Greenspan For Greenhorns
This is one of an occasional series explaining how major economic events affect the stock and bond markets
Federal Reserve Chairman Alan Greenspan has often been called the second most powerful man in the U.S., and it's not surprising that investors hang on his every word like lovesick teenagers. After all, the Fed has the tools and legal mandate to change the direction of interest rates, economic growth, and inflation--the very same levers that move stock and bond prices as well as the dollar.
How can you know what the Fed is thinking? Luckily, the Greenspan Fed has shifted toward greater transparency in its decision-making. The chairman typically telegraphs coming monetary policy changes in speeches, although don't expect him to say, "We're raising rates next week." It's all in the emphasis. In a speech on Jan. 13, for instance, Greenspan made the case that the economy has not slowed enough to curb growing labor shortages and that wealth gains from the stock market mean spending is growing faster than supply. Add in the inflationary prospects from more expensive oil and it's easy to see why almost everyone expects the Fed to hike its main policy rate, the federal funds rate, by a quarter-point, to 5.75%, at its meeting on Feb. 1-2. The central bank has already raised rates three times since June 30, and any increase will be announced immediately after the policy meeting has ended. To read the announcement, you can log on to the Fed's informative Web site (www.bog.frb.fed.us).
The federal funds rate is what one bank charges another to borrow money overnight. Any rate change is implemented by the Federal Reserve Bank of New York's Open Market Desk. When the Fed wants to raise the funds rate, it sells U.S. government securities to commercial banks. In so doing, it takes money, or liquidity, out of the banking system. When it wants rates to fall back down, it can pump money into the market by purchasing securities from banks.
LOUD GONG. The Fed can also change the discount rate when it alters the federal funds rate, a one-two punch called "banging the gong" because it reverberates across global markets. The discount rate is charged when a member bank borrows directly from the Fed, a move done when the bank can't borrow anywhere else. The discount rate is usually set equal to or a half-point below the funds rate, and economists expect that the Fed will hike the discount rate from 5% to 5.25% in February. Lastly, the Fed can change the amount of reserves a bank is required to keep on hand, but that's rarely done.
The Fed lifts the funds rate, or tightens policy, because it wants to slow the economy and head off inflationary pressures. As the funds rate rises, banks increase their lending rates as well. Higher borrowing costs flatten consumer and business demand for big-ticket items that must be financed. Interest rates all along the yield curve rise, which means bond prices fall. In addition, stock prices may slip because higher-yielding bonds become more attractive to investors and higher borrowing costs and slower demand endanger future corporate profits. The stock market has stayed strong since the Fed began hiking rates last year because the moves have only taken back the three rate cuts of 1998. The Feb. 2 hike is already priced into the market, but expect some volatility if the announcement hints of more hikes to come.
Despite its new openness, the Fed still conducts its main work in relative secrecy for a government agency. Policy meetings of the Federal Open Market Committee are not open to the public or press, and the meeting minutes are not released until six weeks later. The FOMC meets eight times a year, on a Tuesday, although twice a year the confab spills over into Wednesday. The FOMC is made up of the seven Fed governors (there are currently two vacancies), the president of the New York Fed, and a rotating panel of four presidents of the other Fed district banks. According to economists, the incoming Fed presidents are more hawkish about inflation than their outgoing colleagues, signaling that they may argue for moves designed to curb price pressures (table).
Although you can't peer into the FOMC's inner sanctum, you can get a feel for what goes on by perusing an April, 1998, speech by Fed Governor Laurence H. Meyer that's available on the central bank's Web site. It describes in detail what takes place around the huge oval table at the Fed's Washington headquarters, culminating in what Meyer describes as the "critical moment...the time to vote" on the course for monetary policy for the next six weeks or so. More often than not, the vote's outcome is pretty well set by the time ballots are cast. This is because Greenspan and the FOMC strive for a consensus vote.
SPEED BUMP? Traditionally, the chairman assesses how the members are leaning and proposes policy that will be acceptable to all. Dissents are unusual, but not unheard of--and they may signal the beginning of a shift in policy down the road. Or as Meyer observed: "The seeds are sown at one meeting and harvested at the next." For instance, in October, policymakers kept rates on hold but they mentioned concerns about the growing shortage of labor. So when the next two employment reports showed even tighter job markets, it was not a surprise that the Fed raised the funds rate to 5.5% on Nov. 16.
If you want to keep an eye on the Fed via the Web, two good sites to visit are www.dismal.com and www.fmcenter.org. For a while last year, you could also gauge potential changes in Fed policy by watching for announcements on the central bank's "policy bias," which was a nonbinding view of what policymakers thought the next rate change might be. A tightening bias, for instance, signaled the Fed was leaning toward a rate hike. But instead of adding clarity, the wording of the bias caused confusion among investors last year. So beginning in February, the Fed will simply report its judgment on the economy in the "foreseeable future," meaning a period well beyond the next FOMC meeting. There will be only three boilerplate assessments: heightened inflationary pressures, economic weakness, or a balanced outlook for growth and inflation.
Right now, the Fed has a "neutral" bias in place. But since the economy is unlikely to slow on its own, the central bank may have to ratchet rates higher over the course of 2000. Tighter monetary policy may be the speed bump that finally slows down the bull market.