MONEY MATTERS
WHEN THE BIG BOYS BUY
BY DOUG WAKEFIELD

Imagine owning a stock that you find out Warren Buffet is about to buy or learning that the property next to your raw land had just been purchased for a billion-dollar development. You’d be more than a little excited and rightly so. The investment actions of large investors, who going forward I’ll call the big boys, have a major impact on our much smaller investments. The ultimate big boy not only has the power to make huge purchases, but can also print the money needed to do so. 

Let’s start with the Federal Reserve Bank of New York’s description of open-market operations, one of the powers of the Federal Reserve: The Fed can “buy or sell U.S. Government Securities in the open, or secondary, market as one of its most flexible means of carrying out its objectives.” 

So, if we know that the Federal Reserve can buy or sell U.S. Government Securities, then the most logical follow-up question would be, how much do they trade? According to the Federal Reserve Bank of New York, in 2003 they traded $454 billion through their 22 primary dealers.

While it goes without saying that the Federal Reserve is a “big boy,” the record regarding their sizable buys and sells of U.S. government bonds makes it increasingly clear that the Federal Reserve is not a heady bunch of uninterested, laissez-fair economists relegated to studying reams of economic statistics. They are also a major player who continuously exerts a substantial influence on our bond markets, and therefore our markets as a whole. 

So let’s look at their historical record. 

Established in 1913, the Federal Reserve was spreading its newfound wings in the 1920s. Member bank reserves received the windfall of this newly created credit in three major surges — 1922, 1924 and 1927. The Federal Reserve took a major role in swelling the money supply through their purchase of U.S. government bonds. That is to say the Fed tripled its stock of U.S. government securities from $193 million at the end of October 1921 to $603 million by the end of May 1922. From October 1923 to June 1924 there was another buying binge that topped $339 million. In 1927 alone, more than $445 million in U.S. government securities were purchased.

Before we proceed, we would do well to revisit what Fed purchases do to the amount of credit in the overall banking system.

The Federal Open Market Operations are conducted at the New York Fed and are responsible for the important function of purchasing and selling government securities in the open market. In order to increase the amount of credit in the banking system, the Federal Reserve buys government securities, and when the Fed wants to decrease the amount of credit, it sells government securities, thereby absorbing excess liquidity from the banking sector. When the Fed buys government debt, it pays for these bonds by increasing the banks reserve account at the Fed. It’s just an electronic transaction or a book entry, if you will. Then the banks have more excess reserves, which they can use to lend money to their customers. These loans thereby increase the money supply.

The speed of the money growth then picks up pace since our banking system is based on a fractional reserve standard. That is, reserves have a multiplier effect. If the reserve requirement is 10 percent (technically, today it is less than 1 percent), then for every dollar increase in reserves, the bank can loan up to nine dollars to the public. These deposits are used for making additional loans to businesses and individuals or for investments. LW