LUTZ BUSINESS INSIGHTS
“Ultimately, cynicism is a poor substitute for critical thought and constructive action.” – Ben Bernanke – June 2, 2013
The Federal Reserve was created in 1913, when President Woodrow Wilson signed the Federal Reserve Act into law. While the Fed has many general responsibilities, its main one is to maintain the stability of the financial system and contain systemic risk that may arise in our financial markets. Janet Yellen continues this tricky task today as the Chair of the US Federal Reserve.
The Federal Reserve has used significant latitude in recent years to deal with the risks of the financial system that were most pervasive in 2008 and 2009. Many of the steps taken have no historical precedent. The conspiracy theorists and cynics alike have painted the Federal Reserve as being at the best, too accommodative, or at worst the impetus of our eventual economic demise.
It’s easy to be cynical of an entity that truly yields great power over the world’s economy, but sometimes difficult to understand the rationale for the actions taken and ramifications thereof. Naysayers are quick to say the Fed has inflated the stock market because of quantitative easing, and a market crash is coming when it ends (as the Fed just announced this could be as soon as October). These critics are much less apt to dive into the numbers and understand the organics of quantitative easing.
To understand quantitative easing, you have to begin with the nation’s banking system in 2008. When Lehman Brothers collapsed, questions arose about the health of other banks. At that time the inter-bank lending market came to a standstill. Banks with excess liquidity, that previously lent funds overnight to other banks, hoarded cash and refused to lend to any bank that had the slightest hint of insolvency. Instead of return on their cash, they were worried about return of their cash. Couple this with the fact that consumers were now running to pull deposits from banks based on fear, the banks were in more need of liquidity than ever.
Typically banks access short-term cash in two ways, via the fed funds market as previously described, or directly from the Fed’s discount window. The Fed maintains both rates, the fed funds rate through the use of open market operations, and the discount rate by directly charging the banks. Historically if a bank borrowed from the Fed, it was viewed as a sign of trouble/weakness for the borrowing bank as the Fed was deemed lender of last resort. Beginning in 2008, the Fed recognized this and offered banks loans of up to 90-days and reduced the discount rate to 0.50%. They lowered the target fed funds rate to 0.25%, or virtually to zero. They tried to take the stigma away to encourage the banks to maintain liquidity.
With more banks using the discount window, the Fed had to attract money from the other banks that had excess cash. They embarked on an unprecedented action in 2008 by offering to pay interest on excess bank reserves of 0.25%. Essentially they paid banks interest to deposit money at the Fed. Banks had historically held their required reserves at the Fed earning no interest, but banks could now be paid interest for holding both required and excess reserves. This seemed innocuous at the time, but for capital reasons and for the fact that it paid the same rate as Fed funds, it was an attractive alternative for the banks. While this seems to be an ancillary event, it has had large ramifications on the Fed’s ability to quantitatively ease.
Cynics quickly snipe that the Fed has recklessly printed money to pay for bond purchases which have swelled their assets to over $4.3 trillion as of July of 2014. Prior to the crisis, the Fed’s assets were just above $800 billion. However, one must take the time to look at the other side of the balance sheet to understand the true impact.
Since the Fed began paying interest on excess reserves, reserve deposits by banks at the Fed have jumped to more than $2.6 trillion. You can see this in the graph below from the Fed’s website. The other two lines are currency in circulation and the US Treasury’s balances at Fed.
Source: http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm 7/14/2014
Why is this important? It’s important because a more thorough look at what the Fed has done shows that it isn’t printing all of the money to pay for quantitative easing. What they are doing is using bank reserves that the banks are not lending to purchase mortgage backed and Treasury notes. The Fed is essentially saying, if the banks aren’t going to lend it, we’ll put this excess cash to work for them.
So what does this mean for the markets and for the economy? This is an unprecedented step the Fed has taken. Simple economics would assume that banks will remove some of the excess reserves and lend them to customers when they are willing to justify greater risk to generate greater return. For a couple of reasons, capital and risk, those funds may be used by banks to purchase the same bonds the Fed may or may not be selling.
The balancing act the Fed has to do comes into play when there is a quick demand for reserves; at which point the Fed will have to sell off assets to compensate for lost deposits, or increase interest rates to tempt the banks to keep the funds on hand. So far, they haven’t had the need to do either. The Fed could also sell assets as the banks take back their reserves. Currently, the Fed doesn’t have to do any of this and could keep this balance sheet at these levels. Thus, they will continue to walk the fine line of maintaining stability of the economy and keeping the systemic risk at bay.
Taking a critical and thoughtful look uncovers that the Fed is not simply printing money, but mostly using money that is already in the system that banks are not putting to work. Someone who looks at this exercise at face value may misunderstand and deem it reckless, but it is just another tool that the Fed has used over the past 100 years to reduce systemic risk and promote economic stability. Based on the Fed’s track record for most of its history, we probably should give them the benefit of the doubt.
Important Disclosure Information
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.
ABOUT THE AUTHOR
JUSTIN VOSSEN, CFP® + INVESTMENT ADVISER, PRINCIPAL
Justin Vossen is an Investment Adviser and Principal at Lutz Financial with over 20 years of relevant experience. He specializes in wealth management and financial planning.
AREAS OF FOCUS
- Financial Planning
- Wealth Management
AFFILIATIONS AND CREDENTIALS
- Certified Financial Planner™
- Financial Planning Association, Member
- BSBA in Economics and Finance, Creighton University, Omaha, NE
- St. Augustine Indian Mission, Board Member
- Nebraska Elementary and Secondary School Finance Authority, Board Member
- St. Patrick's Church, Trustee
- March of Dimes Nebraska, Past Board Member
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- An Investor's Year-End Wrap Up & Tax Prep
- Nobody Knows Anything
- Add "Brexit" to the Long List of Uncertainty
- Financial Planning for College Grads
- Fight or Flight - Lesson Learned
- Social Security: The New Rules
- Putting Volatility in Context
- The Asian and European Fronts
- Bubble Looming or a Bubble Popped
- Re-Emerging Markets?
- A Market Perspective
- Timing is Not Everything
- "Yellen" at the Fed
- Mind What Matters...Focus Efforts On What You Can Control
- What to do With a Financial Windfall
- Love Indexes - Hate the Indexes
- Do I Own a Market?
- A Practical Primer On Volatility
- 5 Retirement Strategies for Small Business Owners
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