A Fisher Investments Primer on the Fed

The Fed. It gets heaps of attention, with pundits often acting as if its moves are key to the economy and stocks’ fortunes. We agree the Fed plays an important role, but in Fisher Investments’ view, investors often overrate its ability to affect the economy. To understand why, let us explore how the Fed works.

Congress established the Fed in 1913 with the primary task of serving as lender of last resort in a crisis. The idea was to prevent the string of bank panics that plagued the US economy throughout the 19th century, culminating in the Panic of 1907. Without formal backstops during that crisis of bank runs and bankruptcies, it fell to J.P. Morgan and his fellow bankers to inject their wealth into the banking system to shore up confidence. Introducing the Fed as lender of last resort, theoretically, would give depositors confidence that the bank would be able to repay them, staving off a run. When the Fed hasn’t abdicated this role, it has largely worked as intended.

The Fed’s other main task was—and remains—overseeing the country’s monetary policy, primarily through setting interest rates and reserve requirements. In 2008, it added long-term bond purchases, known as quantitative easing (QE), to its arsenal. When monetary policy proved subject to political manipulation, Congress passed 1978’s Humphrey-Hawkins Act, which created the Fed’s dual mandate of targeting stable prices and maximum employment. That bill didn’t set an official permanent inflation target, as it was more concerned with goading the Fed into addressing the late-1970s’ severe inflation. Therefore, to aid transparency, the Fed set a formal inflation target of 2.0% y/y—based on the Personal Consumption Expenditures Price Index—in 2012. After chronically undershooting that for nearly a decade, it changed to targeting an “average” rate of 2.0% y/y but didn’t specify over which timeframe it would calculate the average, making it a target without much meaning, in our view.

The Fed also gained more regulatory powers after the 2007 – 2009 financial crisis. 2010’s Dodd-Frank Wall Street Reform and Consumer Protection Act created the Financial Stability Oversight Council—a panel of financial regulators including the Treasury Secretary and Fed head—responsible for monitoring financial stability risks and strengthening regulatory capital requirements. Dodd-Frank also created a Vice Chair position for financial supervision. Lastly, it made permanent annual stress testing on the US bank system—determining whether banks must raise regulatory capital and whether they can conduct share buybacks or pay dividends—a requirement. More recently, the Fed has faced calls to incorporate more and more climate and other sociological responsibilities. But these efforts are young, not clearly defined and may simply be symbolic.

The Fed’s main day-to-day job, outside of a crisis, is to steer monetary policy. The goal is to adjust financial conditions to keep money supply growing fast enough to enable economic growth—and hence, employment, but not so fast that the economy overheats and drives fast inflation. The US has a fractional reserve system, which means banks create most new money through lending. Therefore, the Fed’s policies generally aim to speed or slow loan growth, depending on whether they are trying to support economic growth or rein in inflation. Before 2008, when QE caused banks to amass large stores of excess reserves, one effective tool was adjusting the reserve requirement ratio (RRR, the minimum amount of cash a bank holds in reserve as a percentage of its liabilities) to raise or reduce the funds available to lend. Cutting the RRR enabled more lending, while raising it would force banks to tighten. For an extreme example of this, see 1937, when the Fed’s decision to double the RRR caused a severe monetary contraction, driving that decade’s second recession.

The Fed’s primary policy tools today are its interest rates: the discount rate, the fed-funds target rate and the interest rate on reserve balances (IORB), which recently replaced the interest rate on excess reserves. The discount rate is the rate at which banks borrow money from the Fed overnight. The fed-funds rate is the target rate at which banks borrow from one another at anywhere from overnight to three months or so. Since 2008, the Fed has set this as a range with a lower and upper bound. The IORB, which usually sits within the fed-funds target range, is the rate banks receive on reserves deposited at the Fed. Its main purpose is to put a floor under the fed-funds rate when the Fed is tightening, as it removes the incentive for banks to undercut the official rate.

In theory, reducing rates makes money cheaper and more plentiful, while raising them reduces liquidity. Yet Fisher Investments’ research finds there isn’t a precise relationship between policy rates and money supply growth or velocity, as banks’ borrowing costs aren’t the only driver of loan growth. Long-term interest rates, which are market-set, also play a large role. The gap between short- and long-term rates is vital, in Fisher Investments’ view. Banks borrow short term to lend at long-term rates, so the gap is a proxy for their future loans’ profitability. The Fed can also use these rates to boost liquidity in a crisis. One easy tool, which the Fed hasn’t used in the past two recessions, is to reduce the discount rate below the fed-funds rate. This enables banks to borrow more cheaply from the Fed and then lend to other financial institutions for a small profit. This both adds money to the financial system and gets it moving. In our view, had the Fed used this strategy during 2007 – 2009’s downturn, it could have helped ease the liquidity crisis that plagued financial institutions.

In short, the Fed has a lot of levers it can pull, but Fisher Investments thinks it is important to keep measured expectations about its influence. People often talk about the Fed as if it can fine-tune the economy by pulling its policy levers, but Fisher Investments finds raising interest rates a bit here or cutting them a tad there doesn’t have a massive effect. We think you can see this two ways. First, from a bank’s point of view. When the Fed increases the cost of banks’ funding by half a point, banks probably won’t immediately stop borrowing, especially if long-term interest rates remain sufficiently high to make lending profitable. Second, think through this scenario from a business’s perspective. If borrowing costs are below the expected return on a new investment, that project likely makes business sense. But that margin shouldn’t be so slim that small rate moves upend that. In general, if a half-point increase in borrowing costs can render a project unprofitable, then it was probably a marginal investment at best and likely wouldn’t have gotten the green light regardless. In Fisher Investments’ view, it takes much bigger Fed moves to meaningfully alter most businesses’ risk and return calculations.

With that said, we don’t dismiss the risk of Fed error. Indeed, Fisher Investments thinks the Fed has often caused recession by mismanaging monetary policy—letting the economy overheat and then overreacting in the effort to contain the resulting inflation. We think this is why Milton Friedman once quipped that replacing the Fed with a computer that ensured a steady, predictable money supply increase over time would yield much better results. We agree! But alas, ending boom and bust has always been a pipe dream, so we must deal with the Fed. Keep an eye out for massive errors, as this could presage a market inflection point, but otherwise, don’t overthink small monetary policy wiggles. They rarely have a large enough impact on money supply growth to have a meaningful impact on the economic growth rate.

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