Market Insights | September 2013 The Fed, Ben Bernanke and “Tapering” Introduction Recently, much has written and broadcasted about major changes at the Federal Reserve Bank, both in terms of personnel and policy. President Obama is close to nominating a new Chairman of the Federal Reserve to replace Ben Bernanke--whose term expires early next year. In addition, the Fed has talked about “tapering” the dollar amount of securities that they purchase each month. Below we discuss a brief history of the Fed, why Bernanke has been such a key leader and what “tapering” can mean to the economy and the financial markets. A Brief History of the Federal Reserve System The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, including a severe financial scare in 1907. Over time, the roles and responsibilities of the Fed have expanded and its structure has evolved. Events such as the Great Depression (beginning with the stock market crash in 1929) were major factors leading to changes in the system. HSW Advisors | 505 5th Ave., 14th Floor New York, NY 10017 | 212-286-1170 The U.S. Congress established three key objectives for monetary policy in the Federal Reserve Act in that the Fed should: . Maintain maximum employment . Sustain stable prices . Keep moderate long-term interest rates The first two objectives are sometimes referred to as the Fed's dual mandate. Its duties have expanded over the years, and today, according to official Fed documentation, include conducting the nation's monetary policy, supervising and regulating banking institutions, maintaining the stability of the financial system and providing financial services to depository institutions, the U.S. government, and foreign official institutions. The Fed also conducts research into the economy and releases numerous publications, such as the Beige Book - a monthly survey of current economic conditions. According to the Board of Governors, the Fed "is considered an independent central bank because its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government, it does not receive funding appropriated by the Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms.” (FAQs, “Who Owns the Federal Reserve”, the Fed Website). The Fed and Inflation that began in the 1970s The Fed took on great modern prominence following the inflation of the 1970s. With the Kennedy and Johnson administrations of the 1960s trying to finance both the Vietnam War and a growing social welfare system, inflation became a new and ongoing problem in the following decade under the Nixon and Carter administrations. The rise in inflation was due to both fiscal and monetary policies in the US and was accelerated by other factors such as the quadrupling of oil prices in the 1973 Arab Oil Embargo. HSW Advisors | 505 5th Ave., 14th Floor New York, NY 10017 | 212-286-1170 2 Source: "Historical Inflation Rates: 1914-2013." US Inflation Calculator. N.P., 15 08 2013. Web. 5 Sep 2013. <http://www.usinflationcalculator.com/inflation/historical-inflation-rates/>. Jimmy Carter was elected President in 1976 but was not successful in reducing inflation. The administration was further caught off guard with a second Arab oil price hike in 1979 in the wake of the Iranian Revolution resulting in higher oil prices and gas lines in the U.S. Carter appointed Paul Volker to Chairman of the Fed, and he began to focus on reducing the US inflation rate which peaked in 1980 at 13.5%. Volker’s principal tool in fighting inflation was to raise interest rates, which set the stage for a 30-year bull market in bond prices. Volker continued to fight inflation until he was replaced by Alan Greenspan on August 11, 1987. Greenspan served for an unprecedented 18 years as Fed Chairman and also saw his role chiefly as keeping inflation in check. Greenspan was confronted with a crisis right after his appointment when the stock market plunged in 1987, but by and large he reigned during a period of acceptable levels of inflation, and a steadily rising stock and bond market. He is remembered for his comments about “irrational exuberance” and was proven right when technology stocks unwound after March 2000. HSW Advisors | 505 5th Ave., 14th Floor New York, NY 10017 | 212-286-1170 3 Ben Bernanke and the Housing / Banking Crisis of 2008 Greenspan was replaced when George W. Bush nominated Ben S. Bernanke for the Fed Chairman position. He was sworn in on February 1, 2006 and will finish his second term on January 31, 2014. Bernanke has become the world’s most influential central banker. Bernanke graduated Harvard and received his PhD from MIT where he studied under Stanley Fischer. Fischer, who recently retired after being the Governor of the Bank of Israel (Israel’s central bank), introduced Bernanke to the works of economists Milton Freidman and Anna Schwartz who focused on the causes of the Great Depression of the 1930s. His doctoral dissertation, “Long-Term Commitments, Dynamic Optimization, and the Business Cycle”, prepared Bernanke to understand what to do, and as important, what not to do, when confronted with a huge shock to the banking system. As a former economics professor at Princeton University, Bernanke continued his studies in the area of fiscal crises and the banking system. Many academics and other central bankers believe that Bernanke’s lifelong study of central banking under stress meant that he not only knew the available options to confront the US housing and banking crisis of 2008, but he also understood that these options were not enough to get the US economy back on track. For almost three decades the Fed was focused on keeping inflation in check, but in the wake of the financial crisis Bernanke forged a much broader vision of the Fed’s responsibilities. He started experimental and sometimes incomplete campaigns to reduce unemployment and to prevent future crises. In spite of all of the daring, untested and creative tools employed by the Bernanke Fed, it has not been fully successful in achieving its goals. Unemployment is still too high, growth is positive but weak and inflation is too low. HSW Advisors | 505 5th Ave., 14th Floor New York, NY 10017 | 212-286-1170 4 Bernanke has taken the tack of communicating clearly about the future intentions of the Fed--termed “forward guidance”--reasoning that transparency and predictability would improve the Fed’s performance. This is in contrast to Paul Volker who argued that too much guidance would make investors overconfident, leading to too much risk-taking. Bernanke has said that the crisis of the fall of 2008 was “the worst financial crisis in global history, including the Great Depression”. Though he had not seen it coming, he has been exceptionally aggressive and creative in new ways to stimulate the economy. He has declared that the Fed intends to keep short term rate near zero (the Fed Funds rate is currently targeted at 0% - 0.25%), until unemployment declines below 6.5%. Unemployment currently stands at 7.4%, down from its peak of 10.0% in October 2009. Quantitative Easing and Tapering Bernanke has aggressively expanded the Fed’s balance sheet to engineer lower long- term interest rates that would help incentivize growth in the US economy. Through Quantitative Easing (“QE’), the Fed has been purchasing Treasury and mortgage-backed securities. The premise he employs is that low bond yields should stimulate home buying and mortgage refinancing, while allowing corporations to borrow at low interest rates to fund their capital investment and hiring plans. In the current program--QE3-- the Fed is purchasing $85 billion of Treasury securities and mortgage backed securities a month. These purchases are unprecedented and have ballooned the Fed’s balance sheet (see graph below), however, in May Mr. Bernanke announced that the Fed may begin to “taper” its purchases in the near future depending on the trajectory of economic data. HSW Advisors | 505 5th Ave., 14th Floor New York, NY 10017 | 212-286-1170 5 U.S. Federal Reserve Bank Credit Outstanding (EOP, $Bn) $4,750 Taper to: $4,500 Hold m/m purchases at +85Bn m/m +65Bn m/m $4,250 +35Bn m/m $4,000 $3,750 $3,500 $3,250 $3,000 $2,750 $2,500 $2,250 $2,000 $1,750 $1,500 $1,250 $1,000 $750 Projections $500 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 May-14 Source: Strategas: Keep In Mind: Tapering Does Not Equal Tightening. 30 08 2013. 3. This announcement sent the bond market into a quick decline. The 10-year government bond yield jumped from about 1.6% to the current yield of about 2.95%. The Fed effectively indicated to the world that the days of low and declining interest rates may be over. Interest rates have effectively been declining since the early 1980s, and as the economy strengthens, the Fed will reduce the liquidity it provides in the form of asset purchases. This explains why bonds have declined in value this year, but it is ultimately a sign about the building strength of our economy.