The Fed, its Role, its Goal
It took less than nine minutes on Friday, August 26th for Fed Chair Jerome Powell to whip the financial markets into shape, making it clear that the central bank was not done with its rate hikes yet. “We will keep at it until we are confident the job is done,” Powell said in remarks delivered at the Fed’s annual conference in Jackson Hole, Wyoming.
If you pay close attention to economic news and the market, you may have noticed that lately, it has been a “bad news is good” environment for the stock market. Economic headlines that sound positive, such as “record low unemployment” and “strong wage growth”, have increasingly become catalysts for stock market selling, which may seem perplexing considering that job losses and record unemployment triggered a massive selloff just over two years ago during the depths of the COVID-19 pandemic.
From a human perspective, people losing jobs is clearly “bad” and people making more money is “good”. Similarly, inflation is a “bad” outcome – who wants to pay more for discretionary or everyday items? However, for the US Federal Reserve (“the Fed”), things are not so black and white; the Fed is all about balance, summarized in the Fed’s “dual mandate” of maximum sustainable employment and stable prices. Presently, prices are unstable, therefore the Fed is utilizing its available tools in trying to restore balance.
For years following the global Financial Crisis of 2008-2009, the Fed tried to spur higher inflation, often remarking that it remained “stubbornly low” and below its 2% annual inflation rate target. The Fed tried to boost spending by increasing the money supply using two tools – Open Market Operations, also known as Quantitative Easing, and the Discount Rate, also known as the Fed Funds Rate. Open Market Operations refers to the Fed’s ability to buy and sell bonds and hold them on its balance sheet. Each time the Fed buys bonds (from banks) the banks receive payment as a deposit, which then, due to the multiplier effect, satisfies the reserve requirement allowing them to make additional loans. So, for example if the Fed buys $1 million in Treasury bonds from ABC Bank, ABC Bank delivers bonds, receives $1 million and can also loan an additional multiple of the $1 million (minus the reserve requirement) as banks use leverage on their assets. This increases the supply of money circulating in the economy. The Discount Rate has a similar multiplier effect; banks can borrow from the Fed at this typically low rate and then offer loans to customers. The lower the rate, the more incentive for banks to borrow from the Fed and make more loans to consumers and businesses.
The Fed is now taking the opposite approach by no longer purchasing bonds in the open market, and placing them on its balance sheet, and it is also allowing its current holdings of bonds to mature without replacing them. The Fed is also raising interest rates for banks, which causes banks to have to raise interest rates to maintain a proper profitable spread, and therefore their customers pay higher interest rates which causes customers to potentially not pursue taking the loan. This trickles down into all aspects of the economy; for homebuyers it means higher mortgage rates, for businesses it means higher borrowing costs. If it seems like the Fed is trying to slow down the economy, it’s because they are.
“Recession” is a term with an inherently negative connotation due to experiences during poor economic times. It seems unconscionable for the Federal Reserve to intentionally trigger a recession but again. The Fed’s primary goal is restoring balance therefore, it must restrict economic growth to bring inflation back in check. The Fed is willing to push the economy into recessionary territory if required, although Chairman Powell has adamantly stated that is not his intention.
Now that we are clear on what the Fed is trying to accomplish, and how they plan on doing it, the question is – will this work and are the people in power capable? In theory, it seems reasonable that slowing the economy will limit demand for goods and services and therefore reduce price inflation. However, the inflation we are currently experiencing is a global phenomenon; Europe and many Emerging Market countries are experiencing double digit inflation, such as Turkey and Argentina with inflation rates of 36% and 51%, respectively. The war in Ukraine has poured gasoline on the inflationary fire, with much of the food and energy inflation stemming from the ongoing conflict. Similarly, China’s continued struggles with COVID-19 and ongoing city-wide shutdowns are still impacting supply chains. The US has an outsized influence on the global economy. Higher rates domestically and a strong US dollar have the side effect of decreasing foreign investment (capital flows out of foreign markets and into the US due to better yields on safe fixed income US bonds and the US’s much lower default risk) so US actions can cause ripples globally, but it is uncertain exactly how effective the Fed’s measures will be against the backdrop of global inflation.
International issues aside, the Fed’s efforts to spark economic activity and inflation following 2008, metaphorically described as “pushing on a piece of string”, were ineffective; so why should we have confidence they can pull off the reverse? Recent history shows that pulling on the string is more effective, although as the Volcker-engineered recession of the early 1980s demonstrated, the resulting impact can be quite harsh.
If we presume that the Fed policy tools are the appropriate medicine for our inflationary ailment, the next question is can they administer it in the correct dosage? Based on recent commentary from various Fed officials, the rate hikes will continue until the annual rate of inflation returns to the Fed’s 2% target. The Fed measures inflation via the Core Personal Consumption Expenditure Index, which grew at a year-over-year rate of 4.6% in July. With unemployment at near historical lows of 3.7%, the Fed is only focused on one side of the scale – inflation – and is unlikely to be swayed by an uptick in job losses until inflation subsides.
While the Fed was dismissive of inflation in 2021, and should have taken steps sooner, lately the central bank has begun to acknowledge the gravity of the situation, reflected by the increasing magnitude of the rate hikes. Following back-to-back 0.75% hikes in June and July this year, we will likely see another similar increase in September followed by a cumulative increase of 0.50-1.00% in the subsequent November and December rate hikes, bringing the Fed Funds rate to near 4.0% by year’s end. What happens after this base case scenario is uncertain and data dependent. Ideally, inflation continues to moderate, as it has in recent months. In this case, the Fed will be able to hold rates steady at a neutral level that allows inflation to resolve itself organically. The bearish case is underlying inflation data does not improve even as Fed Funds rates approach 4%. Will Chairman Powell be willing to follow his predecessor Paul Volcker in making a politically unpopular decision that drives the country into a deep recession?
As investors we must consider all possible scenarios and outcomes, regarding both the underlying data, and policymakers’ decisions. The data is showing decelerating inflation; however, the pace of that deceleration has been slower than desired by the Fed and there isn’t quite enough data yet to confirm the trend. Forecasting the path of Fed policy decisions in 2023 and beyond is more challenging. The Fed professes itself to be data-dependent and politically independent. We will be closely observing their words and actions to see if that holds true, and as always taking steps to protect our clients’ capital and deliver competitive, risk-adjusted returns.