V.9:11 (455-457): Fed Policy And The Stock Market

Fed Policy And The Stock Market Revisiting Gould's Rule by George A. Schade Jr.

On February 24, 1989, the Federal Reserve Bank of New York raised its discount rate to 7% and triggered the most recent signal of the "three steps and a stumble" rule. The rule decrees that whenever three successive rises occur in any of the three rates set by the monetary authorities—the discount rate, the reserve requirement and the margin requirement—sometime afterward the market is likely to suffer a substantial setback. The rates are set by the Federal Reserve Board. The discount rate is the interest rate that Federal Reserve banks charge member banks for direct loans. The reserve requirements are the percentage of deposits that commercial banks must set aside in cash for reserves; classifications by bank type, deposit and deposit interval have determined the required reserve levels. The margin requirement is the minimum percent of a stock's current price that must be paid for buying or shorting the stocks.

The rule is credited to the late Edson B. Gould during the time he worked for Arthur Weisenberger & Co. The term "three steps and a stumble" is derived from the ladderlike chart of these monetary rates, which tend to change infrequently. Since 1914, the discount rate has been adjusted an average of less than twice a year, and the margin requirement for stocks was last changed in January 1974. To date, there have been 13 signals, 11 due to discount rate increases and one each due to increases in reserve requirements (May 1,1937) and in the stock margin requirement (January 21, 1946) . Gould's rule uses the effective date of discount rate increases of the Federal Reserve Bank of New York and the reserve requirements applicable to large city banks or in the past to "reserve city" banks. Figure 1 shows the dates of the signals.