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December 31, 2003 THE FEDERAL RESERVE SYSTEM In recent years, the Fed has almost reached the cult status: Inflation slayer, recession causer, neither or both…will the real Fed show itself? Changes in the Discount Rate have similarly taken on an aura that can at times cause a furor on Wall Street but at other times, it causes hardly a stir. Names like William McChesney Martin, Arthur Burns, Paul Volcker, and Allan Greenspan have approached near celebrity status, at least in the communities of economics and finance. This issue of the Newsletter will examine the Fed from many angles and from an historical perspective. Can it really do what many say it can? How does it attempt to impact the financial system and the economy? How has its modus operandi changed over time? Has it out lived its usefulness? These questions have been asked before and continue to be asked. WHO IS THE FED? The two major components of the Fed as an organization are the Board of Governors and the 12 Federal Reserve District Banks. The most important group within the Fed is the Federal Open Market Committee (FOMC). The FOMC voting contingent consists of the seven Governors of the Federal Reserve Board: Alan Greenspan, Chairman Roger W. Ferguson, Jr., Vice Chairman Edward M. Gramlich Susan Schmidt Bies Mark W. Olson Ben S. Bernanke Donald L. Kohn …and five of the Presidents of the twelve Federal Reserve District Banks (four of the five rotate on regular basis): Cathy E. Minehan, Federal Reserve Bank of Boston Timothy F. Geithner, New York (Vice Chairman: FOMC) - NY has a permanent, voting position on the open market committee) Anthony M. Santomero, Philadelphia Sandra Pianalto, Cleveland J. Alfred Broaddus, Jr., Richmond Jack Guynn, Atlanta Michael H. Moskow, Chicago William Poole, St. Louis Gary H. Stern, Minneapolis Thomas M. Hoenig, Kansas City Robert D. McTeer, Jr., Dallas Robert T. Parry, San Francisco (from the Board of Governors Federal Reserve System - December 12, 2003) See the following link for an explanation of the Fed’s function…In Plain English - St. Louis Fed). The Governors are nominated by the president and confirmed by the Senate. One of the Governors is appointed as Chairman of the Federal Reserve Board of Governors for a 4 year term that begins in the mid term of the Presidential term an and ends at mid term of a president 4 years later. The Governors are nominated by the President and confirmed by the Senate for 14-year terms or to fill out a term of an exiting Governor. If appointed to a full term, that Governor cannot be re-appointed for another consecutive term. If filling out a term of a former Governor, then that appointee can serve for another 14-year term. A tri-partite group representing the financial, and business communities, and the public elect the District Bank Presidents at large. They are neither appointed by the President of the United States nor confirmed by the Senate. These nineteen people (twelve voting) make up the Federal Open Market Committee that meets about every six weeks throughout the year. While much of what the Fed does is fairly mundane, such as supervision and regulation, keeping the currency money of the system in a useable condition by destroying the portion that wears out and reissuing new replacements, acting as the fiscal agent of the United States Government, its most prominent role to the press and the public is its role as the monetary authority. This is the role on which we shall focus. The Fed is mandated by a significant number of laws to achieve a number of economic and financial outcomes. Among these are high employment, price stability, orderly markets, etc. It is up to the Fed to prioritize them at various times. For example, in the 1970s in order to keep unemployment relatively low, it pretty much ignored the fight against inflation and then in the spring of 1980, reversed field and fought inflation that was approaching 20% at an annual rate and crushed the economy with a very restrictive policy actions that saw the unemployment approach 10% as a result. When the market infrequently suffers a severe collapse, the Fed will typically focus on establishing order once again before resuming a policy they had been pursuing. Since the policy/goals mandated through congressional legislation over a period of several decades are often at odds with one another, the achievement of one goal (such as fighting inflation) often results in the inability to achieve other goals. The Fed, via the FOMC, chooses from the various menus of goals. How does the Fed influence the economy? Very indirectly is the answer, much more so that the public even realizes. With the exception of the Discount Rate, the Fed does NOT administratively set interest rates. They do, however, influence them through impacting the supply and demand for credit. Their influence is primarily in the short-term end of the maturity spectrum and wanes considerably as the maturity grows…more of this later. The most overwhelmingly important tool the Fed employs currently is the open market operation function, where they buy and sell securities in the open market through a couple of dozen independent dealers. Open market activities are centered at the Federal Reserve Bank of New York. This influences the supply of credit, particularly in the short-term end of the financial markets. The role of open market operations has gradually replaced the use of the Discount rate because the Fed controls the legal reserves of depository institutions. More remotely, the monetary base which includes these legal reserves (plus currency in circulation), through open market operations as opposed to days of yore where the legal reserves of depository institutions (formerly only commercial banks) by lending the legal reserve to depository institutions. Over the years the role of the discount window facility has shrunk and been replaced by a growing reliance on open market operations to control the monetary base and the quantity of legal reserves. The Fed controls money and a good deal of credit creation by controlling the legal reserves of depository institutions and their minimal relationship to checkable deposits (and credit created by these institutions). This minimal relationship between legal reserves and the money and credit depository institutions can create is called the legal reserve ratio. Like the discount window facility, it was used more frequently in past years but in recent times has been left fairly dormant as the Fed rarely changes these ratios anymore. Similarly, the use of the discount window has been relegated to supplying legal reserves for seasonal demand and, if a run on a depository appears to be occurring, to supply it with reserves it has lost, if the Fed deems it good for the system. This has relegated changes in the discount rate to a symbolic importance having virtually no operational impact on the system. This is the case since such a small portion of total legal reserves flow to the depository institution system through the discount window as compared open market operations. BASIC UNDERSTANDING OF MONEY AND CREDIT CREATION Nearly a decade ago, Prof. Byrne designed picture of how money is related to wealth. It has appeared in his text, FINANCIAL ECONOMICS, for several years. It is reproduced here for the reader. Money has two general meanings. First, its broad meaning is that money is a set of assets the store wealth in a very liquid manner. Its second meaning is that money is anything generally acceptable as a medium of exchange. These are the most liquid assets of all. In this nation, the Fed defines the two types of measure. M-1 has traditionally meant the medium of exchange. M-2, M-3, L or liquidity, M-4, M-5, M-1 a, M-1b have been some of the designations given money especially as a liquid store of value. The composition changes over time. At one time years ago, gold coins and gold certificates were included but have not for many years now. The current designation for money as a medium of exchange is M-1. It is composed of three elements: currency, checkable deposits, and non-bank travelers’ checks. The last of the three is so small, it is often ignored. Nearly 99% of M-1 is either currency or checkable deposits. If we divide the economy into the underground economy (in pursuit of indictable activities including tax evasion) and the above ground economy or legitimate economy, which money as a medium of exchange is dominant, if radically different? While currency is roughly one-third of M-1 money and checkable deposits about two thirds, nearly 100% of the transactions in the underground or illegitimate economy is facilitated by currency while the corresponding figure in the legitimate or above ground is nearly 5%. A major part of the currency component of M-1 serves as the preferred currency in places like Cuba, Russia, etc., where local currencies evoke little faith in their ability to hold value. Currency consists of coins and paper money, nearly all of which are Federal Reserve Bank notes. While the coins are heavy, they are swamped in dollar value by the Federal Reserve notes. Checkable deposits consist of demand deposit, negotiable orders of withdrawal (NOW accounts), share drafts at credit unions and ATS or automatic transfer accounts (zero balance checking accounts attached to a savings account. Just below is a breakdown of the components of M-1 along with those of M-2 and M-3. Until a short while ago, L or liquidity was also published but has been discontinued. Text Box: Figure 3.2 (From Financial Economics, D. Byrne) The Various Definitions of Money H.6 Money Stock Measures (M-1) · Consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) travelers checks of nonbank issuers; (3) demand deposits at all commercial banks other than those due to depository institutions, the U.S. government, and foreign banks and official institutions, less cash items in the process of collection and Federal Reserve floa;t and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts and demand deposits at thrift institutions. Seasonally adjusted M1 is calculated by summing currency, travelers’ checks, demand deposits, and OCDs, each seasonally adjusted separately. (M-2) · Consists of M1 plus savings deposits (including money market deposit accounts), small-denomination time deposits (time deposits-including retail RPs-in amounts of less than $100,000), and balances in retail money market mutual funds. Excludes individual retirement account (IRA) and Keogh balances at depository institutions and money market funds. Seasonally adjusted M2 is computed by summing savings deposits, small denomination time deposits, and retail money fund balances, each seasonally adjusted separately, and adding this result to seasonally adjusted M1. (M-3) · Consists of M2 plus large-denomination time deposits (in amounts of $100,000 or more), balances in institutional money funds, RP liabilities (overnight and term) issued by all depository institutions, and Eurodollars (overnight and term) held by U.S. residents at foreign branches of U.S. banks worldwide and at all banking offices in the United Kingdom and Canada. Excludes amounts held by depository institutions, the U.S. government, money funds, and foreign banks and official institutions. Seasonally adjusted M3 is calculated by summing large time deposits, institutional money fund balances, RP liabilities, and Eurodollars, each adjusted separately, and adding this result to seasonally adjusted M2. (from the Board of Governors Federal Reserve System - December 12, 2003) It is critical to understand the overwhelmingly dominant role that checkable deposits play in the legitimate economy. It is also critical to understand those checkable deposits, your checking accounts, are short-term liabilities of depository institutions, commercial banks, savings banks, savings and loan associations, and credit unions. What most people do not understand is that checkable deposits are created by depository institutions when they create credit. Since the dominant form of M-1 money consists of checkable deposits, it means that the private sector creates M-1 money for the legitimate part of the economy and the Federal Government. The checkable deposit money is created by private sector depository institutions in the process of creating credit. That is, the private sector depository institutions create a liability on themselves, swapping it for the financial claims the borrowers’ offer, usually some for of note payable which to the depository such as a bank is a note receivable. The borrower and the depository swap debt and M-1 money in the form of checkable deposits is created as well as credit being created. MONETARY THEORY AND ITS INFLUENCE ON MONETARY POLICY When the Federal Open Market Committee makes decisions about monetary policy, it is not done in an intellectual vacuum. The nineteen members of the FOMC come from a variety of backgrounds and are often bearers of economic orientations that in various ways are inconsistent with one another. Some are monetarists, a few reflect the Austrian tradition, and some are of the Keynesian tradition. Many analysts are eclectic. Lord Keynes in his General Theory back in the middle 1930s spoke of contemporary politicians basing their policies and arguments on theorems of long-dead economists. In the bottom of the economic decline that began in 1999, at least two members of the FOMC suggested even tighter monetary constraint to avoid inflation that would occur since the monetary aggregates were growing too rapidly. This is the argument of monetarists. One member of the FOMC spoke of malinvestment, a term very much related to the Austrian theory of the business cycle. In the next issue of this newsletter, we will devote a portion of that newsletter to a survey of the "schools of thought" for want of a better term, that influence the decisions of the policy makers. We will scrutinize these arguments in the light of the New Paradigm, which increasingly makes these arguments, though very relevant in past times, increasingly irrelevant to the evolving economic landscape. There have been claims and counter claims that the Fed mistakenly caused the economic downturn that ended with the recession of 2001. In the very first issue of this newsletter, the editors argued that the economic downturn which began in 1999 and culminated in the recession of 2001 was primarily the result of several years of a rising ratios of federal taxes (receipts) to GDP, a very large trade deficit resulting from an overvalued dollar and also beginning in 1999, a monetary policy change that brought to the economy, monetary restraint. All three contributed to bringing an economy that was growing at a real growth rate of over 7% in 1999, to a trough of a negative 1.3% annual rate in 2001. The large trade deficits began in the early 1980s, the increasing tax burden in the early 1990s while the monetary restraint occurred in 1999-2000. There is plenty of blame to go around. A former Treasury official takes the credit for influencing upward federal taxes as the cause of declining inflation but does not seem to connect that reasoning to the economic collapse beginning in 1999. No credit for eliminating inflation is given to increasing competition, which is the most fundamental cause of the elimination of the inflationary bias. The trade deficit is rarely mentioned as an eventual co-cause of the economic slowdown. Now criticism of the Fed’s role is receiving more press. Federal tax cuts, a depreciating dollar in foreign exchange markets (is easing the trade deficit), and the FOMC - now assuming an accommodative stance (brushing aside fears of inflation as the economy begins to expand at very high real rates), are all contributing to the current vigorous economic expansion. Productivity gains have been great and large numbers of highly skilled and experienced laborers are ready to be called back to new jobs after becoming structurally unemployed. Structurally unemployed individuals represent a rising percentage of total unemployed - even though the unemployment rate is falling. This reinforces the assertion that a fall in the unemployment rate is a lagging indicator of economic recovery/expansion. …a bit more on the Deficits and Unemployment With 2003 winding to a close, the concerns over the economy have switched from whether or not this recovery is for real, to whether or not the price paid for this recovery and expansion are too great. In this issue of the newsletter we have had three "Letters to the Editor" all basically asking if this is in fact not the case. We have purposely avoided delving into the arena of political economy, choosing instead to address issues from an objective viewpoint. Rather than opine, we instead draw data from easily identified and verifiable basic sources, encouraging the reader to digest this information and draw their own conclusions. While we strive to explain in a straightforward manner, economics tends to be a complicated discipline, requiring patience and an open mind to formulate informed analysis. It’s easily discerned and readily understood that many people, rather than explore these areas difficult to understand, would prefer instead to politicize issues, labeling all-comers as either liberal or conservative. The problem, of course, is that while this seems to satisfy some irrational longing to oversimplify and obviate, it does nothing toward shedding light on very complicated, yet absolutely essential aspect of our every day lives. Fiscal Deficit We’ve indicated that the fiscal deficit is likely to surpass $400 billion for 2003, and will likely reach higher levels in 2004 and 2005. We’ve stated unequivocally in previous issues that high levels of government receipts (a.k.a., taxes), coupled with reduced government spending contributed significantly to government surpluses. The downside was that the increase in government receipts put a great deal of stress on the economy and we believe contributed greatly to thrusting the U.S. into recession in 2001 (with the downturn beginning much earlier on - even as early as 1999). Given that we have now embarked on a fiscal policy targeting tax reductions and higher government spending to wage war on terrorism, among other agenda items, what are the prospects for actually reigning in the expanding deficit? How long until we turn the corner and once again experience lower deficits, or even surpluses? What will happen to the projected fiscal deficit of $450 Billion in 2004 if…? · Real GDP grows 5.5% annually on average over the next ten years. · Government spending increases 3% annually on average over the next ten years. · By the end of 2013, the fiscal deficit should be nearly zero… · Continuing at the same rates, by the end of 2023, the surplus should be in the range of $1 Trillion. With the Current Account Deficit likely to be at around $530 Billion for 2003 (the trade deficit will probably come in at $450 - $480 Billion), there is ample reason for concern. On a good note, the dollar has depreciated by nearly 15% since the beginning of 2003. In spite of the locomotive effect (increased imports) associated with an expanding economy, it’s likely that the Current Account Deficit will shrink to under $450 Billion for 2004, and drop even further as exports continue to pick up and a depreciating dollar will cause imports to become more costly. Unemployment Further good news on the unemployment front for 2004… 2003 has been a year where productivity has sky rocketed to levels not seen in twenty years, corporate profits are up and the need for an infusion of labor will encourage employers to once again begin hiring to meet increasing demand. Structural unemployment issues, brought on by persistent cost pressures have forced employers to be more cautious in hiring back workers, but rational decision making should net gains in the employment picture, bringing the unemployment roles down well below the current 5.9% rate. Typically at year-end, employers are unwilling to bring on new workers as their primary goal is to protect their profits. This year, however, has seen new jobless claims drop significantly and steadily, even in late December. While a bit early to say definitively, this increased activity in the labor markets should carry well into 2004. According to the Conference Board, the index of Help Wanted Advertising ticked up to 39 in November 2003 moving from a rather anemic 37, where it had been since August 2003.