Even the most casual of stock
market observers must be aware of the pervasive influence the
Federal Reserve Bank can and does have on stock price movement
by virtue of its control of monetary policy. Although one of the
tools of the Federal Reserve system is the ability to alter
margin rates, the Fed has dropped this as a policy tool and
works almost exclusively through its ability to influence
interest rate movements.
As has also been widely reported,
the Fed's deliberations on what policy initiatives to adopt are
closely linked with the central bank's concerns about the
prospects for inflationary pressures to rebuild in the economy.
What is the relationship between interest rates and inflation
and why does something that seems to be largely a capital market
issue, matter to the stock market?
The answer lies firstly, in
properly understanding what an interest rate is. Most people
think of money as simply a medium of exchange that came into
existence in ancient times as a means of facilitating trade.
People used to barter merchandise to obtain their needs. This
system became increasingly unwieldy and merchants and bankers
banded together to create transferable certificates that
represented available quantities of merchandise. This eventually
turned into what we today refer to as money or currency.
But money itself is also a
commodity. Although we generally think of money in terms of what
we can purchase with it, the fact is that if we do not need it
at present we can give it to someone else who may need it. If it
is a friend of relative, we may not give compensation a second
thought and expect to get back no more than we lent. However, in
a business environment we may feel we are entitled to something
of value in return.
If we were in the car rental
business, we would impose a daily fee for the use of the car,
plus extra charges for insurance, gasoline usage etc. Someone
who is in the money business, in effect rents out money and
expects some fee in return as well. This fee is what is called
the interest rate.
Specifically, when renting a car,
the agency charges a rate it believes covers all its costs and
in addition provides a profit component. The renter is also
required to buy insurance or have coverage from another dealer,
to protect against damage.
When borrowing money, the
borrower is also expected to pay a rate that will cover the
lender for any possible damages or "wear and tear,"
plus some profit. In the vernacular, these components are
referred to as the inflation premium and credit risk. The
greater the threat of inflation and the more risk the lender
accepts if the borrower has some history of not repaying
promptly or fully, the higher the interest rate premium will
have to be.
There is a rule of thumb in
banking circles (although not universally accepted) that the
"real cost of money" is about 3.0%, with anything
above this rate representing the inflation and risk premiums.
The inflation premium is
necessary to maintain the lenders purchasing power. If the rate
of inflation is running at five percent a year, what is really
happening is that the value of the money is depreciating at a
rate of five percent a year. What cost $1.00 the first year,
sells for $1.05 the following year.
When lending money, the lender in
effect says I need to receive five cents on every dollar just to
keep my purchasing power stable. Beyond this, he will want to
earn a bit of a profit, which the "rule of thumb"
estimates to be about 3.0%. Accordingly, if the long-term rate
of inflation is perceived to be about 5.0%, then we would assume
long-term rates to be in the vicinity of 8.0%.
Inflation is not a phenomenon
that just bursts undetected on the scene one morning. It is
usually the result of economic conditions that have been
festering for a period of time, without being checked or
countered. The Federal Reserve Board, mindful of the economic
toll the prolonged period of double-digit inflation had on the
U.S. economy in the 1970’s, has determined that preventing a
repeat of this cycle is one of its primary responsibilities.
There are several ways that
inflation comes into being. One is when a shortage exists in a
desired product. The available supply may be rationed through
price increases. Another method of inflation is provided by
rising costs of the components of a product. When oil prices
rise very rapidly, products or services that are very dependent
on energy will command higher prices to compensate for this
increased costs.
When fuel costs soar, airlines
need to charge more for tickets to counter their much higher
fuel bills. If labor is in short supply, workers may demand
higher salaries to keep producing goods or providing services.
These costs must be passed along to the consumer if the provider
is to maintain a reasonable profit margin on his services. To
the extent the consumer is forced to pay more for a product or
service without obtaining any incremental benefits, the increase
is inflationary.
If, however, the higher costs are
offset by some improvement in the product then the cost increase
may be warranted. If auto manufacturers raise prices for their
vehicles by several hundred dollars the increase would be
inflationary if there were no commensurate benefit in the new
vehicles. However, if the manufacturer includes in the base
price accessories that previously were charged for separately,
the higher cost may not be deemed inflationary.
Historically, inflation was
described as being caused either by "wage push" or
"demand pull." With various international cartels in a
position to artificially influence the costs of some raw
materials, such as OPEC’s role in the oil market, there can be
inflationary pressures that are outside the traditional
channels.
The net effect of inflation on
the consumer, is to rob him of purchasing power. There is always
some inflation going on in a growing economy. When the increase
is moderate, the consumer is usually able to offset the effect
through wage increases. This generally allows him to keep pace
and hopefully even keep a little bit ahead of the trend.
At other times, wages alone do
not provide adequate relief and the consumer may have to find
ways around this that can enable him to maintain a certain
standard of living or consumption pattern. One method is through
a simple process of substitution. In one form or another,
everybody practices this on occasion. If one goes into a store
for a Hershey chocolate bar and they are sold out, the Nestle
bar may make an acceptable alternative. Similarly if the price
of coffee were to spike higher, some consumers may elect to
substitute another beverage such as tea. To the extent
substitution is an alternative, the effect of inflation can be
mitigated. If enough consumers are able to switch products, such
activities may even be able to bring down the price of the
particular product by leaving the producer with unsold
merchandise.
However, such efforts to repel
inflation or mute its impact, are not always successful or even
feasible. To the extent that they are regarded as threatening to
the economy, they may call for more drastic action. This could
take the form of an organized boycott of a particular good or
service if it was felt that this could bring about a price
rollback.
If the threat of inflation is
more widespread or runs the risk of causing more severe damage
to the economy, the Federal Reserve Bank may find itself
compelled to take action to thwart this prospect.
MONETARY
POLICY
The Federal Reserve Bank is
charged with managing the nation's monetary policy. In broad
terms, this relates to controlling the amount of money in the
economy and thereby granting it considerable influence in the
setting of interest rates. In addition to the aforementioned
impact inflation can have on interest rates, by raising the
inflation premium; the Fed too can have an impact by increasing
or decreasing the availability of money for lending purposes.
Working through the nation's
banking system, the Federal Reserve controls the amount of
reserves within the banking system, which in effect, affects the
ability of the banking system to lend money. If money is readily
available, it is seen as encouraging business to spend more on
new products, acquisitions, raw materials and labor. This in
turn is seen as encouraging some upward movement in prices to
pay for these expenditures. As expectations increase throughout
the economic system, everybody wants to share in what is
perceived as the new found wealth. If at the same time the
government seeks to participate in all this by spending beyond
its means, namely raising the deficit, and the Fed acquiesces by
monetizing the debt. This monetization may initially lower rates
by making more money available. But before long the market will
realize the seeds of another inflationary spiral are being sown
and before long rates will be heading higher.
The Fed, therefore, has to walk a
very tight line between making credit too available, and
fostering inflation on the one hand, and being too stingy, and
causing an economic slowdown, on the other.
There are several tools available
to the Fed to manage the money supply and credit. The most
common, used almost every business day, is the intervention by
the Fed's operating arm, the Open Market Desk, in the money
market. The desk enters the market almost every day to arrange
Repo or Reverse Repo. In simple terms, this operation involved
either the purchase or sale of debt by the Fed from or to its
dealer network, on a temporary basis.
When it buys securities (arranges
a repo), the Fed in effect provides the banking system with
short-term money which increase its reserves, and allows its to
lend more money or conversely borrow less. When it arranges
reverse repo, or matched sale, is sells securities to the
dealers forcing them to get more money to pay the Fed for
securities, thereby draining reserves and firming interest
rates.
The Fed also controls the levels
of required reserves, pegs the discount window rate and
determines how much margin investors are allowed for securities
transactions. However, these are rarely altered and most are
utilized mainly when the Fed desires to bring about a
fundamental change in the economic outlook, not fine tune a well
performing engine.
When we read in the paper that
the Federal Reserve is expected to tighten monetary policy, or
raise rates, at it next FOMC meeting, what is meant is that the
central bankers have decided to provide less credit in the form
of reserves to the banking system. This in turn drives up the
price (interest rate) for Federal Funds, which are essentially
excess reserves that banks trade among themselves.
Banks are required to maintain
reserves on all their deposits. Every Wednesday they are
required to balance their books and prove they have adequate
reserves. Usually the large money center banks operate very
efficiently and employ all their deposits to the fullest extent
permissible. Sometimes they run over and are short reserves. At
the same time smaller country banks almost always have excess
reserves because they operate less efficiently or in markets
that are less active. These banks can lend their excess reserves
to the money center banks through the Federal Funds Market. The
Fed's requirement is that the banking system as a whole be in
reserve balance.
When the Fed operates to make
less reserves available, it in effects constrains banks from
lending. This in turn leads to higher interest rates as a means
for rationing the available credit. The higher rates should
cancel some borrowing plans, in effect slowing the economy
enough to wring out some inflationary expectations. While this
may sound like a bit of a "Catch-22" situation, it is
rather a system of cause and effect with more expensive money,
namely higher interest rates, serving to undercut growth efforts
and visa versa.
