Senior Management :
Hello, is there anyone here who plays the board game 'Clue?'
Fresher :
The one in which you've to guess who committed the crime, right? I do!
Senior Management :
Yes, along with the person, you also have to guess the weapon they use, and what room of the building they committed the crime.
Intern :
This is all good, but what does it have to do with our discussion on the Federal Reserve (Fed)?
Fresher :
Oh wait, I get it. We've been playing the giant game of market clue. Whatever the event at the market is, whether interest rates are up, interest rates are down, stock prices are up, stock prices are down, the reason is always the same.
Senior Management :
You get it! Don't we always say 'the Fed did it with quantitative easing in the bond market'? Since the beginning of this decade, we've been using Fed as the defense against everything. We've been obsessed with Fed as to the reason of whatever good or bad happens, and that obsession I find unhealthy.
Intern :
I'd confess I thought along the same lines. I never thought of them as myths! I'll admit, I thought Fed sets the interest rates!
Fresher :
I know they don't 'set' the rates as such, but I thought somehow the Fed is 'responsible' for the interest rates we see in the treasury bond market, the mortgage rates, the bank CD rates.
Senior Management :
Not really! The majority think the Fed is the primary factor behind why interest rates have been low since the beginning of the decade. I think that's a myth.
Intern :
I'm still unsure if these are only theories as you say or are they actually true. Few charter holders at my firm were discussing how Fed is boosting the stock market. They meant it is the lower rates of interest that have been responsible for stock prices going up. Companies can borrow at lower rates so will have higher profits! Since these low rates they think are 'set' by Fed, Fed boosts the stock market!
Fresher :
Yeah, my boss thinks along similar lines. He also says, the rates have currently been low and wouldn't be low for long! If the Fed acts and changes its interest rate policy, the biggest thing it has to fear is that stock markets will react badly.
Senior Management :
I agree that higher rates will make borrowing costly and eat up the profit margins of the companies, making the stock prices fall down. But the point I'm making here is that Fed can just influence one rate - the Fed fund rate - the rate at which commercial banks borrow from the central bank.
Intern :
Absolutely true, but don't you think other rates are influenced by this rate? I think the interbank borrowing rate (the rate at which one bank would borrow from another bank) is directly affected by this.
Senior Management :
Yes, and the interbank lending rate is the only one that has a direct connection. But do you know, it's a short-term rate, and markets are affected by long-term rates! We aren't concerned with what's the borrowing cost today or what it will be there next month. Valuation is done taking a longer time horizon basing the decision on what borrowing costs, returns will be over a period of time!
Intern :
Oh, it seems I missed out on the bigger picture. To clarify, I'd shoot a few questions.
1. Aren't the long-term rates directly affected by short-term rates?
2. If not, then who sets them? Based on what?
Fresher :
Yes, long-term rates are hardly affected by the short ones. To answer the second part of your question, let's go back to basics of economics.
Senior Management :
Wait, I guess Fresher is talking about the Fisher Equation. Interest rates = GDP Growth + Inflation.
Intern :
Wait a sec, I think I'm decoding this now. If I have to lend money and if the prices of the goods are rising too fast, I'd ask for a higher interest. If he's not giving me a higher return, I'd rather buy goods today, keep it for a year and then sell it at a higher price!
Fresher :
Yes, and the same applies to GDP growth. Higher GDP growth means the country's growing well. When the country grows well, the businesses in the country grow well. If businesses are doing good and you're becoming a part of the growth by lending money, why would you stay behind? You would ask for a good return on your capital, too!
Intern :
It's so logical! Now if I see the rates since the beginning of the decade, they have been this low not because Fed does it, but because there's not much GDP growth after the financial crisis nor there's enough demand for the prices to rise!
Senior Management :
Exactly! Didn't I say, Fed doesn't do it! To answer the second part of the second question, it's the market that sets the long-term rate based on judgments about inflation and GDP growth.
Intern :
But we also discussed about stock markets getting a boost. Can you throw some lights on that too if it's a misconception?
Senior Management :
I think the answer is pretty straight-forward. US companies have been returning insane, incredible amounts of cash in the form of dividends and stock buy-backs. Part of the reason for this is, profits are at historic highs. In 2014, US companies returned about 91% of their earnings as dividends. So the high earnings plus the high cash flow returns have translated into very large cash flows for stock investors.
Jenet Yellen :
Hello kids; as the Chairperson of the Federal Reserve, what if I give you the stats to prove the markets actually go up and down just because of Fed changes rates?
Senior Management :
Historically, the Fed affected rates not because it sets the rates but because it has credibility backing it up. What am I talking about? When the Fed acts, the investors assume that it acts because it assumes that it sees something in the economy. It is lowering rates because it sees economic weakness. It is raising rates because it sees economic strength. So the Fed rates are nothing more to me but a signal of inflation and growth. And as long as it acts consistently, it will have credibility.
Jenet Yellen :
Possibly. What’s kept the Fed effective is that it has been independent and credible. And the biggest danger to the Fed is that anything that attacks that notion.
Senior Management :
Yes ma'am. Let me end with the story about a Rooster. The story is a several hundred years old. The Rooster essentially crows at the start of every day as the sun comes up. All the other barn-yard animals pay head to it because they think that it’s the Rooster’s crowing that is causing the sun to come up. Then one day the Rooster doesn’t crow. The sun comes up anyway. The other barn-yard animals wake up, and they realize it wasn’t the Rooster that caused the sun to come up. The Rooster lost its power over other animals from that day.
Fresher :
Hahaha, Fed = rooster. Singing = interest rates. Sun coming up = economy picking up anyways! What the rooster should do to maintain the power: keep singing!
Senior Management :
That's what even I'd suggest to Fed. Crow (act) because irrespective of you crowing or not crowing (rates rising or rates not rising), the economy is going to pick up. But if the market gets to know the discussion happening here, Fed would lose the charm and power just like the poor rooster.
Jenet Yellen :
Thank you for unsolicited advice. But we know how to do our jobs. We need not take lessons from freshers and interns.
Senior Management :
Oh boy, you shouldn't have said that. I've taught these guys enough to take you down. Guys, why don't you take over from here? I think a couple of statements would be enough.
Fresher :
Sure, sir. I just have one question for you, Janet maa'm. I won't even address the conspiracy as to how the Feb came into being. It's a convenient coincidence that the Fed was established in 1913, the same year as the reintroduction of the Income Tax. My question is simple: on what basis is the Fed continuing to print currency and keep on supplying to the US Government? Just because you've started creating money out of thin air, the US dollar has lost over 96% of it's value in the last 100 years.
Jenet Yellen :
There is complicated economics that goes into this policy making. Young children like you won't understand it.
Intern :
Ah, I have an even simpler question, that young children can understand: who owns the Federal Reserve? Surely, this wouldn't be very difficult to answer.
Jenet Yellen :
I'm under no obligation to disclose that either. Even the media or banking network has no authority to know answers to these questions. What makes you think I'll share them with you?
Intern :
I expected that, ma'am. It has been made adequately clear that the US Government does not own the Fed. Complete ownership has never been disclosed at all. It is owned by international banks who are part of the Fed syatem. This means that foreign interests can interfere in the most important economic instituition of the US! Bravo. Think about the damage your greed will do to us.
Fresher :
Oh yes, with the likes of JP Morgan and Rockefeller group holding stakes, I am scared for this country's future. All the best, America!
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