Archive for July, 2008

Understanding Short Selling

Friday, July 25th, 2008

If you think that the value of a stock will rise, you can buy the stock and sell it later when the price is higher. If you think that the value of a stock will fall, the situation is a bit more complicated. One way to bet on a falling stock price is to sell short, that is to sell stock that you do not own, with the idea of buying it back when the price is lower. But selling something that you do not have creates a potential risk to the buyer, who receives a promise instead of the thing he wanted to buy. Clarification: I am not a lawyer and nothing in this article is intended to constitute legal advice; I am an economist attempting to analyze what happens in securities markets.

If you buy a stock from someone, the seller of the stock gets paid at settlement (a few days after the transaction is done). You pay cash and receive the shares of stock and there is no further risk to either party. But if you sell stock that you do not own the settlement transaction is problematic. You receive the cash but the buyer of the stock only receives a promise to receive shares from you in the future. If you have excellent credit this should not present much of a problem. The buyer of the stock will want occasional payments (the short seller must pay the buyer all dividends paid by the corporation) but otherwise should be satisfied having your promise to eventually deliver the stock. There would be an arrangement between the short seller and his stock broker, where the broker would guarantee the eventual delivery of the stock by requiring a substantial deposit from the short-seller.

But US regulators impose an additional complication, that the brokerage firm lend the shares to the short-seller, typically from the account of another investor at the same brokerage firm (see here for the SEC’s 2005 explanation of Regulation SHO governing short sales). The short seller must pay the brokerage firm interest for the loan of the shares, in addition to covering the dividend payments noted above. Under the SEC rule the brokerage firm delivers the shares at the time of settlement to the buyer; the only open transaction is typically inside the brokerage firm, between the seller of the shares and the account that lent the shares.

Even so, there are occasional “naked” short sales, where the seller does not deliver the stock at the time of settlement (”failure to deliver” in the language of the SEC). The SEC slyly notes that “[n]aked short selling is not necessarily a violation of the federal securities laws or the Commission’s rules”, a statement guaranteed to cause brokerage firms to regularly consult their legal staff. The SEC set up a list of “threshold securities”, that is companies that regularly experience delivery failures to ensure that there are no further problems with these shares (see here for the NYSE list of threshold securities and here for the NASDAQ list). Presumably brokerage firms are more careful when their customers try to sell short firms already on these lists.

The SEC’s stated purpose is to prevent abusive short sale practices, something that SEC Chairman Cox has termed “short and distort” (see here for a law firm’s discussion). This practice is the negative version of “pump and dump” (see here); the “pump and dump” scenario is an unscrupulous promoter will buy a large position in a small company and then spread rumors to try to drive the price of the stock up (my spam folder was full of these messages a few years ago; see here in the section E-mail spam), selling the shares once the price rose a bit. “Short and distort” would involve taking a large short position in a company and then spreading rumors to drive down the share price.

On July 15, 2008, the SEC released an emergency order (see pdf here or a subsequent explanation here) that more or less says that no naked short selling would be permitted for a number of large banks and investment banks (the so-called primary dealers, see here) and Fannie Mae and Freddie Mac.

Understanding the Retail Sales report

Thursday, July 24th, 2008

Retail sales is, after the employment report, the second major piece of economic data to be released (see here for the date of retail sales releases) typically arriving 9 working days into the month (around the 14th), about ten days after the employment report.

Personal consumption of goods is about 28% of GDP (personal consumption of goods and services or PCE is about 70% of GDP, also including, among other items, housing and medical care). So by the middle of the next month we have a rough estimate of the performance of a bit over 1/4 of the GDP. But, as we will see below, the estimate is rather rough.

The Advance retail sales report (that is the data that are published first) surveys 5,000 firms, including 1,300 large firms that are always sampled and the remainder randomly selected to represent the entire retail industry (see here for details of the Advance report). A month later the revised report called the Monthly Retail Trade Survey is published; the Monthly report surveys 12,000 retail firms, including the 3,000 largest firms and another 1,000 firms that are the largest in their sector.

Due to the change in the sample, there is often a significant amount of revision in the data; in the most recent release the Census Department estimated that the 90% confidence interval of the Advance number was ±0.5%, meaning that if the monthly estimate is, say, +0.4%, then the true number is likely to be between -0.1% and +0.9%, but there is a small chance (10%) that it is outside that interval. The 90% confidence interval for the Monthly report, that is the data of two months before, is considerably smaller, ±0.2%. If you are confused by the language of statistical inference, the message is that the Advance data are less trustworthy than the revised data, but are better than nothing.

The questionnaire that firms fill out is fairly simple (see a pdf of an Advance Report Survey here), asking for the amount of sales, e-commerce and the number of retail establishments. An important point is that the form does not ask anything about price, just sales. A related point is that the retail sales data are nominal data, that is not adjusted for inflation; careful retail sales analysts will adjust retail sales by the appropriate inflation measure to obtain measures of real activity.

Finally, careful GDP analysts will examine the parts of the retail sales reports that the Commerce Department uses to calculate PCE. Commerce uses other sources for some of the data included in the retail sales report (notably cars, trucks and gasoline); see here for details.

How the Fed Communicates with the Markets

Tuesday, July 22nd, 2008

The Fed communicates in very specific ways to the markets. Because of its structure (seven governors and 12 regional Fed Presidents), the views of the different speakers often diverge on important issues. A good Fed chairman will use his power and influence to present a unified view of the Fed’s view of the current situation, but it is not uncommon that a specific Fed president (or less frequently, a governor) will present an alternate view, arguing that the interest rate policy is too tight or too loose. By understanding the different methods of Fed communication you can better understand what the Fed is saying and how to interpret a particular statement.

The primary communications are through:

  • Official FOMC statements and minutes
  • Official Speeches and Testimony
  • Questions and Answer sessions (often following speeches and testimony)

Official FOMC statements and minutes: When the FOMC has a meeting a policy statement is published shortly after the meeting ends (see here for the calendar of recent FOMC meetings and the associated statements and minutes; this site is the place to find the FOMC statement as is it released). These statements are fairly formulaic: a policy statement, a brief description of the economy as the FOMC sees it and the voting results. Unlike the ECB there is no press conference after the FOMC meeting, so instead there is an active debate among so-called Fed watchers about what the Fed really meant to say, with careful analysis of changes in wording. Economic analysts (including this one) will debate why the FOMC left out a phrase it had used in the past or the precise significance of a dissenting vote.

Approximately two weeks before each FOMC meeting the Fed publishes the “Beige Book” (see 2008 schedule here), officially titled the”Summary of Commentary on Current Economic Conditions by Federal Reserve District.” This is a collection of anecdotal information on each of the twelve Federal Reserve Districts that are collected and presented by an individual regional Federal Reserve Bank. The unusual aspect of the Beige Book is that the tone of the presentation is often sharply influenced by the views of the regional Fed (or more specifically the President of the regional Fed) who is the author of the report; on some occasions the view of the economy can shift sharply from one month to the next more as a result of the difference in perspective of the author than in any change in the economy itself. A careful reader of the Beige Book will determine the author of the particular presentation to see if the summary is merely a restatement of the specific bank president’s well known view of the economy.

Official Speeches and Testimony: There is a modest difference between speeches (usually invited lectures by a Fed official to a group of financial executives, see here) and testimony before Congress (usually a presentation by the Chairman of the Fed that is covered on television, but also presentations by other officials, see here). In general the Fed official will have a prepared text that will be released at the official time on the Fed’s web site (see the links above) and then may answer questions.

Questions and Answers: The most notable Congressional testimony is the Monetary Report to Congress, where the Chairman of the Fed goes to Congress twice a year (usually January and July) and visits both the House and Senate for separate presentations. In a curious tradition, the Senators or Congressmen often speak first, then the Chairman presents the report, and then there is a several hour question and answer session. While the large majority of the so-called questions are actually speeches by members of Congress designed to attract attention to a specific issue and the member of Congress who asks the question and often of little general interest (but see some videos on youtube here), there is occasionally a question that prompts the Chairman to say something more clearly than he has in the past. So these sessions are televised to trading rooms across America, even though there is little news made at any given time.

Fed Chairman Bernanke speaks relatively more clearly than his predecessor, Chairman Greenspan. Mr. Greenspan enjoyed posing rhetorical questions and speaking in a confusing way; markets would often react strongly to his testimony, often changing directions several times before the Chairman’s statement was fully understood. Chairman Bernanke does not seem to move markets as much, partially as a result of his plain speaking. The Chairman of the Fed is an important force in the markets but does not have superhuman powers, and thoughtful investors will evaluate his statements (and his views on the economy and markets) as one source of information among many.

Understanding the Policy Tools of the Fed

Monday, July 21st, 2008

The Fed has three traditional policy tools to implement monetary policy: (1) the Fed Funds rate; (2) the discount rate and (3) reserve requirements.

To understand these tools you must first understand a bit about how banks operate. Banks must keep deposits at the Federal Reserve (more about this below under the section describing reserve requirements and more here). The exact amount of deposits that each bank must hold depends on how much money is deposited in the bank during the week; some banks find they have extra deposits at the Fed, while others have too little. The market for these deposits is called the Federal Funds market, usually referred to as Fed Funds. The Fed owns a portfolio of Treasury securities; by buying or selling these securities, the Fed can increase or decrease the amount of money deposited at banks; these transactions are called open market operations.

In practice, the Fed Funds rate is the tool that the Fed uses most often; by intervening in the Fed Funds market (via open market operations) the Fed can raise or lower the interest rate charged by banks for loans to other banks. In recent years (with the exception of the period starting in the last few months of 2007) Fed policy could be characterized by the Fed Funds rate. When the economy appeared to be slowing the Fed would cut rates (Fed Funds were 1% in Summer 2003) and when the economy appeared to be expanding too rapidly the Fed would raise rates (Fed Funds were 5.25% in Summer 2006). As this tool became the center of much attention a Fed Funds futures market was created; traders can bet on the Fed Funds rate and other investors can use the price of these futures as a guide to the market’s expectation of future Fed policy (see here for the futures contract and here for an interpretation of the prices of Fed Funds futures and options).

The discount rate is not really used as a policy tool during normal times. The Fed wants banks that have temporary liquidity problems to be a bit reluctant to borrow directly from the Fed, preferring that instead they borrow from other banks. Maintaining a modest spread (normally 100 basis points; see here for transcripts of discount rate decisions of the last few years) between the discount rate and the Fed Funds rate discourages use of the discount window for a bank who is not having problems. But this meant that markets started to believe that if a bank used the discount window then the bank was having problems, so banks avoided using the discount window. In normal times, when the banking sector is profitable, this is not really a problem. But during the subprime crisis banks that had problems obtaining short-term finance (because they had big positions in risky mortgage securities, other banks were reluctant to lend them funds) still avoided the discount window, even when the gap between the discount rate and the Fed Funds rate was reduced in August to 50 basis points and several prominent banks borrowed money from the discount window. This led the Fed to create the auction funds from a “Term Auction Facility” (see here for more), that essentially provided discount rate loans with potentially smaller penalties as a way to get funds into the system.

Reserve requirements had been a policy tool of the Fed in the past but are no longer used for policy purposes. The Fed requires banks and other financial institutions to keep 10% (approximately, see here for details) of transactions accounts (essentially checking accounts) in vault cash or on deposit at the Fed or another institution. There have been modest changes to the reserve requirement rules in the last 25 years in ways that seem unrelated to policy concerns.

The Many Mandates of the Fed

Sunday, July 20th, 2008

The Federal Reserve Act states the objectives of monetary policy: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of [1] maximum employment, [2] stable prices, and [3] moderate long-term interest rates.” (numbers in [brackets] added)

If you have difficulty reconciling this sentence with textbook macroeconomics you are not alone. There is no obvious definition of maximum employment (zero unemployment?) or stable prices (zero inflation?) or moderate long-term interest rates, but in any case the Fed must do all three simultaneously. Even if we do not precisely understand the Fed’s official instructions from Congress, we can see that they are fairly broad; a Fed chairman can always claim that a particularly policy was aimed at one of the objectives.

In contrast, other Central Banks whose have a single objective to maintain price stability (for example the ECB, see here) and attach secondary importance to employment and growth. There are a number of other jobs for the Fed described in the Federal Reserve Act but they are of lesser importance.

Congress created the Fed and holds a good deal of power over it. The Humphrey-Hawkins legislation (see section 108 of the rather large pdf) required the Fed to report to Congress twice a year about how it is meeting its objectives; while the legislation expired in 2000, the Fed chairman voluntarily testifies before Congress twice a year (more often if there are important issues) and is required to answer a number of questions on various issues.

If Congress is not happy with the Fed’s performance they could theoretically redesign the system and replace the Fed with something else. While it would take a major crisis to provoke such a reaction, this scenario happened during the Great Depression. In 1942, Congress took interest rate policy away from the Fed and gave it to the Treasury Department (see here); the Fed only regained its independence in 1951.

So the Fed is very responsive to Congress. The Fed Chairman routinely endures lengthy questioning from Congress about many topics in an effort to be responsive to the concerns of Congress (a search on youtube.com for Fed Chairman Bernanke produces over 1000 videos, many of which appear to involve Congressional testimony), and tries to carefully explain policy to preserve the Fed’s independence in the future.

The Fed chairman technically has two separate appointments: a term as governor (just like that of the other six governors) that lasts 14 years (unless the chairman initially takes the remainder of the term of another governor) and a four-year term as chairman (see here for Chairman Bernanke’s terms). Again, the chairman can remain chairman until a new chairman is nominated. The practical result is that Fed chairmen in recent years have worked closely with each new President; Chairman Greenspan was nominated initially by President Reagan and then renominated by Presidents Bush and Clinton. The current understanding in Washington appears to be that markets would be upset by the ouster of a Fed chairman who is doing well, making administrations reluctant to change. Chairman Bernanke’s handling of the current economic mess will likely determine whether he will be renominated when his term as Chairman expires in January 2010.

There is one important mandate that the Fed does not have: managing the external value of the Dollar. It is a curious relic of the 1951 Fed-Treasury accord that the Treasury is responsible for the Dollar, so that only the Secretary of the Treasury will speak about the Dollar’s value or order intervention in currency markets (which will be carried out by the Fed). Most economists believe that the value of the Dollar is largely determined by monetary policy, which is planned and executed by the Fed. But for legal/political reasons, the official authority is in the Treasury.

The Structure of the Fed

Saturday, July 19th, 2008

The Federal Reserve was created by Congress almost 100 years ago, when the economy and markets were very different from today. Creating a central bank was controversial at the time and the political compromises led to a peculiar structure (see here for the official version of the Fed’s history; there are numerous alternate versions of the Fed’s history, including this one that is considerably more skeptical).

The Fed consists of 12 regional Federal Reserves that were established in the large financial centers of 1913; there is only one regional Fed in the western US (in San Francisco) while there are two in Missouri (St. Louis and Kansas City). You can see the map here.

The decision making body of the Fed is the Federal Open Market Committee (FOMC). When you hear that the Fed cut rates it is by a vote of the FOMC. There are two sorts of members of the FOMC: seven governors, selected by the President, who serve 14-year terms. Due to a conflict between the Democratic Congress and a Republican President there are currently several vacancies; Board members can remain on the Board until their replacements are named or until their full 14-year term is completed. Few board members serve a 14-year term, so a two-term President is likely to have the opportunity to name all seven Board members.

The remaining five members of the committee come from the 12 Presidents of the regional Federal Reserve Banks (on a rotating basis), who are selected by the locally-based Directors of the Banks (see here, at the bottom of the page, for the list of which Fed President serves when).

The crucial policymaking is done at meetings of the FOMC in a large conference room in the Eccles Building in Washington, DC. Sitting at the table are the Chairman of the Fed (Ben Bernanke), the Vice Chairman of the Fed (Donald Kohn), the other five governors, the President of the New York Fed (Timothy Geithner), who is somewhat confusingly the Vice Chairman of the FOMC, and the other eleven regional Fed Presidents, four of whom are voting members of the committee at any time (the other seven participate in the discussion but do not vote). Also in the room are a number of high-level Board and regional Fed officials and economists who make presentations to the committee on various topics.

Recent Fed Chairmen (Bernanke, Greenspan and Volcker) have had a very important influence in Committee decision making. While there may be extensive debate on what the Fed should be doing, there are very few close votes. It has been said that three negative votes are sufficient to veto any policy decision, so in recent years most votes have been unanimous or with one or two members dissenting.

Understanding the Federal Reserve

Saturday, July 19th, 2008

The Fed is the US central bank. The US has a fairly complex history of central banking (see here for the official version); the Fed was officially created by Congress in 1913 but did not really get the independence that it enjoys today until 1951. The following essays address the structure of the Fed, the mandates (or objectives set by Congress) of the Fed, the tools with which the Fed tries to achieve those objectives and the methods with which the Fed communicates with the market,

Understanding Inflation Data: PPI

Tuesday, July 15th, 2008

[If you would like a brief review of ways to measure inflation and the most important U.S. monthly inflation indices you should read Understanding Inflation Data: An Introduction first and then return to this article that is about the PPI, the producer price index]

The PPI or the Producer Price Index is published by the Bureau of Labor Statistics (the BLS) an independent agency of the U.S. federal government. The BLS publishes PPI data in the middle of the month after the data were collected (data for June 2008 will be released on July 15; see here for the release schedule).

The PPI set of indexes measures price changes from the perspective of the seller, in comparison to the CPI that measures price changes from the consumer’s perspective. These two price indices may differ because of government subsidies, sales or excise taxes and distribution costs.

The BLS calculates the prices of about 100,000 prices from 25,000 estabishments every month (see here for the BLS handbook explaining the methods used to assemble the data). There are three separate reports:

  • Prices by industry (see here for the most recent table): there are price indexes for 600 industries, ranging from manufacturing to services and health care.
  • Prices by commodity (see here for the most recent table): there are price indexes for 2000 commodity groups.
  • Prices by stage of processing (see here for the most recent table): there are price indexes for finished goods, intermediate goods and crude goods, with and without food and energy.

The PPI weights prices using data from the 1997 economic census (see here) and some 2002 data.

The PPI does not attract the same degree of attention as the CPI, partially since it is not used as frequently by policy makers. In the past, the PPI was regularly published a few days before the CPI and was viewed as a forecast of consumer prices; now the CPI published before the PPI around half the time. Even so, the BLS appears to spend considerable energy improving the report. The BLS believes that the PPI is more of a work in progress, in transition from a report that measured the prices of goods to a report that will measure the entire domestic output prices of goods and services.

The most interesting use of the PPI (in this economist’s view) is as a way to view the transmission of inflation through the economy, the so-called “pass through”. By looking at the stage of production indices you can see whether increases in commodity prices in crude goods result in increases in prices of finished goods. A great puzzle of recent years has been the lack of pass through, meaning that increases in the prices of oil and food have not, so far, resulted in increases in finished goods prices.

Understanding Consumer Confidence Measures

Wednesday, July 9th, 2008

One of the biggest problems facing an economic analyst is the lack of timeliness of published data. Most economic numbers are published a month or two after the data are collected, due to the difficulty in collecting and assembling the data (for example, the CPI measures the prices of 80,000 goods and the employment report surveys 60,000 households and 160,000 businesses; both reports are released between three weeks and a month after the surveys are conducted). Measuring what people have done in an economy of 300,000,000 residents is hard work. It is much simpler to contact a small group of Americans and ask them how they are feeling.

The reports on how Americans are feeling are called surveys of consumer confidence or sentiment. There are two main measures of consumer sentiment, the Conference Board and the University of Michigan. The Conference Board publishes (among other data) the Consumer Confidence Survey (available by subscription, see here for a sample issue) that asks 5,000 households by mail how they are feeling (see here for a description of the Conference Board methodology, which I can no longer find on their website). The University of Michigan Survey Research Center (see here for past data and survey description, registration required) does 500 telephone interviews asking people in the mainland U.S. (residents of Alaska and Hawaii are excluded) about their perception of the current and future state of the economy.

The obvious advantage of these data is that they can be published almost immediately. The obvious disadvantage is that the data are measuring what people say and not what they are doing. While both entities have published studies demonstrating the usefulness of their data, there are numerous skeptics (see here for one) who argue that at best confidence surveys reflect the current economic situation but are not good at predicting the future. An earlier, more careful study (see here) finds some evidence that the Conference Board data can be useful at predicting consumer spending (but note that one of the co-authors is a former employee of the Conference Board, see here). But more recent studies (see here) are considerably more skeptical. Recent Conference Board data (see here) show that confidence was at a relatively high level as recently as July 2007, just before the subprime problems affected markets and the price of petroleum started to climb.

There is a third confidence measure published by the Washington Post/ABC News that appears weekly that does not attract as much attention as the two monthly surveys. The survey does telephone interviews with 1000 randomly selected adults (see here for details) and data are released every Tuesday evening at 5pm. You can examine past polling data here or see a table of past data here. If you look at the historical data, you will find out that the answer to the question “Would you describe the state of the nation’s economy these days as excellent, good, not so good, or poor?” is generally “not so good” or “poor”. From 1986 to 2007, there were only five years when a majority of respondents described the economy as excellent or good, from 1997 to 2001. While there are numerous problems in the US, this view seems overly pessimistic.

There are other measures of how consumers feel about the economy (available here; there are also a large number of polls on more traditional topics such as politics) but these days markets seem to attach little weight to these surveys.

The media report the confidence data as if they represent important news; see here for a newspaper article about the July 2007 surge in the Conference Board consumer confidence index. While forecasting the economy is always difficult, economists who believed that “[the] rebound in confidence suggests economic activity may gather a little momentum in the coming months” probably made worse forecasts than economists who ignored the report.


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