A Lesson on Monetary PolicyWhat exactly is the Fed doing and what are its main tools?
Most of the focus in the press and the financial reporting community focusses on the Fed and what it does in in terms of setting the federal funds rate. In reality, the federal funds rates only directly affects short term interest rates since the federal funds rate is the interest rate that the banks get for overnight deposits with the Fed. That said, the federal funds rate is often used a benchmark for longer term rates such as mortgages but this is up to individual banks as to whether they pay attention to it or not.
The other tool the Fed has is to buy or sell longer term bonds in the open market. When they buy these bonds, they are effectively printing money out of thin air and the press calls this monetary easing. These actions do have a direct impact on longer term interest rates.
So how do we get inflation?
Inflation comes from a combination of two things. The scarcity of a particular thing or things and the growth in the money supply. Growth in the money supply comes from the amount of money that is printed by the central bank (The Fed) and what is called the velocity of money or in simple terms the speed at which money changes hands. The speed that it changes hands is directly influenced by the rate of growth of the economy.
Sooo...just focussing on the money supply, through quantitative easing, the Fed has been printing a lot of money over the past number of years (about 7 trillion dollars since late 2008). Over the past couple of years since the COVID meltdown in March 2020 the economy has grown at a quick pace and so this plus the printing of alot money by the Fed has massively increased the money supply and hence created inflation. The outsized rise in the stock market has reflected this increase in the money supply.
Where do we go from here?
Well, you guessed it. The Fed is now selling bonds and increasing its discount rate. The selling of these bonds reduces the amount of money in circulation and the higher interest rates reduce economic activity and this results in a contraction in the money supply.
The Fed hopes that it can find the right balance between these forces to get the right amount money supply to cool inflation without sending the economy into a recession. The problem is that nobody knows what the right amount is and the Fed historically has pretty much gotten it wrong every time since it was started in 1913.
In a recent post, Obscure posted a number of questions. What this list of questions serves to illustrate is that world has gotten very complicated with many conflicting forces and making it even more difficult if not impossible for the Fed to find the right balance to cool inflation without causing a recession.
All of this makes it difficult for the stock market to figure out what to do and hence we see a lot of day to day volatility. For some people like Migraine who is skilled in options trading and leveraged investments, this volatility presents an opportunity to make a lot of money. For most people that is not the case.
Each investor will in one way or the other make decisions on how to handle this situation but in a way the root of the decision either conscious or not will be whether he/she thinks the Fed will get it right or not.