Federal Reserve outline

Federal Reserve outline

·        Est. 1913 by Congress, Federal Reserve Board (FRB) aka “The Fed”

·        Regulate economy

·        Set monetary policies for government

·        Regulate banks

·        Keep financial system stable

·        Do financial services for U.S. government

·        Control federal funds rate, discount rate

·        Try to control inflation

·        Promote US credit & banking system

Methods used to control economy

·        Four ways to effect economy

·        Open market operations

·        Discount rate

·        Reserve requirement

·        Margin requirements

Open market operations

·        Federal Open Market Committee (FOMC) controls daily money supply

·        Buys and sells U.S. government securities in open market

·        Buying and selling T-bills and T-notes and Treasury bonds changes interest rates

·        FOMC buys securities, increases money supply, more money is available, interest rate decreases, interest rate decrease, price of treasuries increases

·        FOMC sells securities, decreases money supply, increases interest rates

·        FOMC buying, lending between banks overnight decreases

·        FOMC selling, lending between banks overnight increases

·        FOMC buying, banks increase their reserves, borrowing decreases

·        FOMC selling, banks reserves decrease, borrowing increases

·        Fed funds, account to meet bank’s reserve requirement and to buy  and sell Fed securitieis

·        Fed buys and sells repurchase agreements daily

·        Repos, Fed can influence market most

Discount rate

·        Discount rate, Fed lends $ to member banks for loans, controls money supply

·        Increase discount rate, bank borrowing decreases, money supply decreases, cost of borrowing increases

·        Decrease discount rate, cost of borrowing decreases

·        Change discount rate affects other interest rates

·        Interest rate increase, commercial paper, negotiable CDs, T-bills, bonds-decrease in price, yields increase

·        Interest rate decrease, debt securities prices increase, yields decrease

Reserve Requirement

·        Reserve requirement, Fed can control money supply, %age of deposits banks must keep on reserve and not loan

·        Banks take $ from customer’s savings and checking accounts and loan it to others for personal, home, other types of loans

·        Intermediation, $ is deposited into banks and interest rates>returns on money market instruments

·        Disintermediation, investors withdraw $ from banks to get <higher returns in other money market instruments

·        Fed increases reserve requirement, money supply decreases

·        Fed decreases reserve requirement, money supply increases

·        High interest rates, decrease borrowing

·        Low interest rates, increase borrowing

·        Change of reserve requirement has a multiplier effect

Margin requirements

·        Fed regulates how much investors must deposit when borrowing on margin

·        Reg T-rules of margin lending-Broker/Dealers to customers, initial requirements, which securities can be used for collateral

·        Reg U-amount of $ a bank can lend to a customer to buy securities

·        High margin requirement, less $ to borrow, tight credit

·        Low margin requirement, more $ to borrow, easy credit

The Fed changes the reserve requirements when it believes it will benefit the economy. Changing the bank reserve requirement has what effect on the economy?

·        It has a multiplier effect. When Fed increases or decreases the amount banks must hold, it is considered a multiplier effect because it will affect $ lent, $ deposited.

The Fed’s methods:

·        Deflationary move-Fed decreases flow of $ by removing $ from market

·        Sell treasuries

·        Increase discount rate

·        Increase reserve requirement

·        Increase margin requirement

Inflationary move

·        Fed buys Treasuries

·        Decrease discount rate

·        Decrease reserve requirement

·        Decrease margin requirement

The Federal Reserve most often uses which of the following methods to affect the money supply and the economy?

·        Changes the discount rate. Fed often changes discount rate to increase speed or decrease speed of the economy. Between 2000-2007 The Fed +,-, +,- discount rate

Federal Funds rate

·        Federal funds rate, interest rate commercial banks charge each other to borrow to meet overnight reserve requirement

·        Overnight rate aka federal funds rate

·        Federal funds rate, most volatile, changes most rapidly

·        Rate changes from 3pm-5pm EST

·        Federal funds rate, usually less/lower than discount rate

Rates highest to lowest:

·        Prime

·        Call money-B/D to customers to margin purchases

·        Commercial paper

·        Banker’s acceptances

·        Discount rate

·        Federal funds rate

Which of the following rates is the most volatile?

·        Federal funds. The Federal Funds rate is the most volatile rate because it changes by the moment every day as banks meet their reserve requirements. The discount rate, less volatile- changes when the Fed decides to change it. The prime rate, base for interest on commercial loans,  influenced by discount rate.  Savings account rate a.k.a. passbook rate, least volatile.

Basics about the economy

·        Money supply-M1, M2, M3

M1

·        All $ in circulation

·        Demand deposits

·        Interest receiving checking accounts

M2

·        All of M1 + money market funds

·        Small savings and small time deposits

·        Overnight repurchase agreements

·        Overnight Eurodollar deposits

M3

·        Large time deposits in commercial and savings banks and savings and loans ($100,000+) aka jumbo CDs

·        Balances in institution’s $ funds

·        Eurodollars US residents hold in foreign branches of US banks

·        Liquidity=M3 + individual’s liquid assets

·        Fed has targets for M1, M2, M3

·        M2-not accurate predictor of economic growth

Inflation

·        Increase in average price level of all products

·        Increases when demand increase>supply increase

·        Consumers compete for goods

·        Decrease interest rates, increased $ supply, increase demand for goods, increase inflation

·        Low interest rates, high wages, many prospective home buyers, high demand, increased price for a home

·        Increasing income, increasing prices to cover cost of goods produced

·        Fed wants 1-3% inflation

 

High inflation

 

·        Decrease in purchasing power of $, bad for individuals on fixed income

·        Increased prices, Fed increases cost of borrowing, bond values decrease, increased interest rates

·        Saving and investing-if inflation>earned interest

·        During inflation-interest rates decrease or are low

·        Counter inflation-Fed increases interest rates until prices stabilize or decrease

Deflation

·        Decrease in average price level of all products in an economy

·        Demand decreases > quickly than supply

·        deflation occurs: price decrease, purchasing power increases

·        Fed increase interest rates, decrease $ supply, people decrease buying, increase in # of goods available, prices decrease, job losses increase

·        Depression-1930s

·        Returned in 2000. Fed increased discount rate, increased interest rate, decreased consumer credit card spending, increased amount of goods available, companies decreased production of goods, companies reduced prices of goods

·        Fed likes to avoid deflation

·        Deflation period, increase in interest rates

·        Fed lowers interest rates, fight inflation, hopes to increase consumer spending

·        Demand for securities decreases

·        Counter deflation, decrease interest rates, issued bonds increase in price, yields decrease

Velocity of  money

·        Velocity of $, # of times a $ is spent /time

·        Rapid turnover, high velocity

·        High velocity, less need for Fed Intervention

·        Slow velocity, Fed intervenes and injects $ into economy

·        Decrease in velocity, decrease in economic growth even if money supply stable

Credit conditions decline:

·        More bankruptcies

·        More consumer debts

·        More bonds in default

·        More tax collection delinquencies

·        Increase in company/distributor inventory

·        Result: investing in securities decreases

Credit conditions improve:

·        Less bankruptcy

·        Less consumer debt

·        Less bonds in default

·        Property value increase

 

Recession

·        Two consecutive quarters of declining business activity (GDP)

·        Short term decline in business activity

Depression

·        General economic decline

·        Falling prices

·        High unemployment

·        Low economic confidence

·        Six consecutive quarters of declining business activity

All of the following are indications that credit conditions are worsening except? an increase in property values. People are able to borrow more

Interest rates as economic indicators

·        Prime rate, indicator of economy

·        Reflects $ supply and demand for $

·        Rate banks charge best customers

·        Set by banks based on a)demand for $ and b)rate from Fed

·        Increased demand for $, increase interest rates

·        increase interest rates, decrease in bond prices because people want to invest in high interest bonds instead

Fluctuating interest rates:

·        short term bonds, change more quickly with changing interest rates> long term bonds change

·        short term bonds must adjust to present rates

·        long term bonds adjust prices more, move more in price

·        utility companies and auto makers-changing interest rates have a big effect on their operations

·        municipal bond, not exempt from interest risk

·        interest rate increase for common stock, decrease ability to borrow, decrease company growth

·        interest rate increase for preferred stock, decrease dividend, prices decrease

Interest rates have been rising. Which of the following bonds will decrease the most? The longest bond will always move the most. The prices of bonds with the longest amount of time until maturity will always move the most.

Causes of Devaluing dollar

·        Trade deficit-U.S. buys > goods than we export

·        Cheap labor countries are exporting more goods, U.S. is importing more goods

·        Dollar, underlying currency for the world

Cause of revaluing dollar

·        Fed increases discount rate, revalue dollar

·        U.S. trade surplus, increase in dollar value

·        Effect: decrease in dollar value, U.S. exports more competitive

·        Dollar decrease in value, price of bonds decreases, yield increases

·        Dollar increase in value, US goods less competitive, foreign goods more competitive

·        Increase in dollar, increase in price of bonds, yield decreases

·        Dollar decrease in value, bonds decrease in price, increase bond yield

·        Dollar increase in value, bonds increase in price, decrease in bond yield, U.S. goods less competitive

Foreign currencies

·        Euro, main currency in Europe

·        Euro used to trade with individuals and businesses

·        Euro-currency can be exchanged for it

·        Countries that didn’t adopt Euro treat it as foreign currency

The exchange rate of the dollar has been increasing. Which of the following is true regarding foreign imports and US imports?  US goods into foreign markets become less competitive, foreign goods into US become more competitive.

Economic theories

Monetarist

·        Money supply, most important economic influence

·        Fed-change interest rates and money supply

Keynesian theory

·        Government spending, will grow economy

·        Increased taxation, increased government spending to stimulate economy

·        Result: more $ for people to spend, more prosperity

·        Criticism: high taxes give people less $ to spend

Supply side theory

·        Tax cuts

·        Less government spending

·        Government should be passive

·        Tax cuts give citizens more $ to spend, increase growth

·        Rhetorically President Ronald Reagan

The economic theory that says government should influence the business cycle through decreased government spending and tax cuts is called? Supply side-tax cuts, less government spending increase consumer spending and increase economic growth. Keynesian-increase tax, increase government spending. Monetarist-control money supply, improve economy

Economic indicators

·        Leading indicators, give investors an idea where the market may be in 4-6mo

·        S&P 500-if stock index rising, economy should improve, if S&P 500 decline, economy may worsen

·        Building permits from housing starts reports-new housing construction shows people are increasing spending, stimulates economy

·        Durable goods/consumer goods-if consumers increase purchases of appliances and durable goods such as cars, shows consumer emotion is confident, people confident to spend money, economy will improve. If consumers hesitate to buy cars and appliances, economy will worsen

·        Machine tool orders: increase in tool purchases, increase in need for labor and large construction projects, economy will improve. Decrease in tool purchases, economy is worsening

·        Consumer confidence index (CCI) consumer confidence supports up trends in stock prices

Coincident Indicators

·        Industrial production index-producing at 40%-60% then orders down, increasing inventories, decreasing spending. 80%-90% productivity, increasing spending, strong economy

Lagging indicators

·        Follow economy

·        Corporate profits-compare results to economy later

Reported movement in economy

·        Employment can be leading, coincidental, lagging

·        Gross domestic product-GDP, economy growing or not growing? market value of all goods made in a country in a year. =government spending + consumer spending + exports – imports within US boundaries

·        Gross national product, economy growing or not growing? look in constant dollars, includes cost of goods & services produced by US companies in foreign countries

·        Consumer price index-shows inflation by month

Which of the following are leading indicators according to the Department of Commerce? S&P 500, Housing starts, CCI. Coincident: Industrial Production Index. Statistic info: CPI and GNP

Business cycle

·        Expansion,when economy is rising

·        Peak, high point

·        Recession/contraction-when economy is declining

·        Trough-low point

·        Increase inventories, decline in economy

 

Fundamental analysis

·        Management

·        Outlook

·        Research abilities

·        Earnings

·        Dividends

·        Balance sheet

·        Annual report

·        Financial ratios-working capital, current ratio, debt/equity ratio

·        Review company’s financial statements

·        Review industry

·        Rely on technical aspect of company stock performance

·        Main concern: financial and management performance compared to rest of industry

·        Low debt equity ratio, good buy for a fundamentalist, technical would look to see price is not declining

·        Primary way to look at investments, stock price is based on expected growth

·        Belief in increased earnings, then good investment

Technical analyst

·        What is happening in the market in general?

·        What is the individual price of stocks in similar industries?

·        Dow theory

·        Odd-lot theory

·        Advance-decline theory

·        Short-interest theory

·        How is the market moving?

·        What is the price/earnings ratio?

·        Where is the stock compared to its highs and lows?

·        Resistance level, # of stock sellers> # of buyers and price doesn’t seem to move past that price

·        Support level, # of buyers>sellers, price rises

A fundamental analyst would use which of the following in making decisions in their investing policies? Earnings of a company and the debt/equity ratio of the company