Zaks Investment Advisory Service

On Current Events, the Federal Reserve, and a Bit About BRICs

Last time, we concluded a series of programs about China and promised to talk about other developing nations today. But the past week was so chockfull of unusual financial events that I would like to begin with these. As you of course know, on Tuesday, December 11, the Federal Reserve lowered the federal funds rates by a quarter of one percent, from 4.5 percent to 4.25 percent. It also reduced its so-called “discount window” rate by the same amount. Just to clarify: the Federal Reserve does not set directly the federal funds rate (i.e. the interest rate that banks charge each other for short-term loans), but affects it through the so-called open market operations. In other words, 4.25 percent is the target to which the Federal Reserve steers the rate. Our central bank explained this cut by noting that economic growth was slowing, the real estate market crisis was raging on, while the financial system was struggling to pull out of its credit crunch. There was nothing new or unexpected here. But how did the stock market react to this news? Immediately after the Federal Open Market Committee meeting’s results were announced, it fell by nearly 300 points. Why?

Many commentators declared that the market was “disappointed,” that it expected more – a cut of 50 points and not 25. I am not certain that this is the case. The market (i.e. most of its participants) assumed that the Federal Reserve would be cutting rates by 25 points. One may confirm this by looking at the Internet site of the Federal Reserve Bank of Cleveland. The Cleveland economists have developed a program that calculates the odds of a Federal Reserve rate hike or cut of a certain magnitude. These calculations are based on market prices of the Federal Fund futures and options. On Monday, on the eve of the Federal Reserve meeting, the market presumed that there was a 70 percent probably that rates would be lowered by 25 points, and a 30 percent one that they would be cut by 50 points. In other words, most were prepared for a small reduction in interest rates. The market is rational about its future expectations. Over the preceding four trading sessions, it had gained 3.5 percent. So most likely, Tuesday’s market fall was a case in point of the well-known saying: “buy the rumor, sell the news.” The “disappointment” was an insignificant factor in the market’s fall.

Financial market developments did not end there. On the following day, Wednesday, the Federal Reserve announced it would soon be holding a series of auctions. At these auctions, it will put up about 40 billion dollars that banks could borrow directly from the Fed for a period of four or five weeks, while using all sorts of different securities as collateral. The decision to stage these auctions is meant to abate the credit crisis on the short-term securities market. These auctions will be quite similar to how banks borrowed money at the Fed’s discount window, but with one small but significant difference: the banks can take part in these auctions anonymously. We have already talked about how banks dislike borrowing at the discount window because it has a stigma attached: it means that the bank’s affairs are in such a sad state that it is no longer able to borrow from its colleagues on the federal funds market. And so, despite coaxing from the Federal Reserve, banks prefer to shun the discount window, even when they need additional funds. It will be easier for them to participate in anonymous auctions. The decision to stage these auctions was unexpected and practically unprecedented. The stock market initially reacted enthusiastically to the move, gaining nearly the same amount it had lost the previous day (i.e. about 2.5 percent). But by the end of the trading session, this enthusiasm faded and stocks gained only 0.6 percent.

But the problems did not end there: on Thursday, the Labor Department reported that wholesale inflation, in other words, the level of prices at which stores purchase their goods, rose in November at an annual rate of 3.2 percent. And on Friday, it published the consumer inflation figure, which is what we usually refer to as the “inflation level.” It turned out that prices rose by 0.8 percent in a month. If one discounts the prices for energy and food (these vary much more than the so-called “core,” which is why the Labor Department always publishes two figures: the average inflation level for all goods, and the “core” rate), then one still finds that prices grew quite substantially – by 0.3 percent. It is interesting to note that many economists had recently blamed the Federal Reserve, which, citing a potential inflation risk, was in their eyes failing to cut interest rates fast enough. These economists argued that there was no inflation to speak of, that the Federal Reserve was being overly cautious, and that the economy was suffering as a result. As it turned out, the Federal Reserve was absolutely correct and the risk of inflation, unfortunately, remains. The market, for its part, reacted negatively – it is hard to expect large future interest rate cuts when inflation is growing. It fell on Friday as a result, and lost about 2.4 percent for the entire week.

But let us return for a minute to our main topic – developing nations. About three years ago, the renowned investment bank Goldman Sachs published a sensational document predicting that by 2050, the global economy would be dominated by four countries – China, India, Russia and Brazil. These countries’ first four letters make up a catchy acronym: BRIC. Goldman Sachs predicted that China and India would become the main suppliers of goods and services, while Russia and Brazil would dominate commodity supplies. We talked about China in our previous programs. It looks like the Goldman Sachs prediction about China is coming true. We will discuss the other nations in our next programs.

But with this, we will draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.