If you have ever visited Washington D.C. you know there are plenty of must see destinations. Unless you plan an extensive visit or go many times, you will need to pick a few of the sites most important to you and regretfully bypass the rest. Crowded along the two and a half mile strip of grass known as the National Mall are monuments to almost every conceivable artifact of American history. Statues of men you’ve never heard of. Museums of art and war. Buildings of stone and steel. Even a visit to one place such as the famous Smithsonian Air and Space Museum can be a full day. There’s even a museum of the Bible. There’s no way you can see it all.
You might start at the East end for a visit to the Supreme Court and Capital buildings on their adjacent grounds. Being inside the capitol dome is an awe inspiring experience all by itself. You might move west from there down Constitution Avenue to peer between the bars of the wrought iron fence surrounding the White House. It’s a curious feeling to think how bars so thin can separate men between vastly different worlds. From there you might go on down to the banks of the Potomac and stand in the cool shade of the Lincoln Memorial. It’s a place that is quiet and pensive, like the man enshrined there.
In all your wanderings and thoughtful gazing, there is one place not likely to make even the top 20 on your list. Yet it is one of the great, if not the greatest economically important places on the planet. Perhaps you’ll miss it because the building itself is not eye-catching. Though grand in its own right, it is an intentionally understated design. Perhaps you’ll miss it because one of your stops is just across the street at the Vietnam memorial, a place even more somber than the Arlington Cemetery. Lost in your reverie as you trace the thousands of names etched on that black granite, it might not occur to you to turn around and glance across the park, across the street, across another yard, to see a building of contrasting color. It is made of white Georgian Marble and was standing there for four and a half decades before the Vietnam Memorial was built. It is known as the Eccles building, home of the Federal Reserve.
The Federal Reserve, known colloquially as “the Fed” is an institution commissioned by Congress to oversee and regulate the banking system of the United States. Originally conceived in 1913 as a way to solve liquidity problems in the commercial banking world, its role has gradually expanded to encompass outright management of the economy and of equity markets. Let’s take a peek inside those marble walls and see what we can learn.
A Need for Stability
By the early 1900’s, it was becoming clear to lawmakers that something needed to be done to stabilize the banking system, and by extension, the economy of the United States. Several attempts at creating a central bank, dating all the way back to George Washington’s time, had already been tried and eventually abandoned. At that time, gold was still considered true money, but paper currency as a redeemable substitute was in common circulation as well. What was happening on an all too regular basis, was people in regions around the country beginning to worry about the viability of their bank, and demanding either gold in exchange for their cash or simply wanting to withdraw all their cash from their accounts.
For as long as banks and paper currency have been around, banks have used a system called “fractional reserve lending” as a means of issuing loans and generating profit. Basically, a bank would put its own reserves of gold in a vault, and lend paper currency in its place. However, they were not limited to lending only the value equivalent to their reserves. They might lend out anywhere from twice as much or even up to five or ten times as much currency as they had reserves on hand. In this way, they were able to compound their interest returns by leveraging their own reserves. There is only one practical limit to this scheme. It is called risk. You see, if you issue $1,000 between twenty people in cash loans against $100 of your own gold reserves, everyone is happy until three of them show up at the bank at the same time wanting to convert their $50 to gold. Remember, this was the days of redeemable cash, so anyone holding cash had the right to show up at his bank asking to convert it to gold. If too many people showed up at the bank at the same time wanting to convert to gold, the bank would become illiquid and be forced to close its doors. This is known as a bank run. A bank’s calculation on how much it might leverage its reserves is a bet. On the one hand, a bank wants as much return as possible on its limited reserves. On the other hand, if it leverages those reserves too much, it runs a higher and higher risk of an unexpected draw on its reserves which it cannot service. A bank must weigh its risks against the stability of the economy and the confidence of its patrons in its own management. In the modern world, of course there is no redeemability for gold, but the same concept applies, only substituting digital Federal “reserves” for physical gold.
Pre central bank, the problem of bank runs kept recurring in different regions around the country depending on the local economy and local bank practices. The goal in creating a central bank was to eliminate regional or local bank panics by providing a central reserve depository that all banks could both draw and borrow from, thus eliminating the limitations of local liquidity. Effectively, it is the banker’s bank.
The governing body of the Federal Reserve is made up of individuals who are the heads of the regional Federal Reserve banks stationed at major cities around the nation. These governors convene at regular intervals in Washington D.C. to set policy that will be enacted by the members.
Purpose of the Federal Reserve
At the beginning, the mandates for the Federal Reserve were somewhat straightforward. The regional banks served as depositories for the commercial banks within their region, meaning that each bank could deposit their extra reserves of gold or cash in the vaults of their Federal Reserve branch where it was safer than in their own vaults. In addition, these Federal banks could provide extra liquidity in various forms to individual banks who needed it and who met minimum criteria. Just as an individual who wants to borrow from a commercial bank must demonstrate their creditworthiness, a commercial bank is also limited by its own management history on how much “help” it can get from the Federal Bank. This is how it became known as the banker’s bank. The Federal Reserve was also given the responsibility to be the depository for the Federal government. This function was previously held by the Treasury but was now partitioned as a separate function by this new institution. The Treasury collects taxes. The Federal Reserve is the bank where they keep the money.
Another part of their mandate is setting interest rates. Previous to the Fed charter, interest rates were set by the market. Interest rates went up and down based on the supply vs. demand for available money and might vary wildly from region to region. After the Fed was created, it was tasked with setting the base interest rate. Since every bank now (more or less) had the same ability to borrow reserves from the Fed at the same rate, unevenness of supply and demand were eliminated, thus standardizing interest rates nationwide. Commercial banks still had the freedom to mark up interest rates above the benchmark rate per their own policy, but since every bank had close to the same rate at which they could borrow, competition eliminated large variations except at the margins. The interest-rate-setting part of the Federal Reserve is hugely important to the national economy, and easily the most visible part of their job. Bankers, stock brokers, corporations, and journalists, all stop what they are doing when the Federal Reserve chairman steps to the podium to announce the most recent “guidance” on where interest rates are headed. There are whole institutions dedicated to guessing ahead of time what their decisions might be. Some of the guessing is very sophisticated. Some less so. During Alan Greenspan’s tenure as Fed chairman, someone noticed there might be a correlation between how thick or thin his binder was as he walked up to the podium to whether interest rate policy would go up or down. There were equity traders literally buying or selling stock in the seconds before he started speaking based on how thick his folder was. It was ludicrous and Greenspan himself said so, but in the world of high finance with razor thin margins, everyone looks for any kind of an edge, ludicrous or not.
And yet, as important as interest rate policy is, the Fed has another duty more weighty still. It is the creation or destruction of dollar reserves. Here again, in the beginning, this was somewhat straightforward since dollars were redeemable for its gold. The Fed had the same ability to fractionally lend against its gold that commercial banks did, but had little incentive to do so. It was much more in line with their “price stability” mandate to supply enough currency to meet demand and no more. The tie to a physical commodity was a short tether and left little room for imaginative policy. Today that constraint is a distant memory, and with it, true conservative monetary policy. Once gold was removed by the Nixon administration as the reserve asset, the role of the Fed changed from custodian to creator. The implications can hardly be overstated. Now, instead of the dollar being a note issued against collateral, it became the collateral. Instead of representing an underlying asset, it became the asset. Instead of being limited by physical reality, the Fed became almost unlimited. Almost. But not quite. Today, the Federal Reserve is tasked with a vast array of responsibilities, but perhaps the most important is the creation and destruction of money.
Creation of Money
Like any regular business, the Fed has a balance sheet which must balance. If you or I buy a tractor for our farm, the value of that tractor goes on our balance sheet as an asset. Offsetting that is the reduction in cash or the increase in liability in the form of a loan. When the transaction is finished, our balance sheet still balances, and we understand it did not change its overall size. If we exchange $100,000 in cash for a tractor, we did not increase our balance sheet, only traded one asset for another. Only profit can actually grow our balance sheet.
But for Jerome Powell, the current Fed chairman, there is one big difference. He can create or destroy his own reserves (money) and grow or shrink his balance sheet at will. And why, you might ask, would he do that? Good question with two answers.
First, in order to fulfill its mandate for managing the economy, the Fed wants to control how “hot” (or not) the economy is. Interest rates, as mentioned, are an important and intuitive tool for that. Increasing or shrinking its own balance sheet is another. Here’s how it works.
Let's say you do business at a good local bank that has a strong balance sheet. You would like to borrow money to buy that tractor you need, and so you go to your banker and politely ask him for $100,000. Now, your banker always wants to lend more money to good businessmen such as yourself, because his profits come from loaning good businessmen money and getting an interest return for doing so. But your banker has a small problem. He is already as far out the risk curve as he can go in the whole fractional reserve scheme of things. He can’t lend any more money no matter how good a credit risk you are. In the old days, that would have automatically driven the interest premium up as your banker sought to balance his limited reserves against too much demand for credit. In turn, that would have a dampening effect on the economy, since you are now limited in your ability to expand your farm by the lack of available credit. Enter the Fed. Remember I said that your bank has a strong balance sheet. That means it will own some saleable assets which it can sell in exchange for more liquid reserves. If the other banks who can buy them are also strapped for reserves, he may very well have a strong balance sheet but remain illiquid. But if he has a customer who can create reserves, then he has a sale for his assets. In this case we’ll say the assets for sale are treasuries (government issued debt) which the bank is holding as safe assets on their balance sheet. The Fed, who has been duly watching his economic indicators, concludes that more credit (money) in the system would be a good thing. He decides he will expand his balance sheet by creating more reserves, then using those reserves to buy your bank’s available treasuries. Now your bank has the extra reserves it needs to lend more money. You have your $100,000 to buy the tractor, which is stimulative to the economy, which helps the Fed fulfill his mandate. Everyone is happy.
On the other hand, the Fed may also choose to shrink its balance sheet by destroying reserves. Here’s how it works.
Destruction of Money
Your neighbor Bob, who is a lousy farmer, watches with envy as your gleaming new tractor goes back and forth on your field, and he decides he must have a new one as well, as soon as he can borrow the money. Now Bob has several problems. First, he has a poor track record of paying off his debts timely. He is a bad credit risk. Secondly, he waits for a while to borrow the money, and during that time economic indicators have turned. Thirdly, the banker, in his eagerness to re-balance his fractional reserve ratio, has already made several other risky loans, some of which have not turned out well. However, he and Bob were old school mates and the banker trusts him and would like to recoup some of his losses from the bad loans, so he decides to sell more treasuries to the Fed in order to free up reserves for Bob. But alas, the Fed has been watching as over eager bankers have been making riskier loans, and the economy has become too “hot.” Remember I said the Fed is almost but not quite unlimited in its ability to create money? That limitation is inflation. Inflation is now roaring and loan defaults are on the rise. The board decides it is time to shrink the balance sheet. Now they are no longer buyers of treasuries. Instead, they are allowing the treasuries they do own to mature without replacing them. They call that “letting treasuries run off the balance sheet.” At first, this seems counter intuitive, because that’s not how it works for the rest of the world. If you or I or the bank hold a treasury or any other debt instrument to maturity, we expect to get paid for the value of the instrument at the time of maturity. By buying a treasury, a business or individual intends to get paid back plus interest when the treasury has reached its term. That’s the only reason we would buy one to begin with. But for the Fed, it’s different. When their treasuries reach maturity, and they get paid for it, they have a choice. They can keep the reserves for use in the commercial banking sector, or they can destroy them. Why would they do that? Because there are too many bad credit Bob’s running around out there making the economic indicators look scary. Federal Reserve board members like to sleep at night too, so they decide to “cool” the economy a bit by shrinking their balance sheet. They refuse to buy any more treasuries from your banker and begin actively destroying reserves. Your bank cannot leverage itself any more, either because of legal or internal policy restraints. Your banker has to tell Bob he can’t give him the money, which causes Bob to go home somewhat sad but hopefully wiser. Everyone is happy. Sort of.
The point is that the Federal Reserve, because it is given the power to create money, by extension has the opposite power to destroy it. It uses this power to stimulate or cool the economy as it sees fit. It also uses interest rate policy for much the same effect. Collectively, these Federal Reserve decisions are known as “monetary policy.”
The Effect on Your Business
Simply put, the decisions made within those marble halls in D.C. have a direct bearing on three important factors for your business. It is worth paying attention to their decisions for the purpose of knowing how your business will be affected.
~ Changing Interest Rates
The first and most intuitive is interest rates. The price of borrowing money is part of every equation, even when it is not borrowed. Interest on borrowed money obviously becomes part of the total cost of owning that new tractor. If you don’t need to borrow the money, it still figures into the price of the tractor, because every wise business man will compare the profit he expects to produce with that tractor against the risk free rate at which he can leave his money in an interest bearing account. For example, if the tractor in question is more a luxury than a pure necessity, you might decide (during a high interest rate period) to keep your powder dry and make do with the tractor you have. It is better to make a tidy 5% on your cash then to spend it on something that will not really increase productivity. Your equipment dealer hates when you think that way. He likes the low interest/loose credit environment much better.
~ Changing Inflation Rates
The second is inflation. Classic economists believe that “inflation is always and everywhere a monetary phenomenon.” This simply means that in a fiat currency world, inflation always correlates to how much money is created. If the Fed increases its balance sheet, inflation will follow. If it shrinks, inflation will slow or even turn into deflation. Even liberal economists will agree there is at least a loose correlation. The problem, of course, is one of timing. It is impossible for anyone to accurately forecast what the lag will be between an increase in the Fed’s balance sheet and the resulting inflation. To make matters worse, it is even trickier to predict where that inflation will show up, since inflation is rarely uniform across prices of all goods and services. Nevertheless, the size of the Fed’s balance sheet will always have an effect somewhere in the economy, and a basic awareness of that and which direction it is going can help put the pieces of the puzzle together as you ponder decisions for your business.
~ Changing Credit Availability
The third is credit availability. If your business is extremely strong, you might not be the first to notice limited credit availability because you are the last one to be told no by the banker. If you are on shakier ground, it will quickly become evident when your credit line is not renewed or you are refused a loan on that tractor. Knowing the credit environment ahead of time can help preempt a situation that at least might be embarrassing, and at worst dire. Even if you are in a strong position in your own business, your vendors or customers may very well be affected by changes in credit markets, so it is always worth keeping a finger to the wind on it. Credit being “tight” or “loose” is generally a function of Federal Reserve monetary and regulatory policy.
If you were to scan back up this article, you would notice I said there are not one, but two answers to why the Federal Reserve would change the size of its balance sheet. The first is its economic mandate as discussed here. The second is political, which I intend to discuss in the next Bear Report. The relationship of the Fed to its elected masters (Congress) is complicated, but has enormous implications for the economy. I hinted at that in the last report, and plan to dive deeper into it in the next one.
In the meantime, God bless you and your team as you try to serve God in your business!
The Arrow Team
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