The Real Purpose Of The Fed

[Guest]

SOURCE: Schaeffers Research

 

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The Real Purpose of the Fed

By Al Schwartz ([email protected])

11/27/2002 11:28 AM ET

 

The basic link between monetary policy and the economy is through the market for bank reserves (more commonly known as the Federal Funds market). The bench mark interest rate charged for the short-term use of these funds (by banks and other depository institutions) is called the federal funds rate. These banks will either borrow or lend to each other depending upon the level of their non-interest-bearing reserve balances.

 

The Federal Reserve (FED) can change reserves market conditions by employing three main instruments:

 

1.) Adjusting reserve requirements

 

2.) Adjusting the discount rate (the rate charged by the Federal Reserve to member banks)

 

3.) Adjustments in the Open Market operations (the Federal Open Market Committee- FOMC)

 

On November 6, the FOMC reduced its key overnight lending rate for a 12th time in its more than two-year cycle of easing. Currently standing at 1.25 percent, this rate is as low as its has been in more than 40 years. On the day of the last rate cut, the S&P 500 Index (SPX ? 932.02) closed at 923.76. Having ramped upward in anticipation of the cut, the index promptly entered a five-session decline to 872.05. As it currently stands, the index has now eclipsed the November 6 high. With the next meeting of the group scheduled for December 10, it might be useful to understand the purpose of the FOMC.

 

The bottom line: the FED and the FOMC are mandated by the Humphrey-Hawkins Act of 1978 to effectively promote the goals of maximum employment, stable prices, and moderate long-term interest rates. The FED and FOMC must establish annual objectives for growth in money and credit, taking into account past and prospective economic developments. As such, the target is not the stock market, despite the fact that Corporate America must function within the constructs of controlled output, employment, income and prices.

 

As stated above, the FOMC must estimate when and to what extend its own policy will affect money, credit, interest rates, business developments and prices. Since knowledge about the way the economy works is quite imperfect, policymakers' understanding of the effects of various influences (including their own policies) is far from certain. As such, monetary policy formulation is not a simple technical matter but rather an art.

 

The chart below indicates how monetary policy influences output, employment and prices through a number of complex channels. These channels involve a variety of forces in financial markets that cause changes in:

 

1.) The cost and availability of funds to businesses and households.

 

2.) The value of household assets or net worth

 

3.) The foreign exchange value of the U.S. dollar with direct impact on import/export prices.

 

When the Federal Reserve tightens monetary policy (possibly by draining bank reserves via open market sales of government securities), the federal funds rate and other short-term interest rates rise almost immediately, reflecting the reduced supply of bank reserves the market. If these levels are maintained over time, lower growth of deposits and money will occur as well as an increase in longer-term interest rates. Over time there is an adverse effect on business demand, home buying, and consumer spending on durable goods.

 

Lowering actual or expected asset values impacts the "wealth channel". Higher interest rates generally tend to lower stock and bond prices, reduce household net worth, and weaken corporate balance sheets. As a result, household and business spending declines.

 

A tightening monetary policy impacts economic activity by raising the foreign exchange value of the U.S. dollar (assuming inflation is held in check). This "exchange rate channel" makes U.S. imports cheaper. It also makes U.S. goods and services more expensive overseas, reducing the demand for U.S. goods and services. This policy has a negative impact on trade balances and U.S. output, but helps in controlling U.S. inflation.

 

The above scenario is what occurs when the FOMC introduces a cycle of tightening. Within the current cycle of easing by the FOMC, we continue to look for the process to reverse. Just how long it will take to trickle through the economy to corporate bottom lines is has proven difficult to pinpoint.

[Hypertiger]

Be nice if it worked that way but the demand for money never decreases. Ant the economy is so dependant for debt creation for it's survival from milisecond to milisecond that Tightening even slightly has the effect of causing serious economic damage plus now a days everything has been thrown out the window the FED is'nt following any rules, the reason they are pumping the market so much is because if they didn't it would collapse in a matter of days and take down the world banking system. And becides the whole banking system is a ponzi scheme which collapses once people stop borrowing money/ creating debt. I especially like the talk about controling inflation... The FED creates inflation... It doesn't control it...what I mean by that is they create it and try to keep it low enough to prevent hyperinflation but that is the end result every time anyways whether it takes 2 years or 70, then It collapses... Thats the way it's designed...

[MaxxPain]

The Fed has allowed the debt monster to grow too large. I think the debt is now controlling the Fed. The problem with reflating is that the Fed can never stop. The more the Fed FEEDS the more dependent the economy and market will become. Consumers and companies will assume its safe to take on more debt. They have to know they are getting near the end, but I would guess they will blow their final wad trying to get the moron reelected.

[Hypertiger]

It would take a Miracle to get that far (2004 election)

[Guest AssMaster]

I remember the last time I underestimated the Fed. Just before Y2K. And then before that in 1998 after LTCM.

 

They can remain irrational longer than you can stay solvent. Having said that, we know where it is going (down) - just not when or how. Speculators and gamblers of either the bearish or bullish ilk are likely to get smacked hard.

 

This looks a lot more like 98 or Y2K than I am confortable with, and could end up big by Feb, then down into Mar/Apr. What happens if it goes up another 20% from here, down 30% from there, then up another 60% higher *before* it makes the new all-time low? How will your current strategy work if the market does not go the way you have planned for it? Will you have enough money left to buy at the bottom? Will you know it when you see it, or will you be shorting it to zero at the all-time low?

 

Don't be like the stupid bulls who were buying CSCO at 80 on margin and just watch your money go up in smoke.

[Hypertiger]

They are in the final stages exponentially speaking. At first it was a simple jam once a year, then twice a year, then once a month, then once a week, Now it?s almost daily. Gold manipulation is like a yo-yo and the bonds are just more paper to be printed? the mainstream is still going like nothing is happening, but creeping doom is pretty close now. Next year almost a trillion dollars will be stripped from GDP and I'm sure it won't show up anywhere official, but the effects will not stay hidden anymore?

 

It?s the end of the line next year unless they figure out how to fix the economic infrastructure in a few months. I?ve seen studies on what needs to be done and basically there is no fix on the fly solution, the system must be bankrupted and then once the smoke clears another couple of decades is required for reconstruction and to top it all off re-thinking Fractional reserve banking is not discussed in any of the scenarios.

[anoscope]

Be nice if it worked that way but the demand for money never decreases. ....Ant the economy is so dependant for debt creation for it's survival from milisecond to milisecond that Tightening even slightly has the effect of causing serious economic damage plus now a days everything has been thrown out the window the FED is'nt following any rules, the reason they are pumping the market so much is because if they didn't it would collapse in a matter of days and take down the world banking system. And becides the whole banking system is a ponzi scheme which collapses once people stop borrowing money/ creating debt. I especially like the talk about controling inflation... The FED creates inflation... It doesn't control it...what I mean by that is they create it and try to keep it low enough to prevent hyperinflation but that is the end result every time anyways whether it takes 2 years or 70, then It collapses... Thats the way it's designed...

actually, decreasing interest does increase the demand for borrowed money. To prove this, consider the fed's increase in rates during the Carter administration to stop the borrowing. Again, the same increase happened 1980-81 as the bubble in the market formed. IMO, greenspan should have decrease rates much faster, but they were doing their best to prevent a true instant crash of money and equity markets.

 

another aside: I heard on proctoVision today that many billions were yanked from stock funds in recent weeks and added to bonds. Doc pointed out today that in the last day or few days there has been a loss to bondholders of moore than 4.5%. So we see that there is no safe haven. I've never bought a bond or SHY (the bond ETF).

[Hypertiger]

In a fractional reserve banking system the demand for money/debt (inflation) never decreases only the ?availability? is affected? And as we neared the maximum potential of debt inflation, stopping or slowing the creation of new debt to cover the compound interest of the previous debts becomes more dangerous. But it doesn?t matter, once you are at that stage there is nothing you can do. It boils down to strict regulation and prudent social engineering which were non-existant then and now.

 

Finally charging compound Interest rates on money/debt created out of thin air is fraud anyways?

[DogBoy]

"they figure out how to fix the economic infrastructure in a few months"

 

Fix ? Are you joking.

 

This is like asking a mortally wounded animal to fix itself.

 

The only thing left to do with the system is for the last man out the door to turn the lights out.

 

MO debt and stealing is all that the Boyz know how to do and they do those things very well.

 

But they can't "fix" this thing.

 

The only fix is a TOTAL replacement with new leaders and a new system.

[Guest Guest]

Assmaster, Beautifully put. Everyone gets creamed. As Dogboy describes-- the economy is like a mortally wounded animal trying to heal itself. It's very difficult to develop a strategy to deal with a creature lurching about, unsure where to settle, willing to do anything to avoid more pain. Even a revival of economic activity may indicate the hysteria of a fever,not a return to health. It's death rattles will probably be misinterpreted as rallying cries when it finally goes down.

 

But when will that be? And exactly what form will it take? The best strategy in dealing with that wounded animal is to stay out of it's way, stay out of debt, be prepared to move either completely or partially out of the mainstream, if at all possible. Most important is to solidify ties with family and friends, and look out for one another. Social capital is a valuable form of disaster insurance.

 

Did any of you see the documentary on LTCM, shown on PBS television? Amazing.

 

Assmaster, I put a call into my husband 3 days before the LTCM collapse, had a feeling something was "going to happen". Begged him to sell all our stock. He delayed by a couple of days. The good news is we didn't lose much, due to the manipulations of Greenspan, but had no desire to get back in, even if it took off like a moon shot. Greenspan created a moral hazard for currency speculators hedgers, etc...and it seemed it would unwind at some point. --Just want to avoid that wounded animal.

 

Y2K--I have about 40 lbs of rice and beans left. Wouldn't it be ironic if they become invaluable in the future?

[Drano]

" I put a call into my husband 3 days before the LTCM collapse, had a feeling something was "going to happen"."

 

Hey, unregistered guest, please let us know the next time you get a "feeling"!

[DogBoy]

"Assmaster, I put a call into my husband "

 

Would buying a CALL on the hubbie be considered investing in "social capital" ?

 

Just kidding. He he he !!

[Guest AssMaster]

Ahh, the "guest" sounds like Charliss without the "disconcerting" picture. Either way, we obviously have our canary in the coal mine for level 10 crash alerts.

 

Put me on your panic button mailing list too, guest.

[assteroid]

I tried logging on as Threadbear, but lost my (p)assword, so just logged in as a Guest. Now I've changed my name to Assteroid, take note. Yeah, I called that one right. It's part of an overly aroused limbic system, combined with altered realty filters. I sniff out underlying chaos like a pig rooting for truffles. Anyone with a fairly good brain dashed against a windshield with sufficient force can achieve the same results!

[DrStool]

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