Fed Tools: The US Federal Reserve’s Toolbox

This past week Janet Yellen, Chairwoman of the US Federal Reserve, gave her report on the state of the economy. The theme was “steady as she goes” with only minor adjustments to monetary policy. Here are some highlights from her text:
The growth rate for the US economy for the second half of 2014 was lowered to 2.1% to 2.3%, down from 2.8% to 3%.
Interest rates are expected to remain near zero into 2015.
The Fed trimmed its bond buying program by another $10 billion bringing it down to $35 billion per month. The Fed is expected to end its bond buying program by Autumn.
Inflation is expected to remain near 2% into 2016. She was referring to the “core” rate of inflation that does not include food and energy. Anyone in their right mind can see that this figure is bogus. Just walk into a supermarket or try to fill your tank with gas. The inflation rate for food and energy is rising twice the core rate with no stopping in sight. What this is doing is draining disposable income from most Americans.
The labor market is improving gradually. It is important to note here that technology is replacing many high paying jobs, making it difficult for the long term unemployed to find good paying jobs.
According to many analysts, this policy leaves room for further price appreciation in equities. The PE ratio for stocks is now at 15.6. The 10 year average has been 13.8 (Reuters).
The highest performing sectors are defense and high dividend yielding stocks like utilities. Retail is the worst performing sector. This makes sense since disposable income is being drained by the high costs of food and energy.

While there is some concern about the Fed’s high balance sheet and the effects that a rate increase would have on the equity market, it is important to note that the Fed has several tools to make the transition to higher rates less painful. Here are a few little known programs at the Fed’s disposal.

Term Deposit Facility

At present the banks can leave their excess reserves with the Fed’s Term Deposit Facility. The Fed pays the banks interest on this money. This is “free” money for the banks. It also explains why the banks have not been lending money long term. Why lend money when you can collect free interest. The Fed has the option of ending this practice, thus forcing the banks to lend more money and stimulate the economy.

Reverse Repos

The Fed would lend securities to the primary dealers for cash for a set period. When the securities mature they are returned to the Fed and the cash is returned to the primary dealers.

Ending the Buying of Mortgage Backed Securities.

The Fed is reluctant to end this program because the ripple effects throughout the lending industry are unknown and the Fed does not want to rock the boat.

Reinvesting the Proceeds from Maturing Bonds.

At present the Fed is reinvesting the proceeds from maturing bonds in its portfolio. It has the option to end this practice if need be.

The Fed’s goal is to bring their balance sheet back to normal with the least upset to the economy and the equity markets. So far, this ‘Steady as she goes” policy has encouraged investors to buy more stocks and leaves room for further gains.

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