The Fed Part 2
It’s been a while since we’ve talked about the Fed, and if you didn’t catch my first post, I’d highly recommend going back and reading it before moving on to today’s. Part 1 will give you a good framework of the Fed, making today’s post a little clearer. Given all the talk surrounding interest rates and inflation, today seemed like a good time to talk about some of the actions Jerome Powell and the Fed have announced and taken and what they really mean.
In our first post, I talked about the Fed’s dual mandate to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates. I think anyone who’s paying attention knows they haven’t exactly succeeded as of late. With unemployment still incredibly high and the “great resignation” we are seeing take place, employment is anything but maximized. According to Trading Economics, the annual inflation rate was 6.2% in October of this year. I wouldn’t consider that stable. And although we’ve seen some movement recently, interest rates still hover around historic lows. What is Powell to do?
First, it’s important to recognize the power of the Fed and where that power ends. The Federal Reserve controls our balance sheet and the Federal Funds Rate. We talked about these two tools in part one. The Fed does NOT have power to make people go back to work. The Great Resignation is something economists have predicted for awhile now and to be honest, there isn’t just one reason for it. There are dozens of reasons people are leaving their jobs; it’s likely that the fallout from Covid sped up a process that was already in motion. Not only does this create a debacle for the Fed in fulfilling their maximum employment mandate, it also trickles down into other aspects of the mandate, i.e. inflation.
Without enough employees, companies are given one of two choices, charge more for the products they supply (goods or services) thus altering the supply/demand equilibrium or offer higher wages to attract new employees. Ultimately, both lead to higher costs. Inflation’s two main components are money supply and money velocity. Increases in wages have the single largest impact on prices.
So why are we in the pickle that we are? There are really a few reasons. Interest rates likely should have begun coming up a couple years ago, but in walked Covid (along with allllll the man-made fallout) and our economy fell into shambles. Raising interest rates during difficult economic times is not ideal, so the Fed held them low. The theory behind this decision is that making money cheap to borrow (low interest rates) encourages companies and individuals to borrow and spend thus spending our way out of recession. According to JPMorgan’s most recent Guide to The Markets, over 68% of our GDP comes from consumer spending. Getting consumers to spend is the quickest way out of a recession. And the only better way to get people to spend than keeping borrowing cheap is to put money directly into their pockets…ta-da stimulus. Stimulus checks began going out to households in 2020 and continued through 2021, thus increasing the money supply. Now, the reason we didn’t see the inflation immediately after stimulus went out is likely because of the strict lockdown measures in place in many areas of the country limiting people’s ability to spend as they wished.
And that brings us to the Fed’s final tool, quantitative easing. Quantitative easing is another form of pumping money into the economy, done so by purchasing assets and putting them on the balance sheet. Again, this increases the money supply, and government spending, although a small pieces, is still part of the GDP calculation at around 18% (JPMorgan Guide to The Markets).
Combine all these factors: a lacking workforce, historically low interest rates, an excessive flow of money in the economy, not to mention supply chain disruptions from around the globe, and you have a recipe for disaster. Or at least one for very high inflation. The Fed has, however, begun to take steps in an attempt to remedy the situation. They announced in early November that they would begin reducing bond purchases beginning with $15 billion that month. The goal is to end all asset purchasing by June of 2022 (Barron’s Nov. 4, 2021). Given that this means less money will be flowing into the bond market, it is possibly we could see an increase in bond yields, particularly on the longer end of the yield curve. Once this tapering is complete, the Fed will likely then make moves in the overnight interest rate (the Fed Funds Rate) to help stimulate the short end of the curve. Making their moves in this order should help to avoid the threat of an inverted yield curve. Jerome Powell knows he has to be careful in what he does and in what he says. In the short term, the market hinges on every word he says and one hint of an interest rate change could lead to a pullback in the stock market.
Unemployment and supply chain disruption are a little different story. There isn’t a simple lever to pull and fix the problem. As previously mentioned, workers left their jobs for a whole number of reasons and while we definitely foresee some of them returning to the workforce (possibly in a different sector), there are likely those who never intend to return and financially don’t need to. We see that in our world A LOT! We’ve had many clients over the past 18 months decide they were done and they are financially well prepared to do so. Others just dialed back at work but did so permanently. If increased wages are what it takes to get others back into the workforce, we can expect the effect on prices to continue. Global supply chains will likely remedy over time, especially if workforce participation increases. But the recovery may not be felt equally across industries. The oil industry, for example, is taking shots from all side, politically, globally, sentimentally. A recent survey conducted by recruitment firm Brunel and oilandgasjobsearch.com found that 43% of workers wanted out of the energy sector within the next five years (oilprice.com). With labor shortages already evident in the oil industry, it’s likely the pain will continue which could lead to persistent high prices at the pump.
While the Fed has finally begun taking necessary steps to get back in front of inflation and raise interest rates, is it too late? Has the damage been done? Are there too many factors outside their control? We certainly can’t predict the future, but many economists and analysts feel that one likely scenario at this point is a return to normal inflation rates over the next year in most industries with a few outliers that will likely remain high for the foreseeable future, interest rates increasing to a, still low but, more acceptable level for savers and a gradual trickle back into the workforce by many young people who exited over the past two years.
Congratulations if you hung on for this entire post! It was certainly not for the faint of heart. As always, never hesitate to reach out with questions or comments, we love hearing from all our readers!
Opinions expressed are those of Molly VanBinsbergen and are not necessarily those of Raymond James. All opinions and numbers are as of this 12/01/2021 and are subject change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the material is accurate or complete.
