The Fed: What investors should know
Kyle Tetting: Dave, a challenging year overall for stocks and bonds alike. The Fed: Really, the focus of the conversation for most of 2022. I think often lost in all that discussion is what the Fed’s actual role is, what they’re actually trying to accomplish. Of course, the law – Congress – has made it crystal clear what the Fed is supposed to do. They have a dual mandate, often said. Tell me a little bit about what the Fed is actually trying to accomplish.
Dave Sandstrom: So, Kyle, the Federal Reserve was created by an act of Congress back in 1913. So, this isn’t something new. This has been around for many, many years. And they’ve been charged with this dual mandate, which is their efforts to create an environment in the economy where we have maximum employment and stable prices. Both of those can be complementary at times, because in an environment with stable prices, where inflation is low and consistent, it can promote growth, and you end up with a nice employment situation. Sometimes, however, you get in a situation where maybe employment’s too tight. It forces wages up, prices go up, and then the Fed’s stuck with a different battle of fighting those stable prices.
Kyle: And of course, a variety of tools that you could come up with to deal with those kinds of potential things, but the Fed is fairly limited. Especially historically, the Fed is fairly limited in what tools they have in order to fight inflation, in order to boost employment – again, the two kind of key components of that mandate. Tell me, what can the Fed do when they see inflation? What can they do when they see unemployment becoming a problem?
Dave: So, the most common response from the Federal Reserve, Kyle, in those areas of the full employment and stable prices, is to manipulate the money supply through the use of interest rate movements, typically. The Fed can change the overnight rate, which is basically what they charge banks in the country to borrow money, which they in turn, turn around and loan out to the economy – individuals and businesses. By increasing the cost of that money, it makes things more expensive. Mortgages is a great example, credit card debt, car loans, business loans, those types of things that people will go out when rates are attractive and do more of, and when rates are higher, they’ll do less of. So, that’s one way where they can control the velocity of the money through the economy.
Kyle: And of course, Jay Powell, the Fed, came out in a speech in Jackson Hole talking about the potential for pain as a result of some of what the Fed is currently undertaking in the form of raising interest rates. Maybe by design, right? That the Fed is trying to induce naturally a slowdown by making it a little more expensive to borrow.
Dave: So, this is one of the negative sides to this is when inflation gets out of control, and gets higher. Now the result is the Fed has to intentionally place a little damage on the economy, slow things down. And typically that can relate to higher unemployment numbers, which is kind of counter to their dual mandate, but it’s typically deemed that high inflation carries a little bit more of an immediacy and a burden to get down than the employment picture. So, I think you’re going to see them be able to put up with some of the higher unemployment numbers in an attempt to bring prices back down to a stable level.
Kyle: That price stability, I think, is the thing that gives confidence to businesses, gives confidence to consumers, that we’re on a solid footing and that things aren’t going to run away from us the way they have in some prior high-inflation periods. Of course, as we look at what the Fed has accomplished so far, they’re kind of driving with their eyes in the rearview mirror here. They’re kind of looking at where we were. We don’t feel the effects of what the Fed is doing with interest rates right away.
Dave: And also remember, Kyle, there are a lot of things that they don’t affect immediately or have a lot of control over. The cost of borrowing is one thing, but volatile items, like energy – gasoline and oil, of course – and groceries are a good example of things that they don’t necessarily have a direct impact on that pricing. And sometimes those things can be a little more stubborn, a little difficult, for the Fed to manipulate.
Kyle: And a few other tools that the Fed has come up with in recent years, in particular, to combat the financial crisis, again during COVID, some ways to keep certain areas of the market more liquid. Things like quantitative and qualitative easing.
Dave: So, that’s something that is relatively new to not only the U.S. but the rest of the world, and that’s when the Fed can further influence interest rate movements by purchasing bonds on the open market. Recently, they’ve even gone to buying some corporate bonds. Typically, it’s all been government-issued Treasurys and government notes that they’re purchasing. So qualitative easing and quantitative easing are ways that the Federal Reserve can jump in and manipulate interest rates further by increasing or decreasing the supply of bonds on the open market. And that has a tendency to either raise interest rates or lower them, depending on the direction that they would like to go.
Quantitative tightening is typically what they’re doing in response to higher prices. They’re trying to bring prices down by raising interest rates, and that’s what we have seen most recently.
Kyle: And of course, I think it’s so important for investors to understand it’s all about earnings and interest rates. The Fed having a pretty big impact on interest rates recently, and so it’s the reason why we pay attention, right? It’s the reason why the market is so tuned in to what the Fed is doing.
Dave: And there’s no question, Kyle, that rising interest rates are going to have a negative impact on the stock market. And it’s a simple mathematical equation based on you’re paying for future earnings when you buy stocks, and when your discount rate, that interest rate, is higher, that means those future earnings are going to be worth a little bit less, which typically forces those stock markets to reprice those assets.
Kyle: And of course, maybe a last reminder that we can’t extrapolate out the current environment in perpetuity, right? We can’t assume that interest rates are going to rise forever. If the Fed finally does get inflation under control, if they finally do keep employment where it’s supposed to be, we reach a point where things stabilize. All of a sudden, stocks have a little more certainty, bonds have a little more certainty, and I think markets tend to settle down a bit from there.
Dave: Thankfully, Kyle, when you look back at history, the Fed has done a pretty good job of maintaining stable prices in the U.S. economy over the long run. Obviously, we do run into periods of time where things become out of control maybe a little bit in either direction, and this is probably one of them. But over time, it’s highly likely that they’ll bring those prices back into a reasonable range. There’s a little silver lining with rates going up in the bond market as interest rates stabilize. Then going forward, you’re looking at higher yields. That makes bonds very attractive again. Stock market ramifications can be very, very different. You don’t know how long it will take, you don’t know how long the markets will stay in a downward trajectory, but at some point in time, when we can see the Fed level off their tightening efforts, that typically brings some calm and some stability back to all financial markets.
Kyle: A very good point, Dave. It’s important to understand that it’s a constant fine-tuning from the Fed.
Kyle Tetting is president of Landaas & Company.
Dave Sandstrom is vice president and an investment advisor at Landaas & Company.
Video by Jason Scuglik
2022 Investment Outlook Seminar, a Money Talk Video
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(initially posted Oct. 29, 2022)
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