Morgan Stanley
“Between a Rock and a Hard Place”
September 2016
The Harbor Oak Group
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The View express herein are those of the author and do not necessarily reflects the view of Morgan Stanley or its affiliates. Printed
9/9/2016
Remember when the majority of folks had no idea who was running the Federal Reserve? Sure,
most people probably remember Paul Volcker, but how about Arthur Burns or even William
Martin? Nowadays it seems like people are flipping back and forth between Keeping up with
the Kardashians and CNBC as they anxiously wait to hear what particular adjective Janet Yellen
or Stanley Fischer use to discuss the potential for a quarter of one percent interest rate
increase.
Established by Alexander Hamilton in 1791, The Federal Reserve was originally called the First
Bank of the United States. This was met with great opposition as many believed this would give
the federal government too much power. Thomas Jefferson once stated “If the American
people ever allow private banks to control the issue of their currency, first by inflation, then by
deflation, the banks…will deprive the people of all property until their children wake-up
homeless on the continent their fathers conquered…The issuing power should be taken from
the banks and restored to the people, to whom it properly belongs.” (FYI, he was referring to
the Federal Reserve Bank). *
Congress failed to renew the First Bank’s Charter and it closed in 1811. Four years later, they
tried again with the Second Bank of the United States, only to close in 1836. After the financial
panic of 1907, Congress decided to take another crack at central banking and in 1913,
Woodrow Wilson signed the Federal Reserve Act which created the Federal Reserve as we
know today. I guess they were a little weary about calling it the Third Bank of the United
States. *
The primary role of the Federal Reserve Bank is to oversee the U.S. banking and financial
systems. The Federal Open Market Committee (FOMC), a committee within the Federal
Reserve, is responsible for the nation’s monetary policy. Put simply, they control inflation or
deflation by raising or lowering interest rates.
Contrary to popular belief, the Fed doesn’t just push a button and interest rates move up or
down. It’s slightly more complicated than that. The FOMC only controls two lending rates - the
discount rate and the federal funds rate, sometimes called the overnight rate. The discount rate
is the rate banks can borrow directly from the Federal Reserve and the fed funds rate is the
interest rate that banks charge each other for overnight lending. Every financial institution is
required to keep a certain amount of cash at the Federal Reserve and at the end of each day if a
bank is short the requirement, they will simply borrow from another institution.
Now, to raise or lower the fed funds rate, the FOMC must first set their target rate and then
attempt to control the money supply by purchasing or selling US treasuries to or from these
financial institutions. So if the FOMC wants to reduce interest rates, they simply buy U.S.
Treasuries which in turn gives the banks more cash to circulate and the fed funds rate moves
lower. Conversely, when they want to raise rates they sell US treasuries which in turn removes
cash from circulation and the fed funds rate moves up.
During 2008, the fed funds rate was reduced from 4.5% to 0% in order to stabilize the struggling
economy. But after rates were at zero, the FOMC had to go with plan B. They began buying
record amounts of treasuries and government related bonds from financial institutions to inject
more and more cash in to the economy, called quantitative easing (QE). During this period the
Federal Reserve purchased close to 3 trillion dollars’ worth of treasuries and government
related bonds and as of December 2015, the Federal Reserve’s balance sheet was listed at 4.48
trillion. (The media would lead you to think that China is the largest holder of US debt but that
is incorrect; it’s actually the Federal Reserve.)**
The good news about having this inflated balance sheet is the Fed receives interest on most of
these assets. In 2015, the net income for the Federal Reserve was $99 billion and $101 billion
in 2014. That’s good news for the U.S. taxpayer as the Fed is required to remit this profit to the
U.S. Treasury at the end of each year. **
So why is the Fed stuck between a rock and a hard place? Well we all know that when interest
rates go up, bond prices fall. So when the Fed raises interest rates the price of all these bonds
they have purchased will start to go down in value. This shouldn’t be a problem for the first
several interest rate hikes as the interest they receive will offset the losses, but eventually that
$99 billion profit could turn into a deficit. I can see it now…Janet Yellen trying to explain to
Congress why the taxpayer is responsible for making up the Federal Reserve’s losses as they
unwind this monetary experiment.
In a perfect world, the Fed could just keep these assets on their balance sheet until they
mature. At that point, the money goes back to the U.S. Treasury and everything’s good. But
keep in mind; if they want to bring rates back to normal, say 4.5%, then they will have to
aggressively sell these bonds to do so. This is why you hear Janet Yellen often talk about the
trajectory of rates; they are buying time.
To add to this problem, in 2008 the Fed decided to start paying interest on the amount of cash
held at the Federal Reserve that is in excess of the reserve requirement for each financial
institution. This is referred to as excess reserves. The interest rate is currently set at .50% but
moves in tandem with the fed funds rate. So if the Fed decides to raise rates they will also have
to pay more interest on excess reserves. The current amount held in excess reserves is around
2.3 trillion. So if the Fed increases rates by just .25% the interest they pay on excess reserves
increases by 5.7 billion, just another incentive to keep rates lower for longer. **
Long story short- If people would just keep watching the Kardashians and focus more on the
Fed’s financial statements, it would be clear that rates are likely to remain low for some time
Mike Anderson
Gray Howard
Vice President
Associate Vice President
Portfolio Manager
Senior Portfolio Manager
Financial Advisor
Financial Advisor
Chartered Retirement
[email protected]
Planning Counselor
[email protected]
Mike Hicks
Financial Advisor
Financial Planning Specialist
[email protected]
Tiffany Sims
Registered Associate
[email protected]
*federalreserveeducation.org, August 29, 2016
**Federal Reserve.gov, August 2016
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