Unless you were visiting another planet, you know the Federal Reserve on Wednesday raised its benchmark interest rate by 75 basis and promised to keep reducing its bond holdings. While investors initially cheered the announcement, the mood quickly soured as fear set in that Jay Powell and team still may not be doing enough to squash inflation. That kind of quick reversal has become all too familiar this year, but no less confusing. We want to acknowledge that monetary policy is not easy to get a handle on, even for those investors paying close attention. But it is important: Along with fiscal policy (government revenue and spending initiatives), monetary policy helps determine the path of an economy. For better or worse, it impacts pretty much everything operating in that company, including the companies in our Trust portfolio. Therefore, we wanted to do a review of the tools the Fed has at its disposal. The goal is to help Club members better understand the dynamics at play, primarily interest rate hikes and balance sheet activity. Consider this your crash course in monetary policy. At the very least, you’ll be ready for any casual conversations about the Fed this weekend. The big debate First, back to that reversal. What changed in the markets after the Fed announcement was not the question of whether the Fed should be tightening (raising rates); given the stickiness of inflation, it’s broadly accepted the Fed needed to act. But rather, the debate is whether the central bank is tightening quickly enough. At first, the markets signaled the hike was good news; later that it wasn’t enough. The dual mandate of the Fed is to maximize employment and ensure price stability. The low unemployment rate means that price stability is currently the primary concern. Since it’s widely agreed on by market experts that the Fed was late in addressing rising prices, many investors are understandably worried it can’t, or won’t, take the necessary steps to battle inflation. How the Fed fights inflation Inflation is caused by too many dollars (demand) chasing too few goods (supply). We recently touched on the supply/demand dynamic and its impact on prices. Too much money with too few assets is how you get the kind of bidding wars we have seen in the housing market. It also results in consumers that can afford the rising costs that companies pass through to protect profit margins. So, if we know that inflation is the result of too much money and too few goods, then we can see that there are really only two ways to address it: Increase the supply of goods or decrease the money supply. Since the Federal Reserve has no control over the supply chain, the only tools they can use are those that can impact the money supply. This is what the Fed is doing when it raises rates and reduces asset holdings. Interest rate hikes Let’s start with rate hikes since that is generally what we see debated all day on CNBC. Should Fed chair Jerome Powell do 50, 75, or 100 basis points (or even more)? The Federal Reserve sets what is known as the federal funds rate, also known as the overnight rate. The Fed uses this rate as one method to try and control the money supply. The overnight rate is the rate at which banks can borrow from one another on an overnight basis (thus the name). When the rate rises, it becomes more expensive for a bank to borrow. It also indirectly causes rates to rise rates time periods longer than overnight (think one month, three months, 6 months and so on). Here’s why: If a bank has to pay more to borrow, then they are going to have to charge more to lend if they want to maintain a healthy profit margin or “spread.” Thus those higher rates on longer-term bonds. By adjusting the overnight rate, the Federal Reserve can attempt to change the “short end” of the yield curve. We say indirectly because again, the Federal Reserve has direct control only over the rate. The impact on the longer rates is a ripple effect. This policy action, if successful, will slow down economic activity because as the cost to borrow rises, businesses and consumers will be less able to use debt to fund spending and therefore will cut back. Open market activity The other major tool the Federal Reserve has at its disposal is the ability to conduct open market activities. When you hear someone refer to the balance sheet and whether it’s growing or shirking, this is generally what they are talking about. It’s a direct means of pumping money into the system (increasing liquidity) or pulling it from the system (draining liquidity). This is also the concept behind quantitative easing/tightening. Here’s how it works: The Federal Reserve purchases longer-term securities, usually government bonds, in order to inject money into the economy. They buy the bonds in exchange for cash. If they are government bonds, the government can then take that money and spend it on infrastructure or other government-funded initiatives to help stimulate economic activity. Of course the flip side of this would be to sell those bonds, calling in the debt and thereby pulling those dollars back out of the system. That said, the Federal Reserve doesn’t usually sell the bonds, instead they let them “roll off.” What this means is that once the bonds hit maturity, the borrower (the government in the case of government bonds), repays the debt. But rather than go out and purchase another 10-year bond to keep the money in the system, the Federal Reserve does nothing, thereby allowing the balance sheet to shrink over time as bond holdings are reduced. This causes liquidity to slowly drain out of the system as the borrower (in this case the government) no longer has that large buyer (the Fed) to buy its bonds. This open market activity is not limited a certain type or duration of bond, but can use its discretion to purchase what it believes will be most impactful. While government bonds are generally the go-to purchase, the central bank can also purchase corporate bonds or mortgage securities – actions we saw taken during the peak of the Covid-19 pandemic. Why the Fed’s balance sheet is so important Unlike changes in the federal funds rate, which target the short end of the yield curve, these bond purchases have a greater impact on the “longer end” as they more directly impact borrowing rates in the 10-, 20-, and 30-year timeframes. And whereas the Fed is the sole determiner of the benchmark rate, the open activity has many buyers and sellers which, in aggregate, impact overall rates. The Fed’s power, however, comes from the simple fact that it can be the largest participant in the massive bond market. After all, the Fed controls the money supply. The yield curve Now that we understand how the Federal Reserve can impact rates on both the short end and the long end, we should touch on the yield curve. When the system is working as it should, the longer the time frame of the borrower, the higher the interest rate. For example, a 10-year rate should be higher than a 3-year rate; a 20-year rate should be higher than a 10-year rate. This is what Jim Cramer was referring to this week when he wrote: “If Fed Chairman Jerome Powell is going to do that [raise rates more than 50 basis points] he should also double the amount of bonds for sale so we get the yield curve back to its normal state where longer-term rates are higher than short term rates.” We don’t want to see the curve “invert” (when short-term rates are higher than long-term rates) because it can cause lending to seize up. A bank isn’t going to borrow money at 2% only to lend it out a 1% and lock in a 1% (the spread) loss. It’s well-accepted the Fed should have been more aggressive before this week, but debate now is whether it is pivoting to strategy that’s tough enough to battle inflation. And the reality is that we will simply not know how effective the recent actions will be until several quarters from now as the data rolls in. And while it is easy to deride the Fed’s actions in the past, we must be mindful that the Covid-19 pandemic and resulting lockdowns that caused them to take such swift and drastic action to stimulate the economy was truly unprecedented. Then there was Russia’s invasion of Ukraine and the supply chain disruptions from more lockdowns in China. Hindsight is so 20-20. Before we denounce Powell as a terrible chair, we must acknowledge the difficult hand he’s been dealt. We hope this has provided some insights into the single most important factor driving the markets — the Fed’s battle with inflation — along with the tools at their disposal and how they are using them. (See here for a full list of the stocks in Jim Cramer’s Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.Federal Reserve Chairman Jerome Powell testifies during the House Financial Services Committee hearing titled Monetary Policy and the State of the Economy, in Rayburn Building on Wednesday, March 2, 2022.
The Federal Reserve raised its benchmark interest rate by 75 basis points on Wednesday and promised to reduce its bond holdings. Jay Powell and his team may not be doing enough to squash inflation, which caused investors to sour on the news.
