Paul Vangilder

The Federal Reserve

HISTORY

• Created on December 23, 1913 in response to a century of banking panics

• Lender of Last Resort• Dual Mandate–Maximum Employment– Price Stability

• Recently assumed increased regulatory duties

STRUCTURE

• 13 Regional Fed Banks• Headquartered in DC

• New York Fed• Largest and most

influential bank• Conducts open

market operations• Vault holds 216

million troy ounces of gold

MONETARY POLICY• 3 Main Tools– Reserve Requirement

• Proportion of demand deposits a bank must hold on reserve at Fed

• Lower Reserve Requirement: Stimulative– Allows banks to make more loans

• Raise Reserve Requirement– Banks forced to keep more on reserve at Fed– Leads to less loans

– Discount Window• Short-term, secured lending facility that banks can

borrow from• Raise Rate-Contractionary Policy• Lower Rate-Stimulative

– Open Market Operations

OPEN MARKET OPERATIONS• FOMC Committee determines Open Market

Operations– Chairman Ben Bernanke and 9 other Members– Eight meetings per year – Announcements on policy highly anticipated by Wall Street

• Fed Buys short-term government bonds – Stimulative– Lowers interest rates– Increases money supply

• Fed Sells short-term government bonds– Contractionary– Raises interest rates– Decreases money supply

MSU Student Investment Association 5

OPEN MARKET OPERATIONS• Fed Funds Rate

– Overnight lending between banks– Currently 0-0.25%, intended to “stimulate” economy

• Recently Announced it will be 0% through 2014– Buy short-term bonds to lower rate

• Increases liquidity in banking system– Sells short-term bonds to raise Fed Funds rate

• Decreases liquidity

• Large Scale Asset Purchases (QE) beginning 2008– Fed buys long-term government bonds as

opposed to just short-term

HISTORICAL FED FUNDS RATE

QUANTITATIVE EASING• QE1 November 2008 to Spring 2010– Fed Purchased:• $125 Billion in Agency Debt (Fannie/Freddie

and Treasuries)• $1.25 Trillion in Mortgage Backed Securities

(MBS)• Objective: Stimulate the economy, lower

interest rates, and fight deflation• Shadow Objectives

– Support solvency of the banking system– Devalue the dollar to boost exports– Drove stock market rally from March ‘09 to April ‘10

QE2• Summer 2010

– S&P 500 down 10%– GDP Growth Sub 2%– Fears of “Deflation” resurface

• Bernanke informally announces QE2 at August 2010 Jackson Hole Speech

• QE2 Formally begins November 2010– To last through June 2011– Fed purchased 4-6 billion in US Treasury securities per

day– $600 Billion in total– 100% monetization of debt issuance from the Treasury

QE’S EFFECT ON MARKETS

• S&P 500 rises from 666 to over 1200 during QE1

• S&P 500 rises to multi year highs of 1,363 during QE2

• Inflation Rises– Oil up to $135/barrel in April 2011– Gold Reaches all-time highs– Tremendous pressure on emerging

market inflation

FED BALANCE SHEET VS S&P 500

OPERATION TWIST

• Shift Duration of Fed’s Treasury portfolio– Fed will sell $400 Billion in 0-3

Treasuries– Buy $400 Billion in 6-30 Treasuries– Designed to lower long-term interest

rates

“BERNANKE PUT”• Put Option

– Contract that insures an investor against loss• Derived from “Greenspan Put”

– Fed Chairman 1986-2006– Met every distress in financial markets with lower

interest rates and more liquidity• QE provides temporary relief to structural

economic problems– Pattern:

• Economic problems resurface shortly after QE ends• Seen in Summer 2010 and August-September 2011

FED AND VOLATILITY• August 2011 Fed Meeting-No QE3• Dow down 200 points immediately• Rallied over 600 points to finish up over 4%

QE3?• Key metrics to watch to provide

political will for QE3– S&P 500~sub 1100–WTI Crude oil~sub $80– EUR/USD continues to fall

• Dollar strength not good for short-term exports• Structure of QE3– Bill Gross: $600 Billion of MBS Purchases– Others: Nominal GDP Targeting