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The Impact Of The Fed's Decisions On September 17, 2019

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Includes: C, DIA, FAZ, JPM, MS, QQQ, SP500, SPY, TLT, WFC
by: Alan Longbon
Summary

The Fed lowered the headline Federal Funds Rate at its last meeting.

The Fed also lowered the Interest of Reserves IOR rate.

The Fed started buying $20B per month agency securities and bonds.

The Fed decided to maintain its stock of treasuries and MBS by reinvesting principal and interest.

The Fed lowered the headline FFR at its last meeting.

This article runs the new numbers to see how lower rates impact investment markets and the macroeconomy.

This article provides an impact assessment of the FOMC September 17/18 2019 meeting.

The extract below is the FOMC implementation note from the meeting.

FOMC implementation note

The analysis below has the above new information in it.

The mainstream tends to focus solely on the change to the headline FFR. The headline rate was lowered from a top range of 2.25% to 2% as the chart below shows.

Not widely reported are other significant changes, such as:

1. The change to the interest rate of required and excess reserves to 1.80%.

2. The offered rate is now 1.7%

3. The rolling off of treasuries and MBS (mortgage-backed securities) stops and will be maintained at present levels. No more QT (quantitative tightening). The $20 billion limit leaves room for mild QE (quantitative easing) given that the limit is more than that required to maintain the present level.

4. The prime rate rises to 2.5%

US FFR

A movement of the FFR has four broad impacts:

  1. Bank lending costs on required reserves.
  2. The interest burden on private debt.
  3. The Interest on newly issued Treasury deposits.
  4. Interest paid on excess reserves, also known as the support rate.

These four impacts will are looked at in turn.

The table below shows the impact of rates on bank reserves advanced by the Fed, via the discount window, when a bank makes a loan.

Fed discount rate on required reserves

(Source: Author calculations based on Trading Economics GDP measure)

Every 0.25% rate movement changes the cost of loan funds by $10 billion. The private banks then pass on this rate change to the customer if they can.

The interbank rate is shown in the chart below.

Libor rate chart September 2019 The chart shows that at present commercial banks can get required reserves more cheaply at the Fed discount window rather than in the interbank market. The interbank market rate has risen out of the maximum target rate of 2% FFR. The Fed will need to allow the level of bank reserves to expand to put downward pressure on the FFR. The Fed does this by not issuing as many bonds to drain excess bank reserves.

This will be hard given the US Treasury plans on issuing lots of bonds soon. US Treasury bond issues are made to cover US government spending over taxation inflows. This keeps the treasury cash balance (the US governments spending account) at the Fed with a positive balance required by statute.

The new Federal budget in October is accompanied by a seasonal rise in expenditure and associated bond issue. Bond yields cannot help but rise, and it will be a challenging time for the Fed. The mainstream press associates any significant bond issue as QE and money printing and the Fed is wary of these harmful and critical press headlines.

The practical reality is that the Fed has been managing the FFR target rate with reserve adds and drains via bond sales and redemptions since its inception, and it is nothing new. It is only more news sensitive since the GFC (global financial crisis) and the advent of QE as a deliberate large scale policy.

The next aspect is the interest burden on private debt.

The following table shows the impact of the FFR on the stock of private debt in absolute terms and as a percentage of GDP.

USA private debt to GDP

The chart shows that with each 0.25% FFR change, $105 billion, or 0.57% of GDP, is transferred from the household and business sector to the finance sector in a macro intersectoral income transfer or vice versa.

At present, just over 4.5% of GDP goes to banks as interest on loans. Debt drag on the real economy.

The lower FFR will give businesses and households in the real economy a big break and cause a flow of $105B to go back to the real economy and out of the banking sector. This will lift aggregate demand for real goods and services and investment goods.

Treasury deposits are the next area of impact from a change in the FFR.

The following table shows the generalized impact of the rate rise on the stock of Treasuries.

USA treasuries and FFR

(Source: Author calculations based on Trading Economics Government Debt measure)

The table above shows that with each 0.25% rate change, a flow of $55 billion occurs either into or out of the economy.

An FFR decrease means that the economy receives $55B less each year by way of interest payments from the Federal Government to bondholders. Overall this is a net loss of income to the economy given that the Federal Government is a net payer of interest.

The fourth and last impact of a change in the FFR is the mutual adjustment of interest on excess reserves and interest on reserves. The table below shows the new interest rate settings.

interest on reserves Each time the FFR falls, the IOER set to just underneath it. The change will remove $4 billion of money from the economy. The total paid per annum is $24.95 billion.

The recent changes to the IOER are summarized in the table below.

IOR changes table This loss of income decreases the bank's capital base, which, in turn, means it must reduce its lending to remain within the limits of its capital ratio.

There are winners and losers from changes in the FFR and IOER, and these can be assessed in terms of key actors in the credit markets.

Banks: Bank stocks can be expected to fall due to the reduced income from:

  1. Decreased loan interest from households and businesses on the existing loan book of over 197% of GDP. Even with lower rates, it is unlikely that the loan book will grow given how high the stock of debt already is. It is though more moderate than the GFC peak of 212.9% of GDP.
  2. Interest on treasuries bought in exchange for excess reserves by the Federal Reserve goes down.
  3. Interest paid on excess reserves by the Federal Reserve bank goes down.

One could look at shorting the big banks (JPM) (MS) (C) (WFC) (FAZ)

Borrowers: Rate decreases allow more cash flow to be spent on real goods and services and investment in new plant rather than going to debt and principal servicing. Aggregate demand in the economy will rise because of this rate reduction.

Macroeconomy: An income loss happens when rates go lower due mainly to the size of the interest income flow from the stock of treasuries. The following table shows the impact on the macro money supply at an FFR of 2% and IOR at 1.8%.

Macro impact table of september FOMC rates

(Source: Author's calculations based on FRED statistics and Trading Economics dot com statistics)

Contrast this with the past situation at 2.25% shown in the following chart.

Previous macro summary of FOMC rate changes (Source: Author's calculations based on FRED statistics and Trading Economics dot com statistics)

The net change to the money supply is -$49B and deflationary overall and shrinks the economy.

The boost to Main Street by way of a reduction of the cost of credit, a key business input, may cause the economy to do better and for the general stock market to rise as a result. (SPY) (DIA) (QQQ)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.