulted in numerous deviations from the original intent.

The Federal Reserve’s mission can today be categorized
into four general areas:

1.) To conduct U.S. monetary policy by influencing the
monetary and credit conditions in the economy

2.) To supervise and regulate banking institutions to ensure safety and soundness while protecting the credit rights of consumers

3.) To maintain the stability of the financial system

4.) To provide financial services to depository institutions, the U.S. government and foreign official institutions

What exactly is Monetary Policy?
The term monetary policy refers to what the Federal Reserve does to influence the U.S. economy. The board’s decisions affect credit rates and ultimately, the overall performance of the economy.

Today, the Fed utilizes three instruments of monetary policy—open market operations, discount rate and reserve requirements. Open market operations involve buying and selling government securities and is the primary tool used to influence the supply of bank reserves. The discount rate is the interest rate on short-term loans charged by Federal Reserve Banks to commercial banks and other depository institutions. Reserve requirements are the portions of deposits that banks must maintain either in their vaults or on deposit at a Federal Reserve Bank.

It has been said that, from a historical perspective, the Fed has reached much deeper into their repertoire of policy tools during this cycle than at any time in the past.

An example of current Monetary Policy.
On Sept. 21, the Fed announced plans to try to push long-term interest rates down by purchasing $400 billion in long-term Treasury securities with proceeds from the sale of short-term government debt, saying the economy clearly needed help. Operation Twist, as it is known, is another attempt by the Federal Reserve to stimulate the U.S. economy.

By purchasing long-term Treasuries financed with short-term borrowings, the Fed hopes to make long-term financing more appealing for borrowers, and to make holding long-term Treasuries less appealing for investors. The direct economic stimulation happens when lower rates bring borrowers into the market to refinance their mortgage, or better yet, purchase a new home, which is now more affordable because the interest cost is lower. The indirect stimulation occurs when buyers of long-term Treasuries decide that yields are too low relative to risk/return characteristics in the equity markets, and opt for stocks, thereby supporting equity market valuations.

Our assessment of this particular monetary policy strategy is that it is not likely to have much of an impact. The idea that lower rates will attract borrowers to the market is valid, however bank credit standards are very high right now, and even highly credit worthy borrowers are challenged when applying for financing. Secondarily, investors in long-term Treasury securities are not in them for their yield, they are there for safety, and that doesn’t seem likely to change.

A historical progression of Fed policy.
Since its inception, the Fed has expanded the interpretation of the “for other purposes” language original act that created the institution. This has resulted in numerous deviations from the original intent. The first road bump from the perspective of the original intent was the loss of the international gold standard around the beginning of World War I. The gold standard was never to return in its true form, and its loss resulted in a need to manage balance of payments activities based on statistics rather than gold movements.

Shortly after the war, in the 1920’s, open-market operations began in an effort to stabilize prices. In the thirties the fed was given the power to set interest rate ceilings on deposit accounts, regulate margin requirements and, in 1935, the power to set bank’s reserve requirements. In the 1940’s with the U.S. entry into World War II, the Fed effectively pegged the entire Treasury market by setting levels at which it would buy all securities offered for sale. The Employment Act of 1946 which committed the Federal government to the goals of “maximum employment, production and purchasing power,” is where much of today’s Fed activity gets its roots.

In more recent times, we have seen the Fed under Chairman Volcker extinguish the Great Inflation of the 1970’s by ruthlessly tightening monetary policy. Following the 1987 stock market crash the Fed was there to reaffirm “its readiness to serve as a source of liquidity to support the economic and financial system.” In the 1990’s the Fed eased policy to stabilize the banking system; contain the impact of the devaluing peso and stabilize markets upon the near crash of Long-Term Capital Management. Finally, in the past few years, we have witnessed activities at the Fed that trump nearly every practice that had been novel before 2008.

Markets seem increasingly dependent on the Fed as source of stability. Therein lays the moral hazard of government manipulation of free markets. For better or worse, this bed has been made repeatedly. Each new policy effort seems the final arrow in the quiver, but a look at the past indicates that our Fed is short on neither creativity nor scope with respect to “for other purposes.”