It’s here! The highly anticipated and mostly unpopular Federal Reserve rate hiking cycle. It is said to be the primary cause of the stock market’s misadventures over the past few months. Misadventures is a nice way of saying drawdowns. Whether you are an astute student of the market or not, you are probably familiar with the Fed’s easing and tightening of monetary policy to either stimulate economic growth or to squelch it. Stimulate is something that, as you might suspect, is loved by stock bulls, while squelching is the rain on a parade. As most of us are investors and not traders, we are all, therefore, ever hopeful that the Fed will be more benevolent and less tyrannical in its role as guardian of the economy, causing stocks to climb. Let’s take a closer look at the Fed and the much-vaunted Fed Funds rate, so that when the changes come, we are ready.
Most of us simply refer to it as The Fed or The Bank (notice the capital “B”). The Fed is, foremost, the Central Bank of the United States. Go back to the early 1900s, and the US did not even have a central bank. Banking institutions at the time were completely independent, and as such, subject to all sorts of potential mishaps. Remember that the primary function of a bank is to borrow money from one customer and lend it out for a profit (referred to as a lending spread). As those investments provide the banks with the means to pay interest to investors and make profits, banks should technically have very little cash in their vaults. If an abnormal amount of withdrawals take place, the bank may find itself short of the cash, which, as you might guess, can cause some problems…and possibly some panic.
Imagine going to your local bank to withdraw $25 from your savings account and the teller says, sorry we are out of money, come back next month. When other customers in line overhear the teller’s admission, they promptly demand to withdraw all their funds. A big problem suddenly becomes a really, really, big problem. That is known as a bank run. I am sure that conjures up memories of a certain scene in the Christmas classic It’s A Wonderful Life, though George Bailey’s problem did not stem from having invested or lending out too much, but rather an unfortunate accident by his Uncle Billy. To avoid the prospect of not being able to fulfill a withdrawal request, prudent banks would make sure to have enough reserves on hand to satisfy their expected liquidity needs, but even the most cautious banks would not be able to survive a bank run. Bank runs were actually frequent in the late 19th and early 20th centuries, most notably The Bank Panic of 1907. Banks during that time were highly invested in risky investments and a declining stock market caused savings account holders to panic causing bank runs. With no central bank as a backstop, vulnerable banks had to be bailed out by notable financiers like J.P. Morgan and J.D. Rockefeller. The events of the panic exposed weaknesses in the US banking system and ultimately led to the formation of the Federal Reserve Act of 1913.
The Act, signed into law by President Woodrow Wilson, created the Federal Reserve. The Fed was created to provide financial stability and act as the principal regulator of banks within the Federal Reserve System. Under the new regulations banks would be required to maintain a minimum reserve to satisfy liquidity requirements. Should member banks require additional funds to meet demands or meet statutory requirements, they may borrow from each other, or the Fed itself, which is said to be a lender of last resort.
The Fed is sub-divided into three distinct divisions.
As mentioned above there are 12-regional Fed banks which are responsible for servicing member banks in the region. The Fed also delegates general tasks out to the regional banks. Finally regional Fed Bank Presidents serve on the Federal Open Market Committee. The following are the different Fed regions and their current Presidents.
The Board of Governors is made up of 7 members which are nominated by the President and confirmed by the Senate. They serve up to 14 years, they come from diverse backgrounds, and their nominations must be staggered by 2 years. Their primary role is oversight and they along with the Regional Fed Presidents make up the FOMC. The following are the Fed Board of Governors.
Those three vacancies are in the nomination process. For the Vice Chair role, President Biden has nominated Lael Brainard (currently a Fed Governor). He is also expected to nominate Sarah Bloom Raskin for the Vice Chair for Supervision. She, if confirmed, will be responsible for oversight of the largest member banks (the role was created in the wake of the 2008 Global Financial Crisis). The final 2 nominees are expected to be Lisa Cook, an economist from Michigan State University and Phillip Jefferson, an economist from Davidson College. The reason that I went through so much pain, and ink, to highlight the regions, their leadership, and the governors is that it is those very folks that are responsible for making policy. They publicly speak often, and they are known to voice their opinions. Paying attention to their speaking and writings can sometimes provide insight into policy.
Recall that, in addition to serving as lender of last resort and a bank regulator, the Fed is responsible for financial stability of the monetary system. That can be further broken down as follows:
This is where the Fed’s so-called mandate comes in. You will often hear me speak about the Fed’s dual mandate, as follows:
The FOMC accomplishes this mandate through monetary policy, which is voted on by the voting members at its 8 pre-scheduled meetings. The Fed can also change policy outside those meetings when necessary.
The committee is comprised of Regional Fed Presidents along with the Fed Governors. The Vice Chair of the FOMC is always held by the sitting President of the New York Federal Reserve Bank. Regional Fed Presidents rotate in and out of voting positions. There is always 1 voting President in each of the following groups:
Non-voting members participate in the deliberations though they do not have a vote. Once policy is agreed upon it is the Fed’s job to enact the policies. For instance, if the Fed wishes to change the Fed Funds rate, it must conduct operations to get the rate to the policy target. As we have learned since the pandemic, the Fed has a long list of financial instruments which can affect monetary conditions, though the most common are related to interest rates. Some rates can simply be changed via policy. For instance, the Fed can change the discount rate, which is the rate at which the member banks can borrow money directly from the Fed to meet bank reserve requirements. The most commonly quoted Fed rate is the Fed Funds Rate. That is the rate which member banks charge each other for overnight loans to meet bank reserve requirements. Though the Fed can set the target rate, it is up to the banks to adjust them accordingly.
In some cases, the Fed must add liquidity to the market in order to force rates lower and stimulate economic activity. Adding liquidity means putting more money supply into the banking system. Remember supply and demand? More supply = cheaper money = lower rates. The Fed pumps liquidity into the system by purchasing instruments in the open market. This is commonly accomplished through the use of Treasury Reverse Repo (reverse repurchase agreements) or match sale. In a reverse repo, the Fed loans money to a bank and takes treasuries as collateral. The repo is a timed, collateralized loan which reverses at maturity, typically overnight. The Fed may also add liquidity to the system by purchasing securities outright in the open market. This is referred to as quantitative easing. Whether through the use of reverse repos or direct purchases, the Fed is able to push interest rates lower. Combining those with the lowering of statutory rates, the Fed is able to stimulate the economy.
It would seem quite easy for the Fed to simply continue to pump liquidity into the system to continuously stimulate the economy. As all things in economics there is a tradeoff. A healthy, fast-growing economy usually has an unwanted side effect: inflation. Remember the Fed’s dual mandate from above? Unfortunately, there is only one proven method for fighting inflation: Tightening monetary conditions. When the Fed wishes to tighten monetary conditions, it raises statutory interest rates such as the discount and Fed Funds rates. Further, the Fed removes liquidity from the system in open market operations using the repos and by selling bonds directly in the market.
As we have learned many times in past several years, the Fed can actually move markets without lifting a finger or making a single transaction. The Fed can simply voice its intent and markets will, in an instant, factor in the eventuality. A clear example of this has occurred in past several months where we have witnessed 2-year Treasury Note yields climb by some +66 basis points by simply stating that it was “probably appropriate to raise interest rates.” The Fed can also signal changes by presenting its projections which it famously does in its dot plot, released 4 times a year. There, members can project where they believe short term interest rates will be over the next 3 years and beyond. Not surprisingly, when a majority of those signals point higher or lower, treasury yields quickly follow.
After almost 2 years of stimulative monetary policy, the US economy is growing faster than it was prior to the pandemic. Unemployment is receding, though not quite at the record lows prior to the pandemic. A side effect of the Fed’s easy policy combined with massive Federal Government fiscal stimulus is inflation, cause by increased consumption. That inflation is made worse by supply chain logjams caused by COVID. Recent readings of the Consumer Price Index show inflation at levels not seen since the early 1980s, when inflation was a real, and persistent problem. Due to all these factors, the Fed must slow consumption which will allow prices to ease. As we have learned above, it can do that by raising statutory, key lending rates and by removing liquidity from the system. Though treasury yields have already factored in higher interest rates, the Fed must still officially raise rates, and they are expected to begin doing so in March. Stocks have already also factored in tougher monetary policy, and they continue to trade at elevated levels of volatility. Though a shift from friend to foe is never received positively, and this recent shift appears abrupt and extreme, it is important to remember that the Fed has raised rates many times since being created back in the early 1900s. Despite this, stocks, though quite volatile at times, have continued to grow…as they will going into the far future.