Life many other investors you are a “Fed Watcher” who constantly monitors any actions taken by the Fed to revise monetary policy.  You believe that 3 key factors affect interest rates.  Assume that the most important factor is the Fed’s monetary policy.  The second most important factor is the state of the economy, which influences the demand for loanable funds.  The third factor is the level of inflation, which also influences the demand for loanable funds.  Because monetary policy can affect interests, it affects economic growth as well.  By controlling monetary policy, the fed influences the prices of all types of securities.

The following information is available to you:

1.    Economic growth has been consistently strong over the past few years but is beginning to slow down.

2.    Unemployment is as low as it has been in the past decade, but it has risen slightly over the past two quarters.

3.    Inflation has been about 5 percent annually for the past few years

4.    The dollar has been strong

5.    Oil prices have been very low

Yesterday, an event occurred that you believe will cause much higher oil prices in the United States and a weaker US economy in the near future.  You plan to determine whether the Fed will respond to the economic problems that are likely to develop.

You have reviewed the previous economic slowdowns caused by a decline in the aggregate demand for goods and services and found that each slowdown precipitated a stimulative policy by the Fed.  Inflation was 3 percent or less in each of the previous economic slowdowns.  Interest rates generally declined in response to these policies and the US economy improved.

Assume that the Fed’s philosophy regarding monetary policy is to maintain economic growth and low inflation.  There doesn’t appear to be any major fiscal policy forthcoming that will have a major effect on the economy.  The Fed’s present policy is to maintain a 2 percent annual growth rate in the money supply.  You believe that the economy is headed toward a recession unless the Fed uses very stimulative monetary policy such as a 10 percent annual growth rate in the money supply. 

The general consensus of economists is that the Fed will revise its monetary policy to stimulate the economy for 3 reasons:  1) it recognizes the potential costs of higher unemployment if a recession occurs.  2) It has consistently used a simulative policy in the past to prevent recessions 3) the administration has been pressuring the Fed to use a simulative monetary policy.

Although you will consider the economists opinions, you plan to make your own assessment of the Fed’s future policy.  Two quarters ago, GDP declined by 1 percent.  Last quarter, GDP declined again by 1 percent.  Thus, there is clear evidence that the economy has recently slowed down.

QUESTIONS 

1.    Do you think that the Fed will use a stimulative monetary policy at this point? Or do you think they will wait and if so, how long?

2.    You maintain a large portfolio of US bonds.  You believe that if the Fed does not revise its monetary policy, the US economy will continue to decline.  If the Fed stimulates the economy at this point, you believe that you would be better off with stocks than with bonds…explain why?

3.    If you switch to stocks, should you consider diversifying your stocks to include foreign stocks?

4.    What models might you use to value the stocks and track its performance?