Understanding Federal Reserve Actions

This blog will have 3 sections: weekly recap from Vanguard, Understanding the Impact of Federal Reserve Actions, and Labor Day trivia.

Vanguard Weekly Recap
The economic news turned somewhat brighter Friday morning, as the Labor Department's unemployment report was better than economists' gloomy expectations. Among the week's other bright spots were better-than-expected expansion in manufacturing, improved consumer confidence, and modest growth in consumer income and spending. But activity in the service sector, a big component of the economy, declined, along with productivity. For the week ended September 3, the S&P 500 Index rose 3.7% to 1,104 (for a year-to-date total return—including price change plus dividends—of about 0.4%). The yield of the 10-year U.S. Treasury note rose 0.05% to 2.71% (for a year-to-date drop of 1.14%).

Understanding the Impact of Federal Reserve Actions
It is important to keep track of the Treasury Yield Curve and the actions of the Federal Reserve. The Treasury Yield Curve shows the interest rate for debt issued by the Treasury Department for durations from 1 month to 30 years. The debt from all other entities within the US follow this yield curve as the Treasury Department is by far the biggest issuer of debt in our country. The growth rate of the economy is linked to interest rate for longer term bonds so as the rate of economic growth increases the yield on longer term bonds should also increase and vice versa.

Recently, the Federal Reserve met in Jackson Hole, WY to do things like review economic policy and communicate to the media. Jackson Hole, WY is a very nice place which shows us that not all economists are boring. The news from this meeting was that the economy was recovering, more Treasury Bonds would be purchased in the future to stimulate the economy, and additional actions would be taken as needed to spur economic growth. Remember that the Federal Reserve has a policy of achieving an annual economic growth rate of 3%.

Since 2008, the Federal Reserve has purchased about $1.75 Trillion in Treasury and mortgage-related debt. Because of this increased demand for Treasury Bonds, the price of these bonds have gone up, using the law of supply and demand, and long term interest rate have gone down. During this period of economic recovery, the 10 year Treasury Bond yield rose to 4%, declined to 2.5%, and is currently at 2.7%.

Typically, the Federal Reserve will also purchase Treasury Bonds from member banks increasing the amount of cash held in reserve. This gives banks more money to make loans increasing the amount of money in the system. Given that the Federal Reserve has purchased $1.75 Trillion in debt, it most likely means that purchases have also been made from both member banks and in the open market.

So where are 10 year Treasury Bond yields going from here? The answer is probably not much lower. During January 2009, when the economy was having a heart attack, (words from an Economics professor) the 10 year Treasury Bond yield reached a low of 2.42%. Since the economy grew 1.6% during April - June it suggests that interest rates should be going up not down. Additional purchases by the Federal Reserve will keep a lid on interest rates.

Who benefits from this policy? Virtually everyone including people who are buying or re-financing mortgages, corporations who are issuing debt, government issuing debt at all level (local, state, and Federal), banks, and investors who understand what is happening.

We will know that the economy has recovered when the Federal Reserve makes a shift in policy and begins to sell these Treasury Bonds. When this happens, the yield on long term Treasury Bonds is going up and anyone who owns long term bonds of any kind is at risk of losing money. Stock markets around the world should react very positively to this news as this indicates faster growth in revenue and profits.


Labor Day Facts
Labor Day, the first Monday in September, is a creation of the labor movement and is dedicated to the social and economic achievements of American workers. It constitutes a yearly national tribute to the contributions workers have made to the strength, prosperity, and well-being of our country.

The first Labor Day holiday was celebrated on Tuesday, September 5, 1882, in New York City, in accordance with the plans of the Central Labor Union. The Central Labor Union held its second Labor Day holiday just a year later, on September 5, 1883.

In 1884 the first Monday in September was selected as the holiday, as originally proposed, and the Central Labor Union urged similar organizations in other cities to follow the example of New York and celebrate a "workingmen's holiday" on that date. The idea spread with the growth of labor organizations, and in 1885 Labor Day was celebrated in many industrial centers of the country.