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Your Friend the Fed

Note: This feature length cover story by Chris McMahon originally appeared in the July 2006 issue of Futures Magazine.

New Federal Reserve Bank Chairman Ben S. Bernanke recently learned an important and difficult lesson. After telling Congress in late April the Federal Reserve Bank may pause in its campaign to raise interest rates, a move that triggered a market rally, he seemingly reversed himself when days later he told a CNBC reporter the market misunderstood his statement and added, "It's worrisome that people would look at me as dovish and not necessarily an aggressive inflation fighter." The move from inflation "dove" to inflation "hawk" caused the market to tank. During an address on financial literacy, Bernanke apologized to the Senate Banking Committee for upsetting the markets and added that in the future his comments would go through regular communications channels.

Watching an accomplished economist and scholar flounder in the spotlight might be amusing if there were not real dollars on the line; but the lesson for Bernanke and for traders is: When the Fed speaks, moves or even whispers, markets move, big time.

"People are parsing everything he says," says Robert J. Griffin, an independent trader in the Chicago Board of Trade's bond trading pit. "We've come a long way with the Fed, especially since the 1960s and '70s, when the Fed would not do anything in English," Griffin says. "Now we are just trying to interpret what they are saying rather than interpret what they are thinking."

The Fed and the markets

The impact of an interest rate change is broad, deep and long lasting. When the Fed funds rate goes up, it is generally perceived as a bearish move. Stocks typically take a hit because it will cost corporations more to borrow money. The prices of six-month bills, two-year and five-year notes will typically go down and their yields will go up. But the effect on the 10-year and the 30-year is subject to additional factors.

"That gets a little more tricky due to the longer horizon," Griffin says. "Generally speaking, that is a bearish indicator. But it could be bullish if the investment community views it as the correct move to dampen inflation in the future," he says, adding the perception of inflation is the crucial determining factor. "Hawkishness makes them more likely to hold on or buy more, and prices could rise or remain the same."

Lowering the Fed funds rate is typically perceived as a bullish move; stocks will generally rally, and the prices of the bonds and notes will typically go up and their yields will go down. It is important to know that while these changes usually have an immediate influence on the markets, the effects on the economy, manifesting in changes in the employment, manufacturing and consumption statistics take weeks, months or quarters to materialize.

The perception of the risk of inflation is key, according to Ashraf Laidi, chief currency analyst at MG Financial Group. There have now been 16 interest rate hikes since 2004. "Those rate hikes were so well communicated that the level of transparency led to lower volatility in the market. And it really made the market dependent on the Fed," he says, adding that Bernanke's admission that neither a pause nor a tightening are predetermined, and that any interest rate change would be dependent on data, will lead to greater volatility.

The Fed and the funds rate

The Fed's goal is to achieve and maintain full employment and price stability, which in translation means stoking growth while choking inflation, which it attempts by constantly calibrating an optimal Federal funds rate.

The Federal funds rate is the interest rate that member banks charge each other for overnight lending; banks occasionally need to borrow short-term cash, to fulfill reserve requirements for example, and the Federal funds rate directly affects the interest rates the banks set for mortgages, auto loans, credit cards, other consumer loans, the prime lending rate and business loans.

The Fed has three tools at its disposal to achieve that optimal rate to stoke growth and choke inflation: open market operations, the discount window rate and setting member bank reserve requirements.

Open market operations involve the buying and selling of government securities (Treasury coupons, notes and bonds) in the open market. The Fed buys U.S. government securities from member banks (repurchases or repos), putting more cash into their hands. More available money in the hands of banks and other lending institutions tends to drive interest rates down, known as "loosening." Conversely, the Fed can sell government securities to remove money from the banking system (matched sales), taking money out of the hands of banks. Less money available to banks and other lending institutions tends to drive interest rates up, known as "tightening."

The discount window rate is set by the board of governors and is the interest rate the Fed charges member banks to borrow money. There are three of them: the primary credit rate, the rate the Fed charges member banks that are in "sound financial condition" for short-term loans; secondary credit rate for loans to meet short-term liquidity requirements or to weather financial problems; and seasonal credit, which the Fed extends to small banks with fluctuating liquidity, such as agricultural institutions. Borrowing at the discount window is more expensive than borrowing at the Fed funds rate and is a relatively rare occurrence. Member banks will typically try to borrow money from each other before resorting to borrowing from the Fed to avoid scaring depositors.

Reserve requirements are the minimums banks are required to keep, in cash, in their Federal Reserve District Bank to cover loans. By decreasing reserve requirements, the Fed frees cash for the banks to loan out, thereby driving interest rates lower. Conversely, increasing reserve requirements would tighten the money supply and drive rates up. This is the tool used least frequently by the Fed. Paul A. Volcker was the last Fed chief to swing this hammer, which he did to quell stagflation, an economic condition characterized by a period of low growth or recession (stagnation) coupled with high inflation.

Meetings, minutes & testimony

Another tactic the Fed employs in its effort to set the Fed funds rate is actually communicating its intentions to the public and announcing the target Federal funds rate (as of May 30, 2006 the target rate was 5%; the actual monthly average to date was 4.94%). As simple as that may sound, the Fed has only been announcing the target rate since 1995. Despite former Fed chief Greenspan's reputation for convoluted messages to the markets, he is largely responsible for radically increasing transparency at the Fed.

The chairman of the Federal Reserve testifies before Congress twice a year, in February and July, and delivers the Monetary Policy Report. These are referred to Humphrey-Hawkins testimony, and were required by the Full Employment and Balanced Growth Act of 1978, which was sponsored by Minnesota Sen. Hubert Humphrey and California Rep. Augustus Freeman Hawkins. The act required the FOMC chairman to report twice per year to Congress on monetary policy and the state of the economy. It expired in 2000, but the Fed continues to deliver the report and testimony in February and July.

In the testimony and report, the chairman recounts the findings of the board of governors and the district Feds, and describes the status of the U.S. economy and the forces at work upon it, such as the lingering impact of last year's hurricanes in the Gulf of Mexico. The Fed is also likely to address the U.S. gross domestic product and inflation, and discuss the context of other economic indicators, such as orders for capital goods, initial jobless claims, homebuilder sentiment, retail sales, the bond market and the consumer price index.

In addition to the testimony and reports, the FOMC meets eight times per year to set and announce the Fed funds rate. Changes are announced in the early afternoon and the minutes of the prior meeting are reviewed, approved and released several days later. Just as any adjustment of the Fed funds rate has the power to move markets, so does the release of the prior meeting's minutes, which traders dissect, looking for the inclusion, omission or repetition of language that provides clues to what direction the Fed is leaning. Traders pore over these releases for the color commentary behind the decisions and because the minutes include the members votes.

Each of the 12 Federal Reserve Districts submits its findings on current economic conditions and gathers impressions and stories from bank officials, regional business leaders, economists and other sources. The findings are released in the "Summary of Commentary on Current Economic Conditions," which is known as the Beige Book. The particular value of the Beige Book is the regional focus, which offers deeper insight into specific sectors of the economy.

All of these addresses, testimonies and reports are intended to lower market volatility by providing greater insight into the Fed's moves and diminishing surprises. But despite Bernanke's resume, the change in leadership entails some uncertainty. "If there is this anything to be learned from the Fed statements, it is that they are not meant to be long-term and they are not forward-looking. Their time horizon is as far as the next meeting," Laidi says.

Note: This feature length cover story by Chris McMahon originally appeared in the July 2006 issue of Futures Magazine.

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