Alan Cring Productions in association with Emergent Light Studio presents
the Illinois State Collegiate Compendium, Academic Lecture in Business and Economics.
This is Business Finance, FIL 240 for autumn semester 2023.
Today's special topic is the Federal Reserve.
A couple of quick announcements before I get started.
This week, this is the Federal Reserve and then on Wednesday I will do ethics.
Now on Monday of next week, since I must be in a hospital,
I will have the first day of the two day review, Monday is day one, Wednesday is day two.
I will do it by Zoom. So you don't have to come to class.
You can just log in and live the dream with me on Zoom on Monday of next week.
Be sure to be there because it's like I said, the second day of the review.
So that will be something worth you coming to attend.
You'll also do your course evaluations on Wednesday.
And on Wednesday, just to let you know, you'll have a quiz this Wednesday,
two days from now, you'll have quiz seven.
Now there is a quiz eight, it's on Wednesday of next week.
Quiz eight is an attendance quiz.
There's only one question, are you in the classroom?
Now don't cheat on that quiz.
It's just sort of a freebie if you decide that you want to come to class
and be here for the last day of the semester for all the hijinks and fun that we're going to have.
But like I said, on Monday of next week, that will be a Zoom session,
provided I'm still alive.
But anyway, and other things.
Now one quick thing before I get to the numbers here.
There's no homework associated with these two special topics.
What there is, however, are some supplements for you to go through.
In modules, this is in student view.
Here at the bottom, you will see special topics, Federal Reserve.
Now if you click on that link, you'll see that there are two embedded links.
One is to a Federal Reserve version, actually from the Federal Reserve,
of what I'm going to teach you today.
It goes into the details, and this is a lightweight subject.
It's memorization, just remembering certain aspects of the Federal Reserve system.
And then below that is a video you can watch.
It's a cartoon video the Federal Reserve of St. Louis made some years ago,
but it's actually, it's cheesy, but it actually goes through a lot of the stuff
that I'll be teaching in the class and you read in that first link.
So that video is kind of worth watching just because it's a cartoon.
It's kind of, it's not the greatest animation in the world, but it's okay,
and it'll give you a good look.
It's just a jump link right there, just a little video that you watch,
and I think it's about 15 minutes long, but that's one thing.
And then the other thing is the document from the Fed.
What is the Fed?
What I'm going to teach in class today.
It's kind of a longish thing, but it's not terribly boring,
and it's very important for business people to know about the Federal Reserve system.
But I'll go through all of that in a little while here.
But anyway, there's your supplemental resources for the lecture today on the Federal Reserve.
Killing that off, now we have a look at the numbers,
and the numbers are not exciting any way you cut it.
You've got the markets are not all down.
The Dow is down about a little, not even two-tenths of a percent.
The S&P 500 is down a little less.
You notice in the last hour and a half, they are taking a turn for the sour.
There's some of the bearish sentiment is getting excited.
Notice the NASDAQ was up, coming up, and then it started to plunge downward too.
So there's been some grouchy news coming through that's pushing the bears to make their move.
It's nothing spectacular.
It's not like we're going to have a black swan or anything, but it is sort of a down day.
Now crude has been fighting to try to come above where it started, but it too is down.
And as you can see from gas prices, as I told you, gas prices have now shown that downward trend as well.
I saw a couple of places that were at 308 this morning.
So yeah, we're going to get a cheaper gas for a while here as long as crude oil prices stay down here in that trading band of 72 to 79.
The gold bugs got all kinds of excited, and I don't know what they're all worked up about,
but they've broken that psychological barrier at $2,000 an ounce thinking that the end of the world might be nearby.
I'm not sure what that's all about, but we'll see.
Now over here, have a look.
Bond yields are down.
When they are down, that's fairly noticeable.
It's about eight basis points.
And you may have seen in the news or not that home mortgage rates are now at their lowest level in quite a while.
So we do have interest rates in the United States coming down.
Not surprisingly, that will cause foreign currencies to appreciate against the dollar.
As you can see, the euro after up and downs is appreciating as is the pound, the British pound.
And the Japanese yen is appreciating as well.
Remember that it's the reverse of the normal way to depict these.
But yeah, we're getting lower interest rates, which weakens the dollar against our foreign currencies.
It's following basic international economics and finance.
And so there you go.
Now the Nikkei just didn't have much punch.
It wasn't a bad down day.
But you notice that it just kept on dropping slowly, just not any confidence in the markets in Tokyo.
And then the Great Britain had the same kind of experience, just a down day, slid not spectacularly, but it was down too.
And that, of course, not of course, but that came over here to our side of the world with our indices not having much to say either.
So it's not an awful day.
It's just kind of one of those grouchy days when it's kind of hard to pinpoint exactly why everything looks so grim.
Everything doesn't look grim, but it looks not very good.
The economy is doing fine.
We do have some troubling spots in the economy right now.
There was an article, Comptroller of the Currency, was showing banks that have closed in Illinois.
And it seems to be a little surprising that of those big banks, Chase was leading the pack of banks that have closed in the last few months or are about to close.
So it's hard to tell what that means.
It could mean that Chase is not getting the business that it wants, that things can support those banks.
Or it could mean that Chase is going to more of an online banking model, getting rid of the physical banks.
Hard to say which way it is.
Here and there across the interwebs, just having a look at just a few, look at the big dog like Microsoft, MSFT, should be, well, it's up a little bit.
The market is down, but Microsoft is showing a little bit of strength.
And it's a low beta, it's somewhat safe stock, a little overvalued, good profitability.
And I say this because I ask this on exams, this kind of know-how, read the screens, terrible dividend, but one way or the other.
But notice even Microsoft, it came up, and then in the early afternoon, just like the markets themselves, it's easing back.
Looking at another one, which should be showing a lot of good signs, is Amazon, Christmas season and all that.
Sure enough, it's doing well today against others, giving us some reason to believe that the large shareholders think we're going to go into a good Christmas season.
Whether or not we are is another matter entirely.
Having my fun day, fun work, Tesla, it's up too, but only about a half a percent.
And it too is sliding.
Notice Tesla, see all that volatility, it's just that risk in that stock.
And you can see that in the beta, the 2.28, a staggeringly high beta.
And that's sort of reflecting that high volatility, high risk, higher expected return that you would see in that one.
But as you can see from this number, right now the forecast is that one year from today, Tesla is going to be, well let's try to get a calculator up here, lower than it is now.
So if we are by today, in a year, at 205, it's forecast to be 205.38, divide that by 236.4, minus one, and then times the result by 100.
So the forecast is that a one year holding period return, and there's no dividend to save you in this, you would lose 13.12% by Tesla.
So that should give you a warning that this is not probably, if you are, you might be a risk taker.
You might say, hey, I believe in Tesla, I want to buy their car, and I want to buy their stock.
You might come out ahead. There's no certainty about the future, never is there certainty in stocks.
But the smart money is forecasting that you're going to lose, and you're going to lose rather badly.
13.12% loss for a one year hold on a stock is not a good idea, and it's not a good idea to take the chance on that, the good chance that that will happen,
if you've got better investment possibilities. So there you are.
Looking over at a war stock, just to have a look at Lockheed Martin, see what the sentiment is about, why can't I type today?
I'm talking and typing, Lockheed LMT, down. So you won't be drafted after all, maybe. I don't know.
I say that with a little bit of caution in my voice, but yeah, there you are.
Anyway, there's one quick dirty one in case I asked about holding period return on the final exam, which I probably will.
Just one of the core objectives in this class for me is that.
Going on to the topic of today, the Federal Reserve System. And I've said this before, and I'll say it again,
a lot of traditional finance textbooks avoid talking too much about the Federal Reserve.
There is a general sentiment that markets take care of themselves. These things like government agencies and quasi-agencies, they're just an annoyance.
They're in the way. That's normal for finance folks to talk that way. It's sort of like you, sir.
You are a 13-year-old and your mom wants to hold your hand, and you don't want anyone to see mom holding your hand as you cross the street.
It's the same thing. We don't want to say that this is the granddaddy of all of them in terms of effects,
at least in the short run and to some extent in the long run, on markets. Not just here in the United States, but across the world.
Because our interest rates, as you can see, drive currency exchange rates, which drive the flow of imports and exports.
They affect the amount of business activity in this country as interest rates go up, business activity goes down, unemployment goes up, all that.
So all of these things are being driven, certainly in the short run, by the Federal Reserve.
Starting out in the early days, okay, central banks, let me do this.
The idea of a country having a central bank goes back centuries.
The beginnings of central banks, you can trace those back to at least the 1600s, possibly the late 1500s.
There was a bank that was owned by a family, a powerful, wealthy family.
And it was sort of the bank that other banks looked to for guidance.
Or it was so dominant that it could make other banks do what it expected to be done.
It was the source of financing for new projects, for the big new projects.
It was even the source of financing for the monarchies.
And so these banks, back in that time, were in some sense central banks.
And that became formalized in the 1600s and 1700s in Europe as these central banks were recognized by the state, by the sovereign.
You are the center of the banking in our country. It became formalized.
So when the United States came into existence, these United States, you would think that that would probably,
we were modeling a lot of what we did on the European countries in terms of, and even earlier than that,
in terms of the philosophical foundations, the recognitions of rights and privileges and responsibilities,
you would have thought that that would kind of be part of, what they did in terms of their financial systems would be part of ours.
But it wasn't. There was this deep suspicion of the central government in the United States.
In fact, I can't remember if I mentioned this or not, before the Civil War, you wouldn't have said,
you wouldn't have heard someone say, the United States. Most people would have said, these United States.
In other words, there was a central government, but it was these United States, bound by a treaty called the U.S. Constitution.
But there was still this high degree of autonomy among them, among the several states.
That was kind of a difficult thing to imagine. It would have been difficult for them to imagine a central government
that would have so much power that it had the power to move and control and regulate the banking system of the whole country.
There were certainly some powerful families that wouldn't have wanted that either.
But that was so, it wasn't a go at the beginning of the country.
Early on though, some of the founding fathers did want to see a central bank.
They saw the European model, they said, okay, well we should do this. But they met a lot of resistance.
The first attempt with a first national bank didn't go over well at all. It sort of fell apart within a year or two.
Well, the thinking people in Washington weren't going to give up that easily.
They knew that there were advantages to having a centralized banking system.
So they came up with a second national bank.
Well, unfortunately, that ran into resistance that went all the way to a populist president.
Sort of a Trump kind of figure. This particular president was something of a rascal and a scoundrel.
He had been an Indian hunter, as they called him back then. And he was very much, I'm for the people.
We don't want no central government doing our business.
So that central bank, sort of like that national bank, second national bank, he just crushed it.
Sent troops in, closed it down, took the money and handed it out.
So that was the end of that for a long time.
Well, everything went along. Banks rose and fell, all kinds of scam banks and dodgy and suspicious banks and con men.
Banks would just pop up out of nowhere. People would put their money in.
And then the people who created the bank would just leave town.
It was not that uncommon, as they called them the sod banks.
And there were other scams and games that were played.
Sometimes a bank would be doing pretty well, but a powerful family or person would cause rumors to be started.
And everyone would run that bank and wreck it.
And then, of course, the powerful interests would step in and buy the remains of it, take over the remains of it, and consolidate monopoly power in that way.
Nothing was really there to stop them. There weren't really even any laws to stop it.
We got into some terrible banking crises in that time.
So serious, some of them were, that it wasn't just local effects.
It was almost like regional and national effects when banks...think about it this way.
You keep 10% of my money on reserve in case I want to back.
But the rest you lend out so that you can make money as a bank. Got that? Okay.
What I do is, I hear he doesn't have any of your money. I heard it from a good source.
So you're going to go in there and you're going to beat the dog food out of him.
And everyone else is going to say, oh my God. And then he's going to say, I don't have all of it. I keep 10%. Yeah, yeah. Run the bank. You collapse.
And then I started a rumor about another bank. And eventually no one trusts in the banks. They run the banks.
And all those banks that were good, they just didn't have everyone's money because they lend it out, fold in.
And I just step back in. Oh, you, two cents. You, one cent. You, nothing. I'll take it.
See how nasty it can get? And these caused collapses of banks across a city. They could do it.
And other things, of course, there were scam banks too. Lots of banks that just took the money and disappeared or set up all kinds of scams and schemes and offered ridiculous interest rates.
So it was not a pleasant time, the late 1800s, for stability of the banking system.
Now, there were a lot of politicians who recognized that there was a big problem with this.
But the problem was that they were all, there were very, very few politicians who were what you would call in the modern sense liberal or government oriented.
They all were to one extent or another bought and paid for by the wealthy, by the powerful of that era.
The government we had was the best government money could buy. And that was just the way it was.
Decisions on who was going to be a senator or a president or a judge were decided literally in back rooms, smoke-filled back rooms.
It just was that was how it worked. Oddly though, and you don't need to keep this in mind, you should have learned it in your economics classes, but I don't know if you would have or not.
In some areas of the economy, the excesses were getting so serious that some rich people and some politicians were getting screwed.
And so there were a couple of efforts of reforms in the late 1800s, getting laws passed that would at least put some kind of reins on this free market, libertarian laissez-faire, leave it alone kind of mentality.
One of those was in 1890, there was a law passed that tried to stop monopolies from forming.
It was the Sherman Antitrust Act of 1890.
Actually, it wasn't a great law because there wasn't much experience in doing this kind of thing, making a law that governed businesses and told them what they could do and what they couldn't do.
But it worked for a while. As a matter of fact, that Sherman Antitrust Law was used successfully against John D. Rockefeller and his Standard Oil Company.
But it didn't take long for the corporate lawyers to figure out how to get around that. So it was a try.
Then something odd began to happen in the second decade of the 1900s, 1911 and on from there.
You began to see a kind of more, maybe even liberal, but certainly one that saw a larger role for government.
And so that Sherman Antitrust Act was tied up with cutting off the loopholes, was the Clayton Act.
And then something amazing, the Federal Reserve Act of 1913, a central bank.
In other words, enough of this free market. There will be a bank that will oversee banks.
It will have broad powers and it will be separated from the main body of the government.
Sort of a semi-autonomous agency.
See, one of the problems with passing laws, and I've said this before, is that Congress can pass all the laws it wants.
But what are you going to do when people break that law or corporations break a law?
You're going to send the police? What police? You're going to prosecute them? Well, what prosecutor?
Generally speaking, we had learned that in order for any kind of law to have any kind of meaning,
there had to be an agency within it, empowered to interpret the law and effectively put the hammer down on the subjects of the law.
The antitrust law. How do you enforce a law that doesn't have anyone who knows how corporations work?
So the Federal Reserve Act, one of its most important aspects was that it created the Federal Reserve Board.
The Federal Reserve Board would take banking laws and they would interpret them as regulations and impose them on the banks.
That's what agencies do, like the Environmental Protection Act created the Environmental Protection Agency
so that there is a body of expertise that can interpret the environmental laws and tell businesses,
thou shalt do this, thou shalt not do that. That's what the Federal Reserve Board does in terms of banking.
It was enabled by the Federal Reserve Act. Now the Federal Reserve Board essentially has seven governors.
These are appointed by the President with the advice and the consent of the Senate.
So in other words, a President says, well, I want to fill this Board position.
That person, that nominee, then goes before the Senate and gets grilled on his or her credentials and then they say yes or no.
Now one of those seven governors is the Chairman. That's one of the seven.
One of my favorite questions is, which of the following is not correct?
I'll say the Board of Governors has seven governors plus one chairman. That's false. The chairman is one of them.
Now something that has come up recently, and I'll tell you right now, I'm not sure of how this is working,
but I've seen the term co-chairman. So it seems that nowadays, within the last maybe few years I guess,
they've decided that instead of a single chairman, as there had always been, now it's like there are two.
They're sort of like the spokespeople. The chairman is the spokesperson for the governor.
The chairman is the leader of the governors, the inspiration of the governors, as it were.
But make no mistake about it, these chairmen are independent thinkers.
You have conservatives, you have liberals, you have inflation hawks, cut the money supply, and you have inflation doves.
Let's let a little inflation if it'll help the economy.
It's meant to be a consensus of dissenting voices, but they are all supposed to be highly educated, industry-aware people.
That has eroded in recent years with appointment of governors who are much less qualified to be in their positions,
but got there through political connections and all of that. It's an unfortunate trend.
It has not eroded the ability of the Federal Reserve greatly, but it has caused some questions to be asked.
Now the Federal Reserve Act divided the country into 12 districts.
The problem was that when this was passed, the districts on the East Coast were very small because of the large number of banks, large amount of economic activity.
The districts out West were huge because not as many banks, not as many people, not as much business activity.
Unfortunately, these days you've got a district bank like the San Francisco District Bank, which has this vast area that's insanely busy and highly active in the banking industry.
There's that.
Here where we are, we're actually not too far from the border between the St. Louis District and the Chicago District.
We're in the Chicago District, but I think it's about 40 miles south of here. You're in the St. Louis District.
Now each of these districts is kind of known for one thing or another.
For example, the St. Louis District Bank is known for its outreach and its education programs.
That video that I told you about at the beginning comes from the St. Louis District Bank.
Others are known for other specialties that they kind of concentrate on.
But they are all, and of course, just as a quick thing here, if you look at a dollar bill, I don't have a dollar bill.
Where do I find one?
Well, these don't have the designation. On the one dollar bills, C, K, oh, it's not easy to see, but you'll see a letter.
A through K, I think it is. That would be the district bank from which that money came, that money was printed.
And that's one of their jobs. I'll talk about that in a minute.
Okay, the 12 districts. Each district oversees the banking and its area.
Now, the governors regulate the banking industry. In other words, they turn laws into regulations.
And then it is the job of each of the district banks to supervise the banks in its district.
Remember that. I'll do that on the final.
The board of governors regulates and the district banks supervise.
Board regulates, district banks supervise.
And there are quite a few jobs that you can get in these district banks doing things like supervision of the banks, analysis of data.
They're actually surprisingly good jobs.
Now, each district bank has a bank president.
One bank president per district.
Now, this is important a little later.
These district bank presidents are consummate professionals.
Accounting, finance degrees, highly educated.
Oftentimes they were in the industry themselves, the banking industry, before they became the president of that bank.
They are, I have seen two of them. I did not speak to them, but I was in the same room with two of them.
It's one, those kinds of people, you can tell there's something different about them.
They are always diplomatic. They're always in their best moment.
They're always dressed to the nines. They're perfect.
I'm sure they don't get traffic speeding tickets. They probably don't even have sex.
Hence why they're in banking.
But anyway, now this will be important here in just a minute.
Why we care about the district presidents of the district banks.
But this is the structure of the Federal Reserve.
And it is everywhere and it is always affecting the economy in a number of ways here.
Find something here.
Okay.
When this legislation was passed back in 1913, and there were some amendments to it to gussy it up,
but the central bank was given three areas of responsibility.
It had three jobs.
The first of those was regulate and supervise the banking industry, what I just talked about.
Regulate and supervise the banking industry.
There's the watchdogs.
Now interestingly enough, I should point this out now instead of later,
there are other agencies of the government that do this as well.
There is a turf, kind of like a turf, each of these regulatory bodies has.
So for example, the Federal Reserve has all of these banks that are under its regulation and supervision.
But then there is the Comptroller of the Currency.
That agency has its banks that it watches.
And then there is the Federal Deposit Insurance Corporation, the FDIC, which has its banks that it oversees.
Then you have, what else is, oh, you have state banks,
which are regulated and supervised by the states in which they are chartered.
And then you have these banks, well, credit unions.
They have their own regulatory and supervision body that oversees them.
It's like a crazy quilt.
After the crisis of 2008, the Congress got involved saying,
okay, who's responsible for these banks and what happened?
And you, well, those guys, those guys, those guys.
And so Congress had this fantasy for a while, we're going to put everything under one authority.
Oh, God, the turf war.
Oh, not my banks, not my banks.
And they got their allies and their lobbyists and their senators and representatives all siding.
And it never did get consolidated.
So we still have a system where there is something of a crazy quilt of oversight.
However, the 800-pound gorilla is the Federal Reserve.
So the Federal Reserve, its authority, its charter.
Back in 1913, regulate and supervise the banking industry.
Two, the Federal Reserve serves as a bank for banks.
Every bank needs a bank.
I mean, well, no, it can't do its own checking account.
It needs another bank that does that kind of stuff like checking accounts, saving accounts,
whatever you want to say, whatever you want to call it.
Every bank has to have a bank for its money, putting it in kind of simple terms.
So this bank for banks, this is one of the most interesting innovations.
And unfortunately, hardly anyone knows about it.
And if they did, we could have some great ideas come out of it.
Let me explain.
Okay, there are private commercial banks that will also be a bank for banks.
So you, madam, as a bank, you could come to me, the Fed, for your banking,
or you could go to this commercial bank that handles banking accounts.
You could come to me, or you could come to him, or you could go to him.
So that means that there's a competition.
The charter says that the Federal Reserve can't cheat in this competition.
They can't undercut prices for checking accounts and all that kind of stuff.
They have to play on a level of playing field.
Even more interestingly, the Federal Reserve under the bank for banks part is mandated
to constantly be improving the technology of the banking industry.
It must pour money into new technologies.
Like if you've ever seen regular old paper checks, those MIRC codes,
those magnetic ink codes down there at the bottom, that was an innovation decades ago.
Of? And then they just shared it for free because they're required,
every time they come up with an innovation, they have to give it for free
to all of their competing private sector banks.
Everything has to be shared.
So in other words, they are the spearhead of all of those things like ATMs,
like electronic checking, debits, and credits.
Through their vast resources, they are constantly innovating
and then completely sharing it with all of their competitors in the private sector.
Now, a couple of things about this.
Someone asked me some years ago when I was doing this very lecture, they said,
someone asked me, well, how much of the banks for banks does the Fed do
versus how much is done by private banks?
Is it 50-50 or does the Fed have almost all at 99-1%?
And I didn't know.
So I called a former fellow PhD student of mine at a district bank and I just asked him.
He was one of my fellow students many, many years before.
And I'd been in communication with him.
I said, I got a stupid question for you.
How much of the banking bank's banking is done by the Fed
and how much of it is done by your private competitors?
And his answer was a little surprising on one thing.
He said, well, I couldn't tell you the numbers nationally.
All I can do is tell you the numbers in my district, which was the St. Louis district.
He said, we've got about 65% and the private banks that do banking for banks, they've got 35%.
So it was about 65%, 35%.
I said, okay, well, that's good enough.
Probably that's about what it is, national average, I would guess.
But the interesting thing is those private banks, they make a fortune doing this.
It's not like they are hurt by the Fed.
And the Fed makes a fortune serving as a bank for banks.
In fact, in a typical year, the Federal Reserve will return to the Treasury
in profits that it made from its banking activities, over a billion dollars.
Just a check.
Here, this is how much we've made through our fees to the banks who bank with us.
And here it is.
And they just give it to the Fed every year.
So, one, it's profitable.
Two, it doesn't hurt the private sector banks that are doing the same thing.
And three, why the hell don't we apply this model to health care insurance?
In other words, we see the model, we know how it works.
Why couldn't we just do that?
You can get your health care from the government, from a central health care insurance agency of the government,
or you can get it from the private sector.
They'll compete against each other.
And all that, oh God, no.
We'll just have a big, huge, constant war over socialized medicine
instead of taking that middle ground approach like we did over a century ago
that has worked like a clock ever since without a glitch.
That would be too easy, I guess.
So there you are.
Anyway, moving on.
And finally, the third, the 800-pound gorilla.
The Federal Reserve conducts monetary policy.
In other words, it keeps the flow of money going into the economy.
If the economy needs liquidity, the Fed adds liquidity.
If the economy has too much liquidity, then the Fed drains liquidity from the economy.
That's what it has been doing.
Back in the 2000, after 2018, 2017, it started fueling money into the economy, to juice the economy.
And it kept doing that.
And then we were beginning to slip toward a recession in 2020, so it juiced more.
It shouldn't have done that, but it did it.
And then we had the COVID crisis and the lockdown, and the economy was just dying.
So the Fed just cranked up the money machines, infusing money into the economy.
And what happened?
Eventually inflation.
That is how it works.
There is one and only one cause of inflation.
It is too much liquidity being added relative to the real growth rate.
So in other words, if the economy is growing at 2.5% in real GDP terms,
then the money supply to keep it properly lubricated would be a growth rate of 2.5%.
But when you go above that growth rate of the economy, well, eventually what happens is you'll get inflation.
It works in the short run to juice the economy, but ultimately you pay the price through inflation.
And then you have to turn back and pull the lever the other way and drain that excess liquidity overhang,
which is what the Fed's been doing for about a year and a half now.
There's no rocket science.
It's not some conspiracy theory.
It's just the plain dynamics of money versus inflation.
And see, that's one of the reasons the Fed was made semi-autonomous,
was so that they would not have political pressures.
During an election year, the politicians are going to want the money to pour into the economy to juice it
simply because they want to be re-elected and then let the consequences come as they may after the election.
Well, then the Fed can try to claw back all that liquidity they poured in.
But that's not the way it should work.
The Fed should and oftentimes has tried to maintain a level growth rate.
But unfortunately, politics comes into play, and then we're in a wild cycle.
Add liquidity, oh, God, inflation.
Drain liquidity, oh, God, now we're going into a recession.
So it's back and forth, and the Fed's job is to try to keep from having to do that kind of forward, backward, like that.
Okay, conducts monetary policy.
The Fed has three ways to do that.
It has three ways.
Now, in terms of frequency, I'll go from the least used to the most used.
The first way is the fractional reserve requirement or the required, as some people call it, required reserve ratio.
Let me explain how it works.
As I go through one marker after another finding one.
Let me show you.
Things like banks have been around for the ages.
We know that, for example, in Rome there were these things like banks around.
They conducted business, sometimes in an established place, sometimes in a not so established place, as you may have read in an interesting passage,
when a particularly irreverent rabbi chased them out of the temple with a whip, as I understand it, but they conducted banking.
In the Middle Ages, there were these things that were essentially like banks.
They were banks, and the wealthy could deposit their money there where it was safe.
It wouldn't be stolen by high women or by thieves in the middle of the night.
And this was just how it was done.
For example, I'm a wealthy nobleman.
I have 100 gold coins.
I should like you to keep it safe for me.
And you say, sure, I shall keep it safe for you.
But the thing though is that you're not going to make any money doing that.
So what you might want to do is say, okay, well let's make it $1,000, okay?
So I deposit an initial investment, we'll call that the base infusion, $1,000.
Now, I'm not going to come back in and give it all back to me.
I might come in, or he might come in with a check I've written for $20, honor it, and you'll say, okay, go into my little area.
But I'm not going to have it all, you're not going to keep it all.
It would be nice if you could take some of it and lend it at interest so you can make some money on it.
Okay, suppose that you decide that you will keep a reserve ratio of 10%.
So you will keep $100 of that and you will lend out $900.
So we're in the Middle Ages and you've got this $900 burning a hole in your pocket.
So let's say you, sir, you come into this bank and say, I should like to start a business and I need a loan.
Well, what are you going to do? I am going to bake meat pies. How much do you need?
Well, I should like $900. And you say, okay, I shall lend you the $900.
So you buy the facility for making the meat pies from this lady and this lady comes back to the bank and puts that $900 on deposit.
Uh-oh, money supply is now $1900.
And then you come in to the bank and say, I should like to start my own company.
Okay, well, what do you want to do? He asks you. Well, I should like to start Ye Olde Escort Service.
Peasants on demand.
Okay, well, we're going to keep 90 and the banker says to you, well, I have $810.
So you do it and you set up your service.
Now, obviously, back then, it wasn't really online, but you did have access.
Did you know the medieval equivalent of YouTube? It was called VowTube.
Fine. I'm trying to be funny in a boring lecture.
Okay, so the money's lent to you. You have him set up your service.
He brings the money back to the bank to deposit $810, of which I keep $81.
What the heck is 80? Minus 81. Quickly, 9, 10. Oh, shut up.
$719.
Do you see what's happening to the money supply? It's growing on its own.
In fact, I can tell you right now that ultimately what's going to happen is that that original $1,000 will become $10,000.
How do I know that? Because of the money multiplier.
The money multiplier says the final amount of money will be the original amount times 1 over the required reserve ratio.
So with 10%, that would mean that the multiplier is 10 times.
With 20%, 1 over.20 is only 5 times.
You see what's happening? As you increase the money at the required reserve ratio, you slow down the growth of money.
That's what the Fed can do. It is a meat ax of a tool, though, simply because, I mean, you know, just a little tick in the thing
will cause quite a little bit of drama in the growth rate of the money supply.
I had another uncomfortable question some years back. Someone said, well, what's the requirement? What is this?
And the Fed sets that. They set the required reserve ratio.
Someone asked me, well, what is it right now? I didn't know.
So I started keeping an eye on it, and I thought, okay, I'll call my contacts.
So I said, okay, what's the required reserve ratio?
And the guy I talked to, I had never talked to him before, he was really helpful, though.
He said, which one? And I said, wait a minute, what do you mean, which one?
And he said, oh, there's a different required reserve ratio based upon the tranche of money.
So, for example, the required reserve ratio for the first $10 million of assets of a bank are one number.
Then from $10 million up to $100 million or something, there's another required reserve ratio.
And then above that, there's another required reserve ratio. I didn't know that.
So they kind of fine-tune it to the size of the banking institution itself.
I said, okay, help me out here. Give me some numbers.
And he gave me some numbers at the time. I think it was like the top was like the required reserve ratio was like 6.53%.
And then he gave me the next number, which was somewhere below that.
And he said, well, for the first tranche, for the small, the lowest amount of money, it's zero.
I said, what? There's no required reserve ratio?
He said, not technically, no, it's zero.
Which kind of floored me. I mean, you're not requiring them to keep any money in the vault.
Oh, they do. We have other ways we have them keep money in the vault.
But, you know, that's not the job of the required reserve ratio.
And that kind of surprised me.
It may be a little bit edgy about small banking institutions and all that, but there you are.
Now, I saw an article a couple of months ago, very reputable financial banking magazine.
Yes, I have a boring life. I read that kind of stuff.
And the author, who was a former Fed official, he just out, he just said it almost in passing,
well, we all know that the effective required reserve ratio is zero now.
And he wasn't talking about tranches. He was talking about the whole system has kind of like an effective
required reserve ratio of virtually nothing these days.
But again, I suspect it's like what the guy was hinting to me that there's other mechanisms.
Well, I know there are.
But anyway, that's the required reserve ratio. It's a meat-axe approach.
Now, interestingly enough, when it is changed, it is usually not changed for the purposes of adding to
or contracting, slowing, increasing the growth rate or decreasing the growth rate of the economy.
Give you an example. After the attacks of September 11, 2001, there was a real, right away, immediately,
there was a great concern that people were going to freak out and they were going to run to their banks
and get all of their money out and hide it under the mattress.
And we've seen it happen historically that everyone's going to run the banks because the country's coming apart
or something or the government won't be able to take care of us or something like that.
So on that day, they increased the money multiply, they increased the fractional reserve ratio
simply to require that banks had more money in the vault to satisfy demands, demand deposits.
They just pushed it up just to make sure banks had plenty of money.
In fact, they did even more. They literally, from all of the district banks,
they ran massive armored convoys of cash money to banks all over the country
just poured money in so that expecting everyone to be running the banks wanting their money,
they wanted to make sure that every bank had sufficient liquidity to handle the demand spike.
As it turned out, oddly enough, people didn't run the banks.
There wasn't any evidence that people freaked out and went and got their money out of the banks
because they thought the world was coming to an end.
So it was good that the Federal Reserve did this, but it turned out that that precautionary liquidity
they wanted to have the banks possess wasn't needed.
Apparently, Americans are a little bit more stable in their thinking than we were expecting them to be.
Or they just didn't think about it, one way or the other.
Okay, enough of that one.
Now, there's another mechanism, the second tool of monetary policy.
The second tool of monetary policy is something called the discount rate.
This was the first one, fractional reserve ratio.
The second one is called the discount rate.
Now, the discount rate is the interest rate at which the Fed would lend money to a bank.
If a bank needs money, it can borrow from the Fed at this discount rate.
Now, the Fed can increase the discount rate so the banks don't want to borrow as much,
or it can decrease it if they want banks to come and get it, borrow money.
So every time the banking officials, the Fed meets for their decisions eight times a year,
and I'll talk about that in a little bit, they set the discount rate.
The discount rate will be for this period, 4%.
Now, if they have nudged it up, that's a signal that they are fighting inflation.
They want to slow down the economy.
If they drop it, that's a signal that they think the economy needs to be boosted.
If they leave it alone at one of their meetings,
that's a signal that they think the economy is on track.
So for well more than a year now, the Fed at every meeting was announcing an increase in the discount rate.
Usually it was 25 basis points, a quarter of a percent.
The Fed increased the discount rate by a quarter of a percent today.
In other words, they're signaling the markets, we want the economy to slow down.
We want interest rates to go up.
And interestingly, the markets work on expectations.
If they think the Fed is going to jack it up, they drop stock prices really quick,
because they think, well, the Fed's about to jack up the interest rate, that'll slow down the economy.
Let's get in front of that.
So expectations of what the Fed's going to do are very important.
Now the Fed was one after the other, just kept increasing, increasing, increasing.
But then they have stopped.
They're warning that they could start up again, increasing the discount rate.
But most of the smart money is saying, well, they may be finished now.
They have slowed the economy enough that they have drained the expectation of inflation out,
as I showed you earlier, that expected inflation.
But the Fed is still, you know, the chairman said, we may raise it again if we smell inflation turning north.
But for the time being, they have stopped increasing it.
That helps, that's why the stock markets in general have been going up, not today,
but because of the expectation that the Fed is not going to try to cool off the economy anymore.
They're doing good.
However, the Fed isn't the only place that a bank could borrow money.
A bank could borrow money from other banks.
There is a market interest rate for money borrowed by banks from banks.
This is called the federal funds rate.
And it is just driven by supply and demand of money in the banking system.
In other words, if there's a lot of money floating around in the banking system,
then you could go to the Fed funds market and borrow money from it.
Or if you had a lot of extra money in your bank, you can put that into the federal funds market,
and it's there available for others.
Now, the discount rate is set by the Fed.
The federal funds rate is set by supply and demand dynamics of the market.
However, the Fed is going to say, we want the federal funds rate to be this.
They can't force it to be that.
They can't say, it is this.
But they can say, we are targeting this.
One of the laughable things you'll see on financial news channels,
well, the Federal Reserve Board set the discount rate at, and they set the federal funds rate at.
No, they didn't.
They cannot set the federal funds rate.
They can move it.
Like, for example, in recent times, the Fed has been trying to slurp money out of that federal funds market,
which makes the federal funds rate go up.
They can't force it, but they can pull money out.
Or if they wanted the federal funds rate to go down, they could put money into the federal funds market.
But they can't set it.
Historically, interestingly enough, now the federal funds rate is typically above the discount rate.
So you as a banking official, sir, I'm the Fed.
You can come to me and get money at 4% from the discount window, we call it.
Or you could get money from your buddy here who owns a bank.
He's going to charge you more.
Historically, interestingly enough, a lot of times you would go to him instead of to me.
Even though I'm cheaper, you'd go to him.
You would pay the federal funds rate set by the market instead of my discount rate, which would be lower.
Why would you do that?
Think about it this way.
I'm your dad.
I know, bad thing.
I'm your dad.
You need $1,000, like now.
So if you come to me, you could get $1,000 at a low interest rate, or you could go to him and get the $1,000 at a higher rate.
Now I want you to imagine what will happen when you come to me.
Dad, I need $1,000, like now.
What the hell do you need that for?
From him?
Cool, bro.
Got the idea?
You might be willing to pay more just so you won't have me beat your ass.
That's how it works.
But anyway, there's the outline of it, and I'll finish up the rest on Wednesday.
That's all I have for you today.
I thank you.