The Federal Reserve’s Actions

Recently, the Federal Reserve announced that it would buy $600B in 10-year Treasury notes.  This is being done in an effort to lower long-term interest rates and cause a modest amount of inflation in order to spur the economy.  This is an unusual move for the Federal Reserve which normally performs actions to control short-term rates, not long-term rates.

The normal actions of the Federal reserve are to set the Fed Funds Rate and the Discount Window rate, which are the basic interest rates on which all other rates (bank interest rates, loan rates, home mortgage rates, etc…) are based.  This is done by buying and selling short-term government notes.  By buying notes, using their magic checking account which has the ability to create and destroy money at their whim, the Fed adds dollars to the vaults of the banks, which in turn are then free to lend out more money.  This has the effect of lowering rates.  When they sell treasury notes, which the banks are basically forced to buy, they destroy dollars by reducing the amount banks have in their vaults and therefore the amount they are free to lend.  This reduces the number of dollars available to loan and therefore causes short-term interest rates to rise.  The Fed may also increase or decrease the percentage of assets banks are required to keep which has a similar effect.

Normally, increases in interest rates cause the stock market to fall, and then economic output to decrease.  It also has the effect of reducing inflation since there are fewer dollars available.  When rates are lowered it reduces the cost of borrowing and generally causes the economy to speed up and the markets to rise, although inflation will eventually result.  This time, however, there is a great amount of uncertainty caused by the unprecedented actions of the Government, including the development of a whole host of new regulations and agencies, huge new government programs such as the Health Care bill, and a take-over of major industries.  Talk of jailing executives has also had a chilling effect.  This has caused paralysis on the part of businesses, making them uneager to borrow and expand because they don’t know what the economic climate will be like over then next few years.  The economy has therefore plodded along despite over $1 Trillion in dollars in the bank vaults that could be lent out and near-zero interest rates.  The banks are scared to lend and businesses are reluctant to borrow.

The Fed is therefore trying to spur the economy by lowering long-term rates, which have a big effect on home loans normally.   This may be a mistake, however, since inflation may well result.  Prices of oil and food have already started to rise.    If this happens interest rates will increase, instead of decreasing, since investors will require greater interest rates to make up for money lost due to inflation.  Foreign governments, such as China, also see the move as an act to create an unfair trade imbalance by lowering the cost of our exports.  This could spur a currency war or a trade war, both of which were present during the Great Depression and may be a reason it lasted so long.

If one wanted to guard against inflation, one way would be to buy the shares of companies that produce raw materials.  This could be done by buying a basic materials ETF on the American exchange or by buying the shares of steel, copper, uranium, oil, and precious metal producers directly.  If inflation results the value of those materials would increase.  Because the amount they produce is relatively constant, this will result in a large increase in earnings (due to the inflation), which should translate into an increase in share price.  While there is no reason to put everything into these stocks since they do not have the long-term growth characteristics that are desired (they tend to go up and down with the economic cycle), an inflation hedge at this point would not be a bad idea.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.