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What the Fed's Actions ForetellDr Richard
Appel The past few years witnessed the orchestration of United States interest rates to their lowest levels in over 40 years. This was the result of the Federal Reserve's effort to reverse the mounting economic decline that our country was enduring. Economic deterioration began to unfold during the latter part of 2000, and was exacerbated a year later by the aftermath of 9/11. We have heard and read that the Fed will continue to suppress interest rates until after the November elections, in their desire to support the reelection of President Bush. However, I believe that their real reason is to prevent the economy from relapsing into the recession that the recent interest rate cuts have to date successfully averted. After a sharp decline, 2002 saw our economy appear to enter a period of expansion. The economic stimulation created by the lower interest rate environment was later augmented by the enormous level of home refinancing that they fostered. This, when homeowners used the money that they acquired from refinancing their homes, to making various purchases. Unfortunately, recent evidence is appearing that indicates that our short respite from a protracted economic decline, may have ended. Employment figures have begun to weaken and corporate earnings are beginning to disappoint the market. Also, the Purchasing Manager's Index fell from its May level of 68, to 56.4 in June. Further, economists are becoming concerned by the numerous earning projection reductions. This has accompanied a waning level of investment by what appears to be an increasing number of technology companies, as well as a fall-off in orders for non-defense capital items. Added to this is the troubling sudden slowdown in employment combined with a retrenchment in hourly salaries, and the recently announced 1.1% decline in retail sales. All of this does not mean that a resumption of the 2000-2002 recession is about to occur. However, to me it indicates that a near term increase in interest rates is virtually out of the question if the Fed has any say in the matter. Time and again since the late 1930's, whenever our economy entered a recession the Federal Reserve System did two things. It injected new dollar credits into the economy and it reduced general interest rates by lowering the discount rate, and more recently its federal funds rate. As an aside, it is amazing how few people seem to recognize the subtle change, and its enormous significance, that the Fed made to one of its most important, historical methods of effecting monetary policy changes. In the old days, prior to the past few years, the discount rate was altered by the Fed whenever they desired to either stimulate or restrain the economy. The discount rate is the overnight lending rate that member Federal Reserve banks pay when they borrow directly from the Federal Reserve Bank. This was typically done when the banks required capital to meet their daily reserve requirements. It was the primary interest rate upon which all other domestic rates were predicated. Originally, it was known as the rediscount rate, but later underwent a name change and became known as the discount rate. The federal funds rate normally traded between about 0.25% and 0.50% above the discount rate. This was raised to about 0.50% and 0.75% or higher a number of years ago, when profit margins universally rose throughout the banking industry. The federal funds rate is the overnight rate charged between banks when they borrow from one another. However, at about the same time that our nation entered its first 21st century economic malaise, a strange thing occurred. The Federal Reserve changed the requirements for borrowing at the Fed's window, when they sharply raised the discount rate to a level above the federal funds rate. Additionally, they also began to verbally focus on the federal funds rate rather than the discount rate, when they discussed their effort to influence interest rates. To me their reasons seemed obvious, but for some reason few recognized the implications of their new directive. When the Fed shifted their emphasis from managing the discount rate to the federal funds rate, they immediately bought themselves added leeway and time. They believed that this would help them in their fight to ward off the approaching recession that they obviously foresaw. The reason that I state this is it gave them an extra 0.50% or so of latitude in cutting interest rates. For example, if the discount rate was at 1% and the federal funds rate was at 1.50%, under the old targeting of the discount rate they could only reduce the country's base rate by 1% before reaching zero. However, by focusing on the higher federal fund rate of 1.50%, they could effectively reduce rates by an additional 0.50%. In effect, the discount rate lost its importance. Further, it literally coerced the member Federal Reserve banks into acquiring their temporarily needed funds from one another, due to the new higher cost of borrowing from the Fed itself. To my mind this change was promulgated in order to take some of the pressure off of the Fed and to shift it to the banks, in the event that problems arose that threatened the integrity of the banking system. This may appear complicated but ponder the brilliance behind this change. Returning to the theme of this essay, since the Great Depression, the Fed was successful in reversing all earlier recessions. They accomplished this by simultaneously flooding the banking system with newly created dollars and fostering lower interest rates. This worked in every instance in the past and, I believe, will remain their first choice of action in their effort to achieve similar future ends. The reduction in interest rates removed pressure from both individuals and companies by allowing the borrowers to retain a larger portion of their cash inflows. This, in turn, helped them continue purchasing goods and services and allowed them to carry themselves through the economic downturns. Increasing the money supply made money more readily available for loans, the proceeds of which were spent on goods and services, as well as to help strengthen the banking system. Conversely, each time that the economy subsequently arose from a recession and gathered strength, the Fed was faced with the appearance of various levels of inflation. Their degrees varied, but were normally dependent upon the level of inflating that the Fed had engendered, in their effort to reverse the earlier economic malaise. Just as they lowered interest rates and flooded the banking system to overcome a recession, the Federal Reserve proceeded to increase interest rates, and contract the money supply as best that they could, to control inflation. The Fed attacked inflation by sufficiently increasing interest rates, which raised the monthly loan payments and thereby reduced the cash flows of our nation's citizenry, to dampen the demand for loans. This reduced the purchasing capacity of our nation's businesses and households, choked off inflation, and caused the economy to falter. Prior to the late1970's, the reduction in the money supply worked well to help reduce loan demand and to reverse the inflationary tides. Later, during the past few decades, the Fed resorted to primarily relying on raising interest rates in overcoming inflation. This resulted from their fear of throwing the economy back into a recession if they pressed too hard on the monetary brakes. In effect, as Richard Russell (Dow Theory Letters, La Jolla, California) has stated for decades, our nation was forced to either "inflate or die." As discussed above, increasing signs of a return to recession are beginning to appear. I believe that Alan Greenspan and the Federal Reserve are well aware of the damaging potential to our economy and way of life if a severe recession occurs. They recognize in that event, that the unprecedented amount of outstanding business and private debt will act as an anchor around the necks of our country's citizens and companies. For this reason, I believe that further Fed sponsored increases in our country's interest rates are out of the question in the short term. What Fed signs should we watch for to determine the economy's future directions? It's all in the short term interest rate targets of the Fed! Only if the Federal Reserve is successful in generating a sustained economic recovery will they allow interest rates to rise! For me, the first sign that they have achieved this end will be seen in a series of Fed sanctioned federal fund rate hikes. In this event, the Fed will be loudly announcing that they believe that they have successfully overcome the recession and that their new focus will be directed to reversing the inflation that they know will be unfolding. Conversely, if the Fed reverses
course and further reduces interest rates, it will indicate that
they fear that the economy will resumes its earlier recessionary
decline. This may prove tragic! Despite the additional 0.50%
or so of breathing room that they achieved by targeting the federal
funds rate rather than the discount rate, they only have 1.25
points remaining before they reach zero and their ability to
further lower rates is exhausted. This gives them little maneuvering
room! Further, they may feel compelled to act as Fed governor
Ben Bernanke suggested on November 21, 2002, before the National
Economists Club in Washington, D.C. When discussing how the Fed
could cure deflation he said, "But the U.S. government has
a technology, called a printing press (or, today, its electronic
equivalent), that allows it to produce as many U.S. dollars as
it wishes at essentially no cost." I truly hope that it
doesn't come to that! If it does, we may suffer a similar fate
as did so many other nations when their governments damaged the
value of their currencies. I publish Financial Insights. It is a monthly newsletter in which I discuss gold, the financial markets, as well as various junior resource stocks that I believe offer great price appreciation potential. Please visit my website www.financialinsights.org where you will be able to view previous issues of Financial Insights, as well as the companies that I am presently following. You will also be able to learn about me and about a special subscription offer. CAVEAT I expect to have positions in many of the stocks that I discuss in these letters, and I will always disclose them to you. In essence, I will be putting my money where my mouth is! However, if this troubles you please avoid those that I own! I will attempt wherever possible, to offer stocks that I believe will allow my subscribers to participate without unduly affecting the stock price. It is my desire for my subscribers to purchase their stock as cheaply as possible. I would also suggest to beginning purchasers of these stocks, the following: always place limit orders when making purchases. If you don't, you run the risk of paying too much because you may inadvertently and unnecessarily raise the price. It may take a little patience, but in the long run you will save yourself a significant sum of money. In order to have a chance for success in this market, you must spread your risk among several companies. To that end, you should divide your available risk money into equal increments. These are all specula-tions! Never invest any money in these stocks that you could not afford to lose all of. Please call the companies regularly. They are controlling your investments. FINANCIAL INSIGHTS
is written and published by Dr. Richard Appel and is made available
for informational purposes only. Dr. Appel pledges to disclose
if he directly or indirectly has a position in any of the securities
mentioned. He will make every effort to obtain information from
sources believed to be reliable, but its accuracy and completeness
cannot be guaranteed. Dr. Appel encourages your letters and emails,
but cannot respond personally. Be assured that all letters will
be read and considered for response in future letters. It is
in your best interest to contact any company in which you consider
investing, regarding their financial statements and corporate
information. Further, you should thoroughly research and consult
with a professional investment advisor before making any equity
investments. Use of any information contained herein is at the
risk of the reader without responsibility on our part. Past performance
does not guarantee future results. Dr. Appel does not purport
to offer personalized investment advice and is not a registered
investment advisor. The information herein may contain forward-looking
information within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of
1934. In accordance with the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995, the statements contained
herein that look forward in time, which include everything other
than historical information, involve risks and uncertainties
that may affect the company's actual results of operations. ©
2004 by Dr. Richard S. Appel. All rights are reserved. Parts
of the above may be reproduced in context, for inclusion in other
publications if the publisher's name and address are also included
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