The fuss about Federal Reserve cutting back the stimulus.

The financial markets signal, by their gyrations whenever Federal Reserve suggests tapering of asset purchases, that the policy change will have a very adverse effect on the corporate sector. The Federal Reserve adopted quantitative easing to pull the economy from the eminent danger of sliding back into recession. The standard procedure to promote economic activity is for the Bank to increase money supply by purchasing of securities in the open market or by reducing the interest rate it charges on loans to banks. 1. Though the Federal Reserve loans are for short term, in general, long-term interest rates like mortgage rates move with it. Lower mortgage rates will increase demand for real estate and lower rates for commercial loans will induce firms to expand their operations. The additional construction and investment increase employment and the income they generate counter the threat of recession. In 2008 Fed realized that it had lost the ability to affect the economy through interest rate. Feds target rate was close to zero the real estate market in crisis. During 2006 and 2007, percentage of mortgage loans were given to buyers with low credit scores increased delinquency rates leading to what is known as subprime crisis.2. The delinquencies threatened solvency of interdependent financial institutions of the economy and the Federal Reserve decided to relieve the stress by purchasing on a large scale securities from government sponsored agencies Fannie Mae and Freddie Mac.3. The two institutions purchase mortgages from lending institutions and securitize them for resale in secondary markets. The purchase securities from the two allow them to buy more mortgages from lending institutions and mortgage banks in turn can in turn give out more mortgages. The availability of additional funds will also lower mortgage rates. . In spite of the unconventional stimulus offered by the Federal Reserve, the economy began to slow down in fall of 2010 and there was fear of it even sliding into double dip. After much discussion, the Federal Reserve announced on November 4, 2010 that it will purchase $600 billion of securities at a rate of $75 billion a month. The Fed had followed it with other measures to enhance liquidity in the economy.4. In 2013, the unemployment began inching down and the economy was showing steady growth even if at a lackluster rate. In July 2013, Chairman Bernanke announced that the bond-buying programme could be pared back at a "moderate" pace later this year if unemployment continues to fall and inflation stays low.5. It will be irresponsible for the Federal Reserve not to do so as it will lead to inflation. Yet the stock market is reacting as if it will be a disaster for the corporate economy. Share of a company is a right to its future profits and should ideally fluctuate with it. The reduction of the stimulus can affect a firm in many ways. The interest rate which was kept low through the actions of the Federal Reserve will now begin to increase. This will add to the cost of

Operating income Interest net Income before taxes Provision for taxes Net Income

Millions of dollars 12,200 600 11,600 4,000 7,600

Funds borrowed, the extent of which will depend on how much the firm has financed itself by debt as compared to equity. The table above is structured to roughly reflect the annual report of a major corporation in the technology field. 6. Its interest cost is only 5 percent of its operating income (roughly income from sales of its product less manufacturing costs). Even a 50 percent increase in interest rate will increase it only to $900 million. Assuming operating profits to be the same, it net income will decrease by 4 percent. But if the growth of economy, the reason for ending stimulus, increases the demand for product of the firm and a 2.5 percent increase in the net income will compensate for the interest cost increase. A corporation with a higher debt to equity ratio than the one in the table will find the increase in interest cost to be higher. The increase in interest rate has other effects. It will increase the flow of funds to the country as US citizens bring funds invested abroad home and as foreigners find that investment opportunity better in this country. The depreciation of Indian Rupee is attributed by many commentators to the policies of the Federal Reserve though, given other problems Indian economy have, it is hard to put much weight on that claim.7. The inward flow of funds into US will lead to appreciation of dollar. American goods will become more expensive abroad while foreign goods become less so in US. It will reduce the competitiveness of US industry. In turn that will reduce profits of the firms and employment in the country unless economic growth abroad Europe is showing positive growth - creates additional demand for US goods. The net effect on the economy and on the profitability of the firms depends on the balance of these opposing trends. The Federal Reserve has clearly stated that its policies will be based on the trends in economy. The gyrations in stock market are unwarranted.

Footnotes:
1.

For more details how discount rate affects market rate, see http://www.frbsf.org/education/publications/doctorecon/2002/june/discount-rate-mortgage-interest.
2.

See: http://www.investopedia.com/ask/answers/07/subprime-mortgage.asp ; http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1020396 .

3.

For an explanation of the historic origin of the program, see http://www.commercialappeal.com/news/2013/jul/17/why-the-fed-can-buy-mortgage-backed-securities/ . For a discussion of its effect, see http://www.federalreserve.gov/faqs/what-are-the-federal-reserves-large-scale-assetpurchases.htm .

4.

For a detailed discussion of how QE2 came into being is in Chapter 15 of The Alchemist by Neil Irwin (New York: The Penguin Press, 2013); http://money.cnn.com/2010/11/03/news/economy/fed_decision/index.htm
5.

http://www.theguardian.com/business/2013/jul/17/ben-bernanke-fed-stimulus-programme; also, http://research.stlouisfed.org/econ/bullard/pdf/BullardLouisville15August2013Final.pdf .

6.

Opportunities and choices: understanding our economic decisions http://www.scribd.com/doc/49513234/Opportunities-and-Choices

7.

http://www.ft.com/intl/cms/s/0/6bcd340a-0675-11e3-9bd9-00144feab7de.html#axzz2cM8kQAQH

Rama V. Ramachandran
http://www.visualeconomicanalysis.info/index.html Facebook: Ramanomics
Copyright 2013 Rama V. Ramachandran