The Federal Reserve: A Little History, Functions, The Dual Mandate, & A Little More

About two weeks ago, I posted about the Fed telegraphing its next policy moves, and a few of my connections asked me to explain this more simply. You got it! Except, the videos I made and this piece are a bit longer than a simplification. But if you read til the end, you'll understand the Fed a little better.

The policy moves I spoke about were two fold: 1) to peg the 2-year treasury at 1% if the benchmark rate goes to 0%, and at the time (about 2 weeks ago) 2) the Fed was set to begin discussing its 2% inflation target.

So lets back track a little. In order to understand what is going on here I think it’s important to understand what it is that the Fed does in the first place, and what is this concept called “Monetary Policy”. 

History

The Federal Reserve is America’s central bank, and we usually just call it the Fed. It was created under the Federal Reserve Act of 1913, not so coincidentally at the same time as the first income tax was passed into law. But let’s forget about income taxes for now. The Fed does several important jobs that aren’t related to taxes (more to come soon on this).

The Fed has 12 regional branches located in New York, Philadelphia, Dallas, St Louis, Atlanta, Kansas City, San Francisco, Richmond, Boston, Cleveland, Minneapolis, and Chicago.  Each regional branch conducts their own economic research as well as conduct surveys of businesses that are local to their region. They also produce various indexes for public use, such as Wage Tracker and GDP now out of Atlanta, the National Activity Index out of Chicago, the Manufacturing Index out of Philly, and the all-important FRED from the St. Louis Fed which tracks several dozens of categories of economic data like inflation, the 10-2 treasury spread, and defaults on all types of loans.

The Fed also acts as a clearing house for all banking transactions between banks and between bank account holders. For example, if I have a checking account with Chase and write a check to the grocery store, whose account is with Wells Fargo, the transaction passes through the Fed. I’ve left out a few steps here, but that’s the general idea.

Dual Mandate

All of these functions are very important, but the biggest thing to remember is something called the dual mandate. The Fed has the responsibility to achieve two objectives: maximum employment and stable prices.

Maximum employment, very simply, is to try to make sure the most people possible are gainfully employed. Economists agree that maximum employment is generally achieved when unemployment is below 5%. And that’s because some jobs are transient or temporary, some are seasonal, sometimes people work on contracts that expire, and some may have a job that is starting in a few weeks but they aren’t working until then. So someone could be unemployed for just a couple weeks knowing full well that they’ll be working again. And with all that and more under consideration, if unemployment is below 5%, we consider that to be maximum employment.

The other half of the dual mandate, stable prices, means that prices should remain, well, stable and unchanging. If the price of a widget is $1 today, we should expect it to be $1 after 10 years. The price remained stable. However, that is not what the Fed considers stable. As we shall see, the Fed thinks price increases of 2% per year, on average, is stable (even though it’s not).

Monetary Policy

In order for the Fed to achieve either of these two policies, it engages in something called monetary policy. According to Investopedia, monetary policy consists of the rules by which money is created and supplied into an economy. And central banks can use several different policies to do so, including interest rates, buying and selling of government bonds, regulating foreign exchange rates, and adjusting the ratio of the amount of money that banks must keep in the vault versus lending out. One thing Investopedia left out here is that the central bank can make official announcements of these policies, and the officials can give unofficial interviews in which they can say things to try to push the economy in the direction they want.

Dual Mandate Equals Dual Problems

It sounds great. Stable prices? Who doesn’t want to know what the price of dinner will be every day for the rest of their life? Maximum employment? Who doesn’t want to know that they’ll always have a job? And the business cycle? What business operator doesn’t want to see all the bumps smoothed out for him?

Now that we know what the Fed is supposed to do, let’s have a look at the problems with this idea.

Because in reality, there are some problems here. The first is that for prices to remain stable, that means prices don’t change. However, the current policy of the Fed is that prices should rise, on average, by 2% per year. And in fact, since WWII, the average rate of annual inflation is 3.1%. Now I’ve spoken about inflation in the past, and a rise in prices is actually the symptom of inflation, not inflation itself. But let’s just stick to the topic here.

In addition to the Fed wanting prices to continue to rise over time, the Fed is deathly afraid of falling prices. The Fed is so afraid of falling prices that it tries everything it can to avoid falling prices like the rest of us want to avoid fatal diseases. The Fed is convinced that people are walking around, or should be at least, and saying to themselves, “Oh my gosh, I just can’t wait for the price of chicken to go up at the grocery store! When will the price of gas go back over $3.00 already!? It’s just not expensive enough.”

But an even worse reason the Fed likes inflation is because the US government is the largest debtor in the world with over $22T of debt, and if it can consistently create a little inflation on a multi-decade basis, all that debt gets cheaper and cheaper to service and pay off. Kind of like taking a mortgage, and 15 years from now your salary went up but the mortgage payment stayed the same. The mortgage gets easier to pay. And it’s the same for the government if inflation goes up it gets easier for the government to pay back the debts they owe.

The worst part about this is that because of the way in which inflation really works, the entity who lent dollars to the government will get paid back the same dollars that were lent, but those same dollars won’t buy as much stuff as when the loan was made. And it is for this reason that you’ll hear Fed critics call inflation a tax, because like other taxes, once collected, the payer has less ability to buy stuff, and so too with inflation, the lender will eventually have less ability to buy stuff. In fact, at a rate of 3.1% per year since WWII, you daily cup of joe will cost close to $9 at the gourmet national coffee chain (in Manhattan it’s currently over $4 after tax).

The other major problem with the dual mandate of the Fed, stable prices and maximum employment, is that the two objectives can’t possibly be simultaneously achieved. If the Fed wants maximum employment, they have to engage in policies that will cause higher inflation and therefore higher prices (such as lower interest rates, printing money, and buying bonds). On the other hand if they want stable prices, they’ll have to engage in policies that cause higher unemployment (such as higher interest rates, removing money from circulation, and selling bonds or just not buying). It’s because they are mistakenly trying to achieve competing objectives that the business environment becomes so volatile.

Policy Tools

So the Fed has the ability to change policies as it sees fit. As noted above, the policy tools it can use to influence the economy are interest rates, reserve requirements, the buying and selling of government bonds, and regulating foreign exchange rates. Let’s look at these and see how they each affect the economy.

Reserve requirements, also called the reserve ratio, is the proportion of cash the bank must keep in the vault versus how much it may lend out. And in general that ratio stays at 10% of all the deposits we make in the bank have to be kept in the vault, and the other 90% may be lent out. If a bank’s customers have $1000 total on deposit, the bank may legally lend out $900 and the remaining $100 must stay in the vault

There is a big problem with this though, because as I am about to explain, a 10% reserve ratio will actually mean that if I deposit $1000 in the bank, they won’t keep $100 on hand and lend out $900. They’ll actually lend out $10,000. 

Here’s why: say I make that deposit of $1000, and then Joe Alpha borrows the $900 the bank is allowed to lend out. He keeps it in his account until he is ready to use it, but since he deposited that cash into his account, the bank will keep another $90 in the vault and lend out the remaining $810 to Johnny Beta. Now the bank has $190 in the vault and $1710 lent out, all on a $1000 deposit. Johnny Beta deposits the $810 into his account, the bank keeps $81 in the vault and lends $729 to Jamie Gamma. He then deposits the $729, the banks holds $72.90 and lends $656.10. And so on and so forth.

In fact it is not just the Fed that creates money. Every time any person or business takes a loan, that person or business creates cash in the amount of 10 times the loan amount! As if that is not bad enough, there are some deposits that the bank is not required to keep 10% on hand. Some deposits are 1% or lower, and the lower the ratio, the more money creation that happens.

The Fed can affect the amount of money in circulation by changing this reserve ratio. The lower the ratio, the more money in circulation, the more transactions will be made, and potentially the higher the inflation. The higher the ratio, the less money will be in circulation, the fewer the transactions that will be made, and potentially deflation. 

A lower reserve ratio and higher amount of money in circulation will tend to push prices higher, whereas a higher ratio and less money in circulation will tend to cause prices to fall. Also, the lower ratio may tend to cause higher employment rates in the near term, and the higher ratio will tend to cause higher unemployment rates in the near term. Again, the Fed generally keeps this ratio at 10%, though each bank has the option to keep higher amounts on reserve at its own discretion.

The second policy the Fed can use is the regulation of foreign exchange rates. This is something to pay attention to if you’re planning to vacation outside the USA or if you are importing or exporting goods to and from other countries. 

Our Fed generally allows the dollar exchange rate to float directly against all other currencies, which means that the market, not the Fed, decides how many dollars will buy 1 British Pound, 1 Euro, one Japanese Yen, or 1 Swiss Franc. On the other hand, other countries try to peg their currency to the dollar, for example the exchange rate of Hong Kong Dollars to US Dollars has been sitting at 7.75 for nearly a decade, though in recent months it has risen to 7.82 per US dollar. 

The Fed will indirectly change the exchange rate by using other policy tools that may either strengthen the dollar or weaken the dollar, depending on what it thinks is appropriate. And this is one thing that it is relatively comfortable allowing the free market to establish.

The point of the exchange rate is that as the dollar strengthens, it gets easier for Americans to buy foreign goods. As the dollar weakens it becomes pricier to buy foreign goods. For example, all else equal, let’s say I am importing toy cars from China for $1 each. Last year I could buy 6.38 Renminbi for every dollar, and I need to do that because the factory owner in China needs to be paid in Renminbi so he can pay his suppliers and workers.

This really means that while each toy car costs me $1, it also means that each toy car costs me 6.38 RMB. Well now it’s one year later and the exchange rate is $1 buys me 6.90 RMB, but the price of the toy cars is still 6.38 RMB. Last year I bought 10,000 and it cost me 63,800 RMB or $10,000. This year though, with the exchange rate in my favor as an American, it will only cost me $9246 for the same 10,000 cars (92 cents per car).

As the dollar becomes stronger against other currencies, I can keep more money in my pocket, and therefore I have the ability to make more transactions. And the opposite would be true if the dollar would weaken, it would cost more to buy the stuff we need and it will have a negative impact on prices, the economy, and employment.

The third policy tool the Fed can use is to buy government bonds. This is very simply taking money out of your right pocket and putting it into your left pocket. But when the Fed buys bonds from Treasury and investors, it sends very strong and clear signals to everyone else as well, who is either in the market to buy or in the market to sell bonds.

If the Fed buys bonds, that means there will be more demand for bonds. And if there is more demand, the price goes up. 

Remember though, as the price of a bond rises, the yield you’ll earn will fall. It works like a seesaw with the price on one side and the interest on the other; if one goes up the other must go down. So if the Fed is buying bonds, the price will rise and the yield will fall. This tells everyone that borrowing money from the bank is about to get cheaper. A LOT cheaper. So people and businesses go on a borrowing spree, which will cause unemployment to temporarily fall as people and businesses spend all that borrowed money.

On the other hand if the Fed sells its bonds, that means supply will increase, the price will fall on the added supply, and again because price and yield work like a seesaw, the yield will rise. This is a very deflationary event because borrowing money just got more expensive as the interest rates rise. As this happens, individuals and companies who are in hoc will have to pay more interest on their debt, leaving less money on hand to buy stuff or invest back into the business. And anyone who sold a bond may receive less cash than they paid for it, also leaving less in their pocket to spend.

If the Fed is selling bonds that means it thinks the economy is doing well, expanding, and creating jobs. If it is buying bonds it means it thinks the economy is weak and jobs are being lost, so it must do something to restimulate growth.

This method of influencing interest rates and the economy is not as effective as the final method, which is setting interest rates. If the Fed wants interest rates to fall and it buys bonds to do so, it may need an awfully long time period and it may need to buy more bonds than it is willing to. Plus it might miss the mark.

Instead, the last policy tool is directly manipulating interest rates, and this is perhaps the most visible tool the Fed uses. There are two rates the Fed uses to influence all other interest rates in the economy, and those are the Federal Reserve Target Rate (also referred to as the Overnight Rate), currently 2.25%-2.50%, and the Prime Rate, currently at 5.50%.

The Prime Rate is an interest rate that is used as a point of reference lending for borrowers with a prime credit rating, or borrowers with the highest likelihood of paying back a loan without any difficulties along the way because they are the lowest credit risk. For example, you might have a credit card that is set at Prime + 4%, and if that is your current situation then your actual rate right now would be 9.50%. The only real exception to this rate is that banks don’t use it when lending to each other. For that they use the Federal Reserve Target Rate.

The Target Rate, also called the Overnight Rate, is the single most important interest rate in the economy. This rate is the interest that banks charge each other when they borrow from one bank to another. So you may ask yourself, “But if banks are competing against each other for my business, why would Chase for example borrow from Citi or Wells? Wouldn’t they just be helping out the competition?” 

At a glance it doesn’t make sense. But remember when I said banks are legally required to keep a reserve, a 10% portion of their deposits must stay in the vault? Well what happens if Chase calculates it can lend out an estimated $10,000,000 today, but they overestimated and legally were only able to lend out $9M? They have to come up with that $1M to put back in the vault tonight! The easiest way to do that is to borrow from another bank, and the reward for the other bank is that they get to charge interest to Chase. After all, it’s just a loan for the lender.

The reason this is so important is because the Target Rate is the annual interest rate  banks pay one another to borrow on an overnight basis. So it’s the shortest maturity loan possible. And that means that technically it’s supposed to be the cheapest money banks can borrow. But banks aren’t in the business of borrowing money. They’re in the business of lending money at a profit. So when they borrow overnight, that represents the cost of goods sold. And they want to lend that back out to you and I and also to businesses at a higher rate of interest to make a profit. The larger the difference between their own borrowing cost versus what they can make on loans, the larger the profit they’ll potentially earn.

This is where it gets tricky. In general, the longer the term of the loan, the higher we expect the interest rate to be on the loan. That’s because it represents more risk for the bank, as a lot more can happen in the next 10 years to a borrower than can happen in the next 10 hours.

The sticky part is this. What happens if the Target Rate, which again is for loans over night, has a higher interest rate than a loan for 10 years? Normally we expect the rate to be much higher on the 10 year loan duration than the overnight duration loan, but in this scenario, the exact opposite has happened. And that means that it costs the bank more to borrow $1M than they can make on $1M.

In this scenario, the bank stops lending because they’ll actually lose money on every single loan they make. But banks aren’t in the business of losing money. They’re in the business of getting paid back at a profit on the loans they make. If there won’t be a profit they won’t lend, and as you’ve probably heard me repeat pretty often, lending is to the economy what motor oil is to your car. Without it, everything seizes up and comes to a screeching halt.

As of this writing, the rate on overnight lending between banks is targeted to 2.25%-2.50% (it’s actually sitting at 2.38%), and the 10-year treasury is 2.085%. We call this an inversion of the yield curve and it strongly portends turmoil on the horizon. The longer lending stays inverted, the more likely we are to see a recession. This is because the bond markets correctly see one of two situations. First, like I mentioned already, bank lending seizes up because banks don’t want to borrow more expensive money only to lend out less expensive loans at a loss. The second situation that bond markets correctly see as potentially playing out is that the short term situation entails much greater risk than the long term.

Truth be told, it really doesn’t matter why the yield curve inverts. Since WWII, it has not failed to forecast an upcoming recession within the following 12 months or so.

A Fifth Policy Tool?

There’s actually a fifth tool the Fed can use to try to steer all of the other 4 tools, and therefore by extension, the economy. This is telegraphing policy stance and future policy changes. This didn’t really come into use until Ben Bernanke started holding press conferences after every Fed meeting, and that’s why it’s not always mentioned as the fifth tool the Fed can use.

So what is meant by telegraphing policy stance and future policy changes?

Whenever any Fed governor or the chairman gives an official press conference and tell us, “This is what we see, and this is what we expect to do about it.” Or whenever they give an unofficial interview, for example at the annual economic policy symposium at Jackson Hole, Wyoming, at a G-20 conference, on CNBC, or any other interview they give. 

A great example would be the speeches that the Fed Chairman Jerome Powell gave today, June 19, 2019, at the Fed’s press conference, or the speeches given by Messrs. Powell and Clarida two weeks ago. They clearly opened the door to rate cuts this year, and as those words rolled off their lips two weeks ago, interest rates began to fall, the dollar weakened, and gold spiked by almost $50 in just a couple days. Today, with Mr. Powell’s remarks, bond prices rose as did gold, the dollar fell, and commodities were mixed depending if they’ll be negatively affected by recession or will weather the storm. 

That’s because everyone can anticipate the expected outcome if the Fed follows through, and if the Fed chairman is “thinking out loud” you can bet that unless something changes dramatically, we’re probably headed that direction. And it’s important to keep in mind that each public pronouncement may only have a temporary effect for a couple hours or days, but as Fed officials make more statements that are of a similar nature, it begins to build up and we can see the effects over time.

Fed Meetings

The Fed governors and other officials are accustomed to hold a regularly scheduled meeting about every 6 weeks, or 8-9 times per year. The governor of each regional Federal Reserve Bank and other officials hold meetings for two days to discuss the economy and policy. This committee is called the Federal Open Market Committee (FOMC). They are also responsible for open market operations, which is that part I mentioned about buying and selling bonds amongst other activities.

And that is what happened at the meeting they held over the last two days. At the conclusion of the meeting, Mr. Powell gave a press conference. A few points to ponder from his prepared remarks: 1) business fixed investment is soft, which means businesses are not investing as expected into plant, equipment, employees, new products, research, etc. This points to an already softening economy. 2) Inflation is running below 2%, and with a current target of 2%, that means the Fed will try to increase inflation by using some of the policy tools I’ve mentioned above.

The meat and potatoes of Powell’s statement was “uncertainties about this outlook have increased. In light of these uncertainties and muted inflation pressures, the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”

And what that all means is again, the Fed wants higher inflation. The statement seems a little contradictory by saying inflation pressures are muted and also saying inflation is nears its 2% objective. Make no mistake, indebted governments like ours want more inflation. The other key phrase is the last six words, “readings on financial and international developments.” This is key because this is the justification for the Fed to do whatever it wants, regardless of official unemployment and inflation, regardless of how strong they think they can convince us the economy is. This is the opening of the door to rate cuts this year as well as buying bonds and possibly other key measures to try to juice the economy.

I’ve said in the past, and I’ll repeat it again now. Whatever actions the Fed takes will not be enough, even though they’ll likely overdo it. In the very short term they’ll be able to stave off economic pain, but markets will quickly realize the Fed is impotent, causing most asset classes to fall quickly and decisively, including the US dollar.

That’s it for now, and thanks for reading Volume 89 of The Macro Market Wrap Up With The Mad Genius. Make sure to leave any questions or comments below. Until next time remember that there is always a bull market somewhere in the world, and on the opposite side of every crisis there always lies opportunity.

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