Fed Ed White Paper

David A. Houle, CFAElliott J. Orsillo, CFA

November 2013

THIS WHITE PAPER IS FOR INFORMATIONAL PURPOSES ONLY. IT IS NOT INTENDED FOR PUBLIC DISSEMINATION, NOR IS IT AN OFFER OR SOLICITATION TO SELL SECURITIES OR INVESTMENT ADVISORY SERVICES. PLEASE SEE IMPORTANT DISCLOSURES ON PAGE 11. CONTACT SEASON

INVESTMENTS AT(719) 528-8400 OR [email protected] FOR MORE INFORMATION.

FED EDA Primer on the US Federal Reserve

FED ED :: A primer on the US Federal Reserve.

PART 1: THE GENESIS

"Give me control of a nation's money and I care not who makes its laws" -- Mayer Amschel Rothschild

The origins of centralized banking activity here in the United States date all the way back to the American Revolutionary War when the Continental Congress printed paper money known as “continentals” to finance expensive military efforts. Continentals were issued so rapidly that they quickly lost their value and were considered worthless by the end of the war. To address this issue, Treasury Secretary Alexander Hamilton urged Congress to establish a central bank in the United States. In 1791 the First Bank of the United States was created with the charter to “manage the

government's money and to regulate the nation's credit” from its headquarters in Philadelphia. The federal government had a 20% ownership stake in the Bank and elected 20% of the Bank’s directors with the remainder being controlled by private investors.

The First Bank was not popular with many Americans who felt it gave too much power to and favored the New England states. Although it successfully carried out its mandate, Congress fell one vote short of renewing its charter upon its expiration in 1811. Without a central bank, the US economy had no governing agency to oversee banking and credit activity. This led to a plethora of private banks issuing their own form of currency and extending credit in a non-uniform way across the country.

By 1816, the political climate had shifted and was once again ripe for the introduction of a US central bank. After several years of economic

disruptions and numerous bank runs, Congress decided to charter the Second Bank of the United States. The Second Bank was structured similarly to the First Bank and received the same backlash from Americans who felt that its activities advantaged the elite at the expense of the country’s more rural population. In 1828 Andrew Jackson was elected president on the promise of quelling the banker controlled power being perpetuated by the current system. Many Americans shared in President Jackson’s belief that a central bank created “a concentration of power in the hands of a few men irresponsible to the people." The embedded cartoon shows Jackson destroying the Second Bank to the approval of Uncle Sam with the Bank’s president, Nicholas Biddle, depicted as the Devil. When the Second Bank’s charter expired in 1836 it was not renewed.

The period that followed was known as the “free bank” era. During this period of time, banks were unregulated and issued their own currencies in the form of banknotes. The value of banknotes would vary based on the credit quality of the issuing bank. Commerce was difficult since both parties had to be comfortable with and agree upon the value of the banknotes being exchanged. In 1863, during the heart of the American Civil War, the National Banking Act was passed to create a national currency backed by the US government. The Act brought stability to the currency system by levying a tax on state bank notes while exempting the national bank notes from the tax, which effectively created a uniform currency for the nation.

Although a uniform currency provided some measure of stability for the emerging US economy, bank runs and financial panics were still very much the norm. Without a centralized banking system or

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deposit insurance, people’s money was only as safe as their bank’s individual financial state. Whenever a bank was thought to be suffering from a liquidity problem, which was often the case for rural banks whose reserves would be drawn down during the growing season and then replenished after the harvest, people would pull their money out of the bank creating a self-fulfilling liquidity squeeze and eventual bank failure. Because of this, the last part of the 19th century and beginning of the 20th century was characterized by a series of financial panics. Financial panics in 1893 and 1907 led to severe economic depressions, which were only eradicated after J.P. Morgan intervened by effectively acting as a central bank and providing liquidity to the U.S. banking system.

Shortly after the panic in 1907 Congress created the National Monetary Commission to study the nation’s banking system. Senate Republican leader Nelson Aldrich was appointed the head of the commission. He travelled to Europe to study examples of central banking in practice. He left an opponent of central banking but returned in favor of it after studying Germany’s centralized banking system. In 1910, Aldrich and executives from several major banks had a secret ten day meeting at Jekyll Island, Georgia to draft the establishment of a U.S. central bank. What came out of that meeting became known as the Aldrich Plan which proposed a well-capitalized central bank with 15 branches to represent the different regions of the United States. Each branch would then be controlled by their

member banks with voting power tied to the size of each member bank. The plan was well supported by banks and most Republicans but lacked bipartisan support to pass through Congress.

The bill lacked bipartisan support because Aldrich was seen as the epitome of the “Eastern establishment,” which southerners and westerners already felt had too much power. Democratic Nebraskan populist William Jennings Bryan said that if the plan passed, large banks would “then be in complete control of everything through the control of our national finances.” (A

sentiment shared by Mayer Amschel Rothschild in the opening quote over a century before Jennings Bryan’s time.) Opposition to the “money trust” proposed by the Aldrich Plan and support for protecting the general public from financial panics became the central platform of the Democratic Party in the 1912 election. The campaign was successful and the Democratic Party took control of presidency and both chambers of Congress.

The Chairman of the House Committee on Banking and Currency, Carter Glass, redrafted the Aldrich plan for newly elected president Woodrow Wilson who supported the core tenants of the Aldrich plan. When President Wilson first brought the Federal Reserve Act to Congress it was vehemently opposed by some members of his own party on the basis that smaller, regional banks would not be afforded the same government backing as the larger, centralized banks. It was only after Wilson garnered the support of Jennings Bryan and agreed to pass anti-trust measures after the bill had passed, that the Federal Reserve Act got any traction. After months of deliberation, hearings, and amendments the Federal Reserve Act passed both branches of Congress and was signed into law by President Wilson in December 1913.

The final plan represented a compromise between the competing political parties which created an independent central bank that balanced the interests of private banks and American people. The American Institute of Economic Research provided the following synopsis on the bill.

In its final form, the Federal Reserve Act represented a compromise among three political groups. Most Republicans (and the Wall Street bankers) favored the



Aldrich Plan that came out of Jekyll Island. Progressive Democrats demanded a reserve system and currency supply owned and controlled by the Government in order to counter the "money trust" and destroy the existing concentration of credit resources in Wall Street. Conservative Democrats proposed a decentralized reserve system, owned and controlled privately but free of Wall Street domination. No group got exactly what it wanted. But the Aldrich plan more nearly represented the compromise position between the two Democrat extremes, and it was closest to the final legislation passed.

The Federal Reserve Act of 1913 was a monumental piece of legislation in our nation’s history. Some might argue that it is responsible for the current level of prosperity we enjoy in the United States, while others would argue that it was the inflection point where “Big Brother” started down the long path of financial control over its citizenry. Both extremes have merit and as with most things, the truth probably lies somewhere in the middle. Next week we will look at the impact the Federal Reserve has had on the US economy over the past 100 years.

PART 2: FRANKENSTEIN’S MONSTER

“Man, how ignorant art thou in thy pride of wisdom!” - Victor Frankenstein, character in Frankenstein by Mary Shelley

As we touched upon briefly, the idea of a central bank in the United States was birthed out of two desires: 1) to create a more uniform system of credit & 2) to stabilize the banking system. From this humble beginning the Fed mandate has increased significantly over the past 100 years as it has learned (or at least believes it has learned) things along the way. In the novel Frankenstein by Mary Shelley, Dr. Victor Frankenstein takes pride in his wisdom and decides to play god by experimenting with the creation of life. The result is a hideous monster which becomes self-aware and wreaks havoc on its surroundings. In a similar vein, the Federal Reserve was born out of the wisdom and confidence that a central bank can benefit a country’s citizenry by managing the economy. This commitment to “playing god” with the economy is the core reason why the Federal Reserve has grown into what some would consider the most powerful and influential institution in the world.

Up until the early part of the 20th century, banking was a very fragmented industry where the availability and cost of credit varied widely from bank to bank. In addition, seasonal factors such as

planting and harvesting cycles or the need for people to withdraw cash during the holiday season put an unnecessary liquidity strain on the system. When liquidity was constrained, banks would raise their borrowing rates because they didn’t have the ability to lend money as freely, so interest rates and the availability of credit was very seasonal. The Federal Reserve and its regional branches were established to provide more “elasticity” to the banking system. They were given the power to issue new currency (backed by assets such as gold or commercial

paper at the onset) in order to meet the demands for money in the economy. The nearby chart shows how the Fed was successful in smoothing the seasonality of the interest rate cycle by creating a more uniform system of credit, which had previously been heavily influenced by rural supply and demand factors.

The second objective of the Federal Reserve was to provide stability to the banking system in order to reduce the frequency of financial panics which were very much the norm at the end of the 19th and



beginning of the 20th centuries. During the Roaring Twenties, speculation was rampant and asset prices were bubbling up to new stratospheric highs. One of the main factors driving the speculation was an unintended consequence of the Fed’s policy to smooth out the interest rate cycle and make it easier for banks to lend money.

Eventually the Fed decided they needed to do something to stem the speculation so they raised interest rates in order to make it harder for speculators to borrow money and invest in the stock market. The move worked a little too well and money quickly fled out of the stock market causing the now infamous Crash of 1929. The shift in sentiment from the stock market crash coupled with higher interest rates brought the unintended consequence of a reduction in capital spending in the real economy on equipment and infrastructure. The fall in the market and the economy led to bank runs as people feared they would lose their savings if their bank went belly up. As the lender of last resort, the Federal Reserve was in prime position to dampen the fallout by providing funds to distressed banks, but at the time Fed policy limited the Fed’s reach to member banks with sufficient collateral, so cash-starved banks failed by the thousands.

After the fallout from the Crash of 1929, Congress passed several acts to expand the Federal Reserve’s power and authority. The Fed was given the power to conduct “open market operations” (QE falls into

this category) and the authority to regulate bank holding companies. In addition, the Federal Open Market Committee (FOMC) was established to oversee the creation and implementation of monetary policy. After World War II, the Fed’s mandate was again expanded to include the goal of promoting maximum employment as soldiers returned to the workforce. To accomplish this, the Fed kept interest rates at the same low levels used to finance the war for an extended period of time. The path of least resistance for policy makers was to keep rates low in order to execute on their new mandate of maximum employment. This in turn helped politicians get elected by their fully employed constituents. The unintended consequence of this free lunch policy was the stagflation of the 1970’s where both inflation and

unemployment grew in tandem. It was during this time that Congress gave the Fed a new mandate to maintain “stable prices” in addition to their previous mandate of maximum employment; the combination of which is now commonly referred to as the Fed’s “dual mandate.”

The Fed was finally able to get inflation under control after Chairman Paul Volcker ignored the maximum employment part of the Fed’s dual mandate by making the very unpopular decision to raise interest rates to historically high levels during a recession. Once inflation was under control and price stability was reestablished, the economy began to recover. This set the stage for over two decades of credit expansion and prosperity known as the Great Moderation, which was largely credited to the Fed’s ability to tame the business cycle. The unintended consequence of the Great Moderation was the Financial Crisis of 2008 in which the credit bubble over two decades in the making finally burst. Individuals defaulted on debts and banks quickly became insolvent when the mountain of AAA loans on their books were proven to be more of the junk variety. In response the Fed took “extraordinary measures” by cutting rates all the way to zero, pumping money into the economy at record rates, and facilitating the bailout or buyout of several institutional banks.

The actions of the Fed during the 2008 Financial Crisis definitely saved the banking sector and by extension the US economy from something that could have been much worse, but at what cost? What will be the unintended consequences of this go-round of playing god with the economy? One of our favorite economic analysts is Dylan Grice at Edelweiss. In a recent



publication, he wrote the following snippet which beautifully captures the conundrum of playing god with the economy.

Regular readers of our irregular publication will be aware of our thoughts on inflation, but for those who are not we would summarize them thus: inflation is not measurable. We can summarize our views on money with similar succinctness: it is poorly understood. And as for the economy, we know only this: it is a complex system. From these observations can be derived a straightforward corollary on economic policy makers: trying to control a variable you can’t measure (inflation) with a tool you don’t fully understand (money) in a complex system with hidden, unobservable and non-linear interrelationships (the economy) is a guaranteed way to ensure that most things which happen weren’t supposed to happen.

No one knows what the unintended consequence will be for this most recent round of monetary intervention, but unless one thinks history is not a guide and buys off on the “free lunch” philosophy of QE infinity, one must believe that there will be consequences. If those consequences are severe, maybe the Fed will express remorse over bringing more harm than good to the world, much like Dr. Frankenstein’s monster felt after realizing he had brought harm upon his beloved creator. But then again, how ignorant is the Fed in its pride of wisdom?

PART 3: PULLING BACK THE CURTAIN

“I think we’re mysterious to people. I think they’re not sure what we do.” - Jeffrey Lacker, Federal Reserve Bank of Richmond

The opening quote from Jeffrey Lacker is taken from an interview in Liberty Street Film’s Money for Nothing. It’s a sad but true reality that the average American is heavily impacted by the Fed’s policies, but really has very little understanding of what the central bank actually does. Before we get into the nuts and bolts of the Fed’s activities, let’s begin with a brief summary of the various components that make up the central banking system here in the US.

Board of Governors: The Board of Governors (the “Board”) is a government agency based in Washington DC and is at the top of the food chain in the Federal Reserve System. It is comprised of seven members, all appointed by the President and confirmed by the Senate. Each member serves a 14-year term, and the board is led by a Chairman and Vice-Chairman who both serve 4-year terms.

Function: Manage the Federal Reserve system, set banking reserve requirements, and review and determine the discount rate.

Federal Open Market Committee: The Federal Open Market Committee (the “FOMC”) is the policy-making branch of the Federal Reserve. The committee is made up of the seven members of the Board and the twelve presidents of the regional Federal Reserve banks. Although all members participate in discussions, voting members include only the seven members of the Board, the President of the Federal Reserve Bank of New York and four other regional bank presidents who take turns serving 1-year terms.

Function: Set monetary policy and direct open market operations to implement that policy.

12 Regional Federal Reserve Banks: Part of the intent of the Federal Reserve Act of 1913 was to spread power out across the nation’s geography rather than having it all focused on the East Coast. Thus, the country was split into 12 distinct regions, each having its own Federal Reserve



Bank providing services locally and serving as representation on boards and committees back East. The map below shows these various regions and the cities in which their regional banks are located. In the same way commercial banks provide services to individuals, these regional entities provide services to the commercial banks themselves. They can be thought of as boots on the ground, carrying out the actual operations of the central bank.

Function: Clear checks, distribute new currency, remove damaged currency from circulation, administer discount loans to member banks, serve as liaison between local business communities and the Federal Reserve and collect data and conduct economic research.

The Fed system also includes various advisory committees as well as the thousands of member banks scattered all across the country, but the three bodies outlined above are the functional “branches” of the central bank that set and implement policy.

Now let’s look at the nuts and bolts of what the Fed actually does on a daily basis. According to the Federal Reserve’s website, its purpose is "to promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar and moderate long-term interest rates." More simply put, and as we covered in last week’s post, the Fed has been given a dual mandate by Congress to promote full employment and low, stable inflation. Policy makers, of course, cannot just go out and affect employment and inflation directly. Rather, they exercise control over variables that may (or may not) have desired knock on effects, thereby indirectly influencing the general level of prices and economic activity.

The term “monetary policy” is used to describe the various actions the Fed takes to achieve these ends. As defined by a popular college textbook, monetary policy is simply “the management of money and interest rates.” In other words the Federal Reserve is tasked with promoting high employment and low inflation via the effective management of money and interest rates.

Policy Tool #1: Banking Reserves

The Fed extends its influence in a variety of ways throughout the banking system. One way in particular is by controlling the amount of reserves banks are required to keep on hand. When a bank receives funds from a depositor, they are required to keep a certain amount of those funds in cash reserves in order to meet a reasonable level of expected outflow needs. Once the required amount of reserves have been set aside, the rest of the funds can be lent out for a profit.

This level of required reserves for most banks is currently 10%, meaning that for every dollar a bank receives in deposits it has to reserve 10 cents and can lend out 90 cents. If the Fed were to raise the reserve requirement this would reduce the amount of money available to loan out, thereby shrinking the availability of credit and slowing economic growth. This reduces the money multiplier and shrinks the money supply which is economically linked to the level of prices for goods and services (inflation). Vice versa, if the Fed were to lower the reserve requirement it would free up banks’ capacity to lend, thereby expanding the money supply and allowing for increased economic activity.

Changing reserve requirements for banks is one way in which the Fed might hope to impact general economic activity and inflationary pressures.

Policy Tool #2: Open Market Operations

The Fed is an active participant in the open market for a variety of securities, but primarily for government bills, notes and bonds. Through these open market operations they are able to control the level of short-term rates and influence to a lesser extent mid and long-term rates. Let’s look at how this is accomplished.

For any minimum required level of reserves, a bank’s short-term cash needs will fluctuate based on deposit and transactional activity during the day at that particular bank. Some days the bank will come up slightly short and some days it will have a little extra cash (called excess reserves). If a bank needs



additional reserves at the end a day to meet the minimum requirement, it can borrow on a short-term basis from another bank who has more than it needs. These overnight loans take place in a private market called the federal funds market, and the interest rate charged on these loans is called the federal funds rate, or simply the “funds rate”.

The funds rate is one of the most important interest rates in finance due to the fact that it acts as a baseline for all other interest rates charged by a bank. Money markets, mortgages, commercial loans, CDs, credit cards – they are all based to some extent off the level of the funds rate. Therefore, a lower funds rate leads to lower prevailing rates on all types of debt throughout the economy. Additionally, when we talk about the Fed “setting interest rates” we are usually referring specifically to the funds rate. The Fed has a current target of 0-0.25% for the funds rate, which is what is meant by saying that the Fed has “set interest rates at zero”.

So how do they control the funds rate? Through open market operations. Quite literally, the Fed controls the funds rate by buying and selling government securities in the open market. By buying securities directly from a bank they replace that security with cash reserves on the bank’s balance sheet. In doing so, they have increased supply and reduced demand for reserves in the federal funds market thereby putting downward pressure on the rate charged on those reserves (the funds rate). In contrast, by selling securities in the open market they are replacing cash reserves with securities on a bank’s balance sheet, thereby reducing supply and increasing demand for reserves in the federal funds market and putting upward pressure on the funds rate. The Fed’s trading desk in New York is continuously operating in the open market in this fashion in order to keep the funds rate at or near its target.

There are a variety of other ways in which the Federal Reserve is active in the open market, but its influence over the funds rate is by far the most important. More recently, however, the Fed’s large scale asset purchases referred to as “quantitative easing” have dominated the headlines and discussion around monetary policy. Quantitative easing is a less traditional and more controversial form of open market operations.

Policy Tool #3: The Discount Window

In addition to the federal funds market, certain banks also have access to short-term loans directly from the Fed via what’s called “the discount window”. These loans are available at the discount rate which is set by the Board of Governors. The discount rate is closely tied to, and is often below, the fed funds target rate, so it also serves as a sort of baseline for interest rates throughout the economy. The discount window is only available in specified quantities to banks that meet certain criteria, so in normal financial conditions it plays a limited role in monetary policy. That said, in times of distress the Fed may choose to relax the limits and standards for loans issued through its discount window in order to inject additional liquidity into the banking system.

We’ve seen now how the Board of Governors, the Federal Open Market Committee and the 12 Regional Federal Reserve Banks go about attempting to manage money and interest rates via their primary tools of bank reserves, open market operations and the discount window. In addition to these functions the Fed also serves a number of more mundane responsibilities including distributing new currency, regulating member banks and drafting federal law governing the banking and consumer



credit industries. Whether or not one agrees with the way in which our central bank wields its significant power and influence over the economy and financial markets is an entirely separate topic, but hopefully pulling back the curtain on the Federal Reserve has made it a bit less mysterious.

PART 4: MOOD MANAGEMENT

“The psychological impact of QE due to its many myths is extremely powerful.” – Cullen Roache

Quantitative easing has been one of the Fed’s primary policy tools since the financial crisis five years ago. It is also one of the most widely misunderstood, hotly contested and broadly influential policies implemented anywhere on the globe in recent history. In this post we will try to provide a balanced analysis by boiling this policy down in a simple, understandable way.

Quantitative Easing Defined

Quantitative easing, or “QE”, refers to the central bank’s practice of buying securities in the open market with money that was created ex nihilo – out of nothing. Quite literally, the Fed purchases the security from a private market participant by crediting their account electronically with US Dollars that didn’t previously exist.

In one sense this practice is not that unusual. One of the primary ways in which the Federal Reserve implements its monetary policy is through open market operations – the buying and selling of government-backed securities on the secondary market. These operations are typically confined to the ultra-short term interbank lending markets where they add and drain reserves out of the banking system in order to manipulate the fed funds rate to a target level. So it is through open market operations that the Fed even has the ability to set short-term interest rates.

According to Wikipedia, however, “Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective.” So what makes QE so unconventional? It’s the fact that the securities being purchased are longer maturity and might even include bonds other than US Treasuries.

The Virtuous Circle

The stated goal of QE is to put downward pressure on long-term interest rates. Lower interest rates encourage borrowing which in turn lead to investment. The influx of money into investable assets lifts the price of those assets which creates a “virtuous circle” by spurring more borrowing and spending in the economy. Bernanke referred to this cycle in a 2010 article he penned for the Washington Times:

“…higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

This objective was reiterated just last week (three years after Bernanke’s Op-Ed) by Janet Yellen in her Senate confirmation hearing:

“The purpose of our policies, all of them, is to bring down interest rates in order to spur spending in interest sensitive sectors, and if we’re capable of doing that, that will help to stimulate a favorable



dynamic in which jobs are created, incomes rise, more spending takes place and that creates more jobs throughout the economy.”

So while the stated objective of QE is to impact interest rates, the ultimate motivation is much more psychological. Simply put, the Federal Reserve is in the mood management business. Inflated asset prices should lead to more optimism and looser wallets amongst American consumers. The theory (and hope) is that this will become a self-fulfilling prophecy of economic growth that will gain momentum and eventually stand up on its own two feet without any further stimulus from the Fed.

QE = Money Printing?

There is a widely held view that quantitative easing is essentially money printing, and that “Helicopter Ben” might as well be dropping dollar bills from the sky. While there are certain elements of this argument that are true, it’s important to know what you mean by the term “money printing” when making this claim. We believe most people’s definition is somewhat misinformed, and as Dylan Grice recently penned in the Edelweiss Journal, “sloppy language leads to sloppy thought.” Let’s bring some clarity to this issue by considering what actually happens when the Fed purchases an asset in the open market as part of its QE program.

Scenario: The Federal Reserve buys a $1,000 bond from a bank

Private Sector Balance SheetAssets: Unchanged. (The bank has swapped a $1,000 bond for $1,000 in reserves.)Liabilities: Unchanged. (The transaction doesn’t impact any liabilities of the bank.)Net Worth: Unchanged.

Federal Reserve Balance SheetAssets: Increased by $1,000. (The Fed now owns a $1,000 bond that it didn’t own before.)Liabilities: Increased by $1,000. (The Fed has $1,000 of new bank reserves on deposit.)Net Worth: Unchanged. (Assets and liabilities both increased by an equal amount.)

The net impact of a QE transaction is not to increase the financial account of the private sector. Rather, what occurs is essentially an asset swap in which the bank trades a $1,000 asset for $1,000 in cash. The composition of the private sector’s assets has changed, but the total amount of private

sector net worth has remained the same. Meanwhile, the Fed’s balance sheet is expanding in size as both the assets and liabilities side increases in tandem with every QE transaction. The nearby chart reveals how significant this expansion has been since the Fed embarked on this QE journey.

It’s widely believed that every dollar of QE adds a dollar to the money supply, but this is not the case. In order to understand why, it’s important to know the distinction between the monetary base and the money supply. The

monetary base case be thought of as the raw material that the banking system starts with, and the money supply is what that base money is multiplied into via the lending and deposit cycle. Assuming a 10% required reserve ratio, the banking system can take $1 of base money and turn it into $10 of money supply.



Every dollar of QE removes a dollar of bonds from the system and adds a dollar of base money, thereby expanding the potential money supply. But until that base money begins getting lent out it sits idle in the form of excess reserves and the impact on the money supply is limited. This is, in fact, what we’ve seen thus far, and it’s the reason inflation has not yet become a real problem.

Alan Greenspan explained this in a recent interview on Bloomberg Surveillance:

McKee: Does a very large central bank balance sheet always and everywhere mean inflation ahead?

Greenspan: If it sustains itself as an economy picks up, and as the huge amount of excess reserves held by the depository institutions with the Federal Reserve finally begin to enter into the business economy then you begin to have problems. At the moment, the reason we have no inflation in the context of very large central bank balance sheets, is for the vast majority the increase are merely a bookkeeping transaction from the central bank to the depository institution. Until the commercial bank starts to relend those reserves and they begin to multiply in the banking system…until they do that, you have no effect on money supply...”

At some point in the future, the private sector will begin demanding more credit and the banks will begin supplying it. This will cause the enormous amount of base money in the system to begin multiplying into an increased money supply, sparking inflationary concerns and creating a problem for the Fed. One of the biggest questions surrounding the QE topic, then, is how the Fed will be able to manage this dynamic and drain liquidity out of the system at the appropriate time. There are a number of tools at their disposal to do this, and they have (of course) expressed a large amount on confidence in their ability to manage the exit. Still, it remains to be seen and there are plenty of reasons to be concerned that they’ve bitten off more than they can chew.

Quantitative easing is one of the most controversial and widely misunderstood policies in the modern era. Its direct impact on the real economy is debatable, but few would argue it has had significant influence on the psychology of financial market participants. Will it be hailed as the effort that shifted the tide and propelled the US economy out of its worst recession in a century, or will it be seen as an impotent policy that resulted in artificially inflated asset prices and unwanted inflation? We probably won’t know the answers to these questions for many years to come, but hopefully we’ve provided a little more clarity around some of the misconceptions held towards this controversial topic.

ABOUT SEASON INVESTMENTS & THE AUTHORSSeason Investments was founded in 2011 by David Houle, CFA and Elliott Orsillo, CFA and is based in Colorado Springs, CO. Season offers something different for those who want to move beyond the shortcomings of traditional investment models. With an emphasis on bottom-line results and extreme transparency, the firm serves its clients by offering innovative investment strategies focused on true diversification, proactive downside protection and smart growth. Learn more by visiting www.seasoninvestments.com.

David A. Houle, CFADavid is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.

Elliott J. Orsillo, CFAElliott has spent the past ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in



Finance. He also earned the Chartered Financial Analyst (CFA) designation in 2009. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.

IMPORTANT DISCLOSURES

Season Investments does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk and investment recommendations will not always be profitable.

THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION PROVIDED HEREIN OR ON THE MATERIAL PROVIDED. This document does not constitute a complete description of our investment services and is for informational purposes only. It is in no way a solicitation or an offer to sell securities or investment advisory services. Any statements regarding market or other financial information is obtained from sources which we and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither our information providers nor we shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the user. All investments involve risk, including foreign currency exchange rates, political risks, market risk, different methods of accounting and financial reporting, and foreign taxes.

Season Investments’ regulatory disclosure brochure (Form ADV) may be accessed on the SEC’s website.


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