The Federal Reserve System

Understanding the Federal Reserve:

The Federal Reserve (FED) sets interest rates, regulates large banks, tries to control inflation, and oversees the US economy.  Investors watch the Federal Reserve Board meetings for changes in interest rates set by the Federal Open Market Committee and its board of governor’s statements to determine how the economy is performing.  This influences the stock market to go up or down when the Fed changes rates or changes the statement.  When interest rates go up generally the stock market and fixed income investments go down and when interest rates go down the stock market and fixed income investments usually go up.  If the governor’s statement indicates they are going to change rates in the future, it can influence the market even though they don’t change the interest rates at the board meeting.

Some Federal Reserve Policies – their Effect on the Stock Market and Economy:

Generally the Fed does a good job of regulating the banks, setting rates and managing the economy.  However like anybody they wind up getting it wrong and create one hell of a mess.  In fact they have created recessions like in the early eighties when interest rates went to 26%.  The Federal Reserve set interest rates too high and created more inflation and created one of the worst economic situations in the last 50 years.  To illustrate what happened I attended a Management of Accounting Practice seminar in the late ’80s and for some reason which I have forgotten we started discussing what the federal reserve did in the early ’80s.

This was the consensus in the room of what the Fed’s policies caused:

  1. It resulted in the stock market declining by over 50%.
  2. It resulted in a higher rate of inflation, all of us had advised our clients to raise their rates when they charged customers because their interest costs had gone up.  No one indicated that any of their clients reduced the rates they charged their customers after interest rates declined.
  3. Most people in the room said they laid off employees because of a reduction in their business and the majority of their clients did the same thing.
  4. It forced most of our clients in construction-related businesses to radically reduce their operations or go out of business.
  5. It increased future inflation because a lot of the experienced construction people and companies were no longer in business.  In many other industries experienced people were laid off or the business was closed.
  6. Most people thought this was the worst government mistake since the Vietnam War.

Once Fed discount rates go to 5% or more, you are generally going to see a recession and a declining stock market. On the other hand, once Fed discount rates go under three percent as they did in the early 2000’s you run the risk of a bubble and a major recession like we had in 2008.

There were many things that occurred during the subprime mortgage crisis that was beyond the Fed’s control.  In my opinion, Paulson, Bernanke, and Geithner deserve a medal for the handling of the subprime mortgage crisis, it was the Fed’s finest hour.  It cost the federal government $250 billion in the Resolution trust fiasco in the early 1990s while the federal government actually made money on the subprime mortgage crisis investments in the financial industry.

As an investor you need to watch the Fed’s actions very closely, see Federal Reserve Funds for more information when you start your investment plan, or if you invest in preferred stock.

What should the Federal Reserve do with the Coronavirus Outbreak and Oil Price Shock?

Understanding what the Federal Reserve has done to the stock market over the last 10 years and what it will cause the Economy and the Stock Market to do in the future.  The low-interest rates have made the stock market, bonds, houses, and commercial property to become overvalued and now that the Coronavirus is affecting the markets lowering interest rates will not work.  So decreasing interest rates will only increase damage to the stock market because it will increase prices while earnings and Price-Earnings Ratios decrease faster because the prices are higher at the beginning of this downturn and once the fear index-VIX Index increases it will make the downturn worse in dollar terms.  The FED has helped make this the biggest disaster since the Federal Reserve raised interest rates in 1982, see information above.  The Federal Reserve should have started raising interest rates in 2012 and kept them around 3% since that time.

The market would not have been near as high if interest rates were higher and of course the losses would have been a lot less.  The FED should not be decreasing interest rates to keep the stock market up rather it should keep the economy on an even keel and growing moderately by lowering rates that have helped destabilize mortgage, bond and stock markets.  I have been investing for 60 years and the stock market is going to do what earnings do over the longer-term with fear and greed being the most important thing in the short term, not what people want the market to do.

The Fed needs to understand what is happening with Baby Boomers and older Americans, who hold about 60% to 70% of all the assets in their retirement and personal holdings.  This is why interest rates should be at least 2% as soon as possible or the velocity of money is going way down and we will wind up in a situation similar to the 1930s, where people are going to lower their spending dramatically.

 

What the FED should do:

  1. Raise Federal Fund rates by 1 1/2 % to 2% to give banks, individuals, and other interest lenders additional earnings to offset future bad debts.  The current interest rates do not give lenders the necessary income to compensate for the risks involved.
  2. The FED needs to make 5 to 10 trillion dollars in liquidity to bond, money market, mortgage, and treasury markets.
  3. Raise minimum margin to 75% and maintenance t0 50%.
  4. Work with other Federal Entities to support the stock market, see below.

What Federal Entities need to do:

  1. Stop short selling, give existing shorts two weeks to cover shorts.  This should reduce up and down days for the Dow from 1,000 to 2,000 points to 300 to 600 points.
  2. Extend all bank and SBA corporate and mortgage debt and interest payments for 6 months to businesses that are impacted because of oil prices and coronavirus interruptions.
  3. Extend all mortgage payments for 6 months for employees laid off because of oil prices and coronavirus interruptions.
  4. Extending unemployment insurance to 9 months for all employees laid off because of oil prices and coronavirus interruptions.
  5. Set up a separate Federal fund administered by the Social Security Agency to pay for coronavirus health payments at medicare rates for uninsured US citizens.
  6. Set tariffs on oil at $40 a barrel, less what WTI is selling at for a barrel of oil on all imports of oil when it enters the US, (For example, if WTI is selling at $22 then the tariff would be $40 – $22 or $18).  This should result in WTI selling around $40 a barrel because we need to import oil once the coronavirus ends and the oil price should rise to around $40.
  7. Set up a Coronavirus Resolution Trust to handle all debt and property that the Federal Government obtains through its guarantees of various asset classes.

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