Why Traders Pay Attention to the Federal Reserve, Monetary Policy, & Inflation

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Professional money managers and investment firms have a staff and analysts on payroll to do nothing other than assess monetary/fiscal policy, including political implications, pursuant to planning future investment strategies. The average retail trader has very little in the form of a macroeconomic education, and has a great amount of difficulty assessing second and third order effects of monetary and fiscal policy. This entry is designed to slightly remedy that. There is much more below the surface and a lot of nuance that I will not go into. Hopefully however, you will be able to use this information to formulate your own processes for determining Federal Reserve induced macroeconomic trends and their second and third order effects on the market.

Understanding Inflation & Monetary Policy

The Federal Reserve has what is known as its “dual mandate.” The first is price stability. The second is to maintain maximum levels of employment. Naturally when the Federal Reserve was created in 1913 the latter was secondary to the former. Indeed, unless you can maintain price stability you cannot have a maximum level of employment. I will go into this further later, but It if first important that you understand the two primary goals of the Federal Reserve. In doing so you can personally assess if those goals can be met armed with the knowledge below.

The Federal Reserve maintains price stability by controlling the rate of inflation. The Fed controls the rate of inflation by adjusting the interest rate by which money is loaned to banks. In fact, you should not think of a bank as a place where money is stored. Banks are institutions where money is created. When you take out a loan money is created. It is important to know that there is no gold, there is no silver, there is nothing backing the dollar. The dollar is created via loans and those loans must be paid back with interest. The interest rate you receive from the bank is heavily dependent on two things. The first is your credit score. The second is the interest rate the bank receives when they borrow the money they to loan to you. Money loaned to the bank comes largely from the Federal Reserve, investors, and clients of the bank.

There was once a time where banks were loaned a very large proportion of their money from clients buying CD’s and opening savings and Money Market accounts. They still largely do. Today however you will note that all of these are very low yield investments that stand up poorly to the rate of inflation. In short, your dollar will devalue quicker than it will grow with many of these instruments. In large part this is a result of the Fed maintaining low interest rates. Your bank isn’t going to borrow from you at a higher rate than the money received from the Fed. Therefore, if the Fed has a low interest rate, you can expect the bank to pay you a low yield for any money you invest or deposit in the bank. However, when the Fed’s interest rates are low, so too are the interest rates of loans from your bank.

The purpose of the Federal Reserve lowering the interest rate by which they loan money to banks is simply to incentivize banks to loan to their customers at a lower interest rate. When interest rates are low, businesses and individuals are incentivized to finance more, resulting in more purchasing power, and therefore, a high amount of liquidity in the economy. When money is cheap, people borrow and spend more. It’s that simple folks. Look no further than the current housing market. Low interest rates have led to a housing boom in the middle of a pandemic; a time of financial hardship for many. In short people saw the low 30-year fixed mortgage rate for a home, and thought to themselves, “now is the time to buy.” They were right to think so.

The difference between a 30 year fixed rate mortgage for a $300,000 home (Well below the median price for average 2021 homes sales in the U.S.) at a 2.25% interest rate and a 3.5% interest rate is paying an additional $112,826 and $184,968 over the course of the loan. In short, the true cost that you will pay for a $300,000 home loan at each of these rates is $412,826 & $484,968, a difference of $72,142, assuming you make only your monthly payments and forgo making extra payments on the principle. It’s the difference between a monthly payment of $1,147 & and monthly payment of $1,347; a difference of $200 or $2400 a year. The rate at which we borrow money can dictate many years of spending habits! So, interest rates matter! The less you spend on financing the more you have to save, invest, or spend elsewhere! It’s the same for you or any business you can think of. Interest rates can have a profound impact on markets!

Incentivizing borrowing has a massive impact on businesses. When businesses spend money, it increases the multiplier effect. For example, if a business borrows $1M to expand its production capacity resulting in an additional $2M in revenue a year, we can say the business has a $2 return for every $1 borrowed. Additionally, that money spent goes to the construction company that expanded the production facility, who no doubt spent money on steel, wood, concrete, asphalt, and a number of others goods and services. No doubt the company’s that supplied all those goods spent their revenue on raw materials, fuel, equipment, etcetera. This leads us to the “Marginal Propensity to Consume,” or rather, MPC.

The MPC is a term used to describe the rate by which consumers spend and save a sudden boost in income. So in our business example, if the business saves 20% of their increased revenue and spends 80%, they have a Marginal Propensity to Consume at a rate of 80%. As a result we can say the MPC multiplier is [1/(1-0.8)] which translates to every $1 received results in an additional $5 spent in the economy. Should the average consumer save 30% of their income and spend 70%, the MPC multiplier drops to $3.33 spent in the economy for every $1 received. If the average consumer spends 90% of their income and saves 10%, the MPC skyrockets to an additional $10.00 spent in the economy for every $1 received. In short, low interest rates can incentivize borrowing which leads to a great amount of spending in the economy! The less people save, the more people borrow, the higher the consumption. It important to note how things can quickly shift if there is a significant change to the MPC. And the MPC is completely controlled by the consumer, and how confident the consumer is amid current economic conditions. Although the Fed can incentive consumer spending, and therefore the MPC multiple, by lowering interest rates.

Understanding the MPC multiplier is important from the Federal Reserves standpoint. They need to know how much injecting each dollar into the economy will result in additional consumer spending. In hard times, when people are more likely to save their money, the Fed may want to consider lowering interest rates to boost the economy. In good times, where people are more likely to spend, the Fed may want to consider raising rates. The Fed also uses this rate to dictate how much money a large bank must keep in reserve (The reserve requirement) or on deposit, together with the banks liabilities, so as to withstand sudden adverse changes in the economy. However, as a result of COVID-19 the Fed has taken the additional step, (additional to low interest rates), to largely eliminate the reserve requirement, so as to increase the MPC multiplier. But if low interest rates lead to economic prosperity, why raise rates at all? The answer is simple. Inflation!

Too much money injected into the economy too quickly leads to inflation.  Of course, you want inflation. Inflation is healthy. Afterall, you would be less likely to spend today if you knew your dollar would be worth more tomorrow amid deflation. With this in mind ask yourself what would deflation do to the MPC multiplier and the greater economy? It would grind commerce to a halt! So, we should always expect an inflation rate. The only question is at what rate?

It is important to distinguish inflation “rate.” The Fed does not lower or increase inflation, they ATTEMPT to adjust the inflation “rate.” The Fed and the BLS keeps an eye on the price of a basket of goods (the Consumer Price Index, or “CPI,” that no one really takes seriously for a number of valid reasons), to gauge the current effects of inflation. However, the Fed also projects inflation many years out. After all, a modification in the interest rate does not have an instantaneous effect on the economy. Adjusting the inflation rate has implications many years out and the Fed forecasts what the interest rates should be today to achieve goals many years in the future. This is called the “inflation target.” The target may vary, depending on how far out the Fed projects, and given assessed current and future economic conditions.

While a steady rate of inflation is healthy, a sudden sharp increase in inflation can create some serious economic headwinds. After all, inflation is a devaluation of our currency. So, a sharp rise in inflation means a sharp drop in real wages for workers, and real revenue for businesses. And history has repeatedly shown that wages always lag behind inflation. And necessarily so. Businesses aren’t going to pay their workers more if they’re getting less real revenue as a result of inflation. In fact, businesses may need to review how many workers they really need to make up for loss in real revenue. Shareholders of publicly traded corporations want a return on their investment, and therefore will demand that the business act to mitigate the effects of inflation. Amid a sharp rise in inflation businesses pay more for goods and services, they receive less in real revenue, and they grow less than originally expected. Too much inflation doesn’t simply affect the price of goods and services, but it may lead to higher rates of unemployment in the short run.

Amid sharp periods of inflation consumers can’t stretch their dollar as far. As a result workers realize less income than the year before, less buying power than the year before, less savings, less safe investment (more risky investment), and will be more likely to take on additional debt leading to financial hardship and more inflation. In short, workers are paid less and they pay more for the same goods. Their pay is the same, but their “real wages,” are less.

Once the rate of inflation slows, usually as a result of actions taken by the Fed, and businesses can easily predict their economic future, they may begin hiring again. Labor is like any other commodity, and wages will not increase until the quantity of labor demanded in a particular sector exceeds the quantity of labor supplied. Wages truly do not rise until like industries need to compete for their labor pool. History is filled with such instances whereas the limited amount of labor led to increased wages, benefits, and workers rights. Japan, Taiwan, Hongkong, Singapore, are all countries that experienced an increase in real wages and benefits as a result of the scarcity of labor in the last 60 years. In the last 125 years wages and benefits have increased as the quantity of labor demanded exceeded the quantity of labor supplied in countries like the UK, the US, France, and many other first world countries that are economic powerhouses today … largely as a result of the industrial revolution. The number one indicator of an increase in wages and benefits of any given country is the scarcity of labor. The higher the scarcity, the higher the wages and benefits. Nevertheless, wages always lag behind inflation. Businesses are less likely to raise wages in times of sharp inflation & economic uncertainty.

The inflation rate is directly tied to employment and the cost of goods and services. However, long periods of inflation can lead to increased hiring in many cases. Earlier I mentioned that sharp increases in inflation may lead to less employment in the short run, but over time, as wages remain stagnant while businesses adjust and increase in revenue, they eventually come to the realization that the real cost of labor is much less than it was before. In any economy with a constant state of inflation, a worker that is making $15 an hour for the past 5 years is cheaper to pay today than they were 5 years ago. In fact, a worker who makes the same amount of money today as they did 5 years ago has lost nearly 10% of their real wage. Moreover, a worker that made $40,000 a year for the past 5 years of after-tax income had the real spending power of nearly $44,000 in todays money 5 years ago. For the business that individual works for, labor is nearly 10% cheaper today than it was 5 years ago … until …. the quantity of labor demanded exceeds the quantity of labor supplied, resulting in a higher amount of competition for labor between similar businesses, resulting in increased wages.

There are, of course, positive aspects of inflation. If you have a great amount of debt, by the time your wages, or revenue if you are a business, catches up with inflation, your real debt is lower than it was before, assuming a fixed rate. Homeowners over time love inflation. Not only does their home and land value keep up with the inflation rate, but over time the mortgage becomes much easier to pay off. I’ve met people who bought their homes in the 80’s with a 30-year fixed rate mortgage who had a payment of around $300 a month by the time they paid their home off a few years ago. This increases the amount of purchasing power per homeowner, and results in building real wealth over time. This is quite often why, in part, people who buy their home young have considerably more wealth than those who do so many years down the road. Well-kept homes generally retain value regardless of where inflation takes us over time.

The Federal Reserve therefore has a great amount of power to mitigate inflation and employment woes. By adjusting the inflation rate the Fed truly controls the economic engine of the United States more so than Congress or the President could ever hope to achieve. With such immense power, is it no wonder that the markets pump or dump based on what the Fed Chair announces to Congress on a weekly basis. It’s a solid reason to figure out when he/she speaks using an economic calendar.

There is another tool at the Feds disposal I neglected to mention, and saved for last for good reason. Quantitative Easing is an emergency measure the Fed engages in when interest rates are already near zero and bank reserve requirements are eliminated, however the economy does not seem to be improving. This action involves injecting additional money supply into the economy by buying financial assets from banks like bonds, distressed securities (like the mortgage backed securities of the great recession), and other financial instruments. As a matter of policy (and law I believe) the Federal Reserve does not/cannot buy Treasuries from the U.S. Government, and for good reason! If all money in the economy is a result of debt loaned by the Fed, then buying Treasury Bonds from the U.S. Government adds an additional layer of debt on money already lent. However, the Fed does purchase previously issued Treasuries from financial institutions on the open market (I know, it isn’t much of a difference). In doing so they increase the demand for U.S. Treasuries and lower the bond yields while increasing the money supply … and the possibility for sharp inflation.

Perhaps a negative aspect of Quantitative Easing is it lowers the Treasury Bond Yields. Treasury bonds are among the safest investments that anyone can hold, however the returns from bonds are lackluster at best. Treasury bond yields are an excellent indicator of how the bond market is pricing in future inflation. If the bond market expects a high rate of inflation, less institutions purchase Treasuries, and as a result, the Treasury bond yields must necessarily increase to make the bonds more attractive to investors. Without increasing the yield amid low demand for Treasury Bonds, the U.S. Treasury can’t get the money the U.S. Government needs to finance government services. This is why the market generally reacts poorly to increasing bond yields, as the Treasury Bond is an excellent indicator of inflation sentiment. If the bonds can’t meet or beat the rate of inflation, no one will buy them. If no one will buy them, the rates need to increase to make them more attractive. However, when the Fed artificially increases the demand for existing bonds, they also lower the bond yields, which in turn, obscures what the bond market sentiment is for inflation. So in this circumstance the bond yields can remain very low, but the risk of inflation has actually increased.

Many people observe that we have had higher bond yields in the past and the stock market remained fine. This is, of course, very true, but times are different. I have recently assessed that an increasing 10 Year Treasury Bond Yield to 2% will lead to a market fallout. Not simply because the bond market is pricing in sharp inflation, but rather because the bond market is both pricing in sharp inflation despite the artificial demand induced by the Fed which should lower bond rates or at minimum keep them stagnant. Therefore the 2% 10 Year Treasury Bond Yield of today is certainly not your 2% 10 Year Treasury Bond Yield of yesterday! The rising bond yield of today is happening IN SPITE of quantitative easing (Which is ongoing)  .. which is not a good indicator!

Now that you’ve had a very non-detailed overview of understanding inflation and the Fed lets move on to current policy and current conditions. But to summarize what we’ve just explored, we looked at the role of the Federal Reserve and how it operates, how banks create money, how the Fed projects and controls inflation many years out, the effects interest rates have on lending and money supply, how your money will always slowly devalue over time, how the MPC multiplier functions, the effects of inflation on real wages and real revenue, the economic implications of inflation, quantitative easing, the bank reserve requirement, and how treasury bond yields are a good indicator of how the market sees future inflation.

Current Monetary and Fiscal Policy

Facade on the Federal Reserve Building in Washington DC

Inflation for Job Growth: Federal Reserve Chairman Jerome Powell has recently stated that he is less concerned with inflation than he is stimulating the ailing COVID economy to incentivize job growth. The market took this for exactly what it meant .. that Powell is willing to entertain higher inflation rates, and therefore lower real wages, so as long as it means heating the economy up to full employment. I’m personally skeptical, however, the most shocking thing Powell said is that he is willing to have 2% inflation for a year before considering and interest rate increase. This is problematic for three reasons. Firstly, the Feds highest priority has traditionally been controlling inflation to prevent unstable markets that result in employment uncertainty. Second, the Fed throughout history, and my lifetime, has always taken a proactive approach toward inflation. Third, it can take many years before inflation can adjust to the desired rate when the Fed finally does raise interest rates. In the interim the economy will remain overheated. I worry that once the Fed switches back to its traditional role of mitigating future issues with inflation it will be too late, and we will have a new problem on our hands. The markets will react to this adversely. A business, for example, that grows 8% a year under 2-3% inflation truly only grows about 5%.

More Jobs at the Expense of Wages: The welcoming of inflation to spur job growth is essentially admitting that the Fed is willing to devalue the wages of the employed for the HOPE, that inflation will lead to more employment. In the short run it may have the opposite effect. Either way the wages of the average middle-class consumer, on the backs of which our economy depends, will be diluted leading to less buying power which will threaten future growth. In short, people will be incentivized to spend on necessities only. This will be good for inferior goods though. Not so much for normal goods. And luxury goods will take the hardest hit.  

10 Year Treasury Bond Yields: 2% is coming, and the markets will react negatively to it. Not necessarily because it indicates that the bond markets are expecting inflation, but because it demonstrates that the rates are increasing despite QE. And Congress is going to need the money! Over the last 12 months Congress has passed three stimulus bills amounting to roughly $6T. To put this into perspective, in 2008 Congress passed a $700B to combat the housing crisis. Adjusted for inflation all of World War II cost the U.S. Government $4T. Therefore, bond yields will need to rise to not only reassure bond buyers that their investment will beat inflation, but to incentivize additional bond buying pursuant to higher than normal spending.

Conclusion

I hope you have found this informative. It is indeed a bit of information many retail traders are unaware of. Many believe there is a literal printer injecting money into the economy. This is simply not the case. The quantity of money supplied is designed to meet the quantity of loans demanded given the incentives or disincentives of current interest rates. The implications of interest rates and inflation are many. At the moment the Federal Reserve has put themselves in a no-win situation. They’re damned if they do, damned if they don’t. A sharp increase in inflation may eventually incentivize job growth through making labor cheaper and money more available, but at the expense of business growth and real wages. Moreover, it risks out of control inflation; whereas a reactive approach rather than a proactive approach to inflation targets, delays the speed in which it becomes possible for the Fed to curtail the inflation rate. On the opposite side of the spectrum, raising interest rates to prevent high inflation will disincentivize lending and eventually lower the inflation rate, but nevertheless interfere with access to capital for future investments and the rate of long-term job growth. Such a damned if you do and damned if you don’t scenario leads to uncertainty, which is generally bad for markets. Uncertainty leads to market skepticism and defensive investment strategies. And this is why we pay attention to Federal Reserve policy.

Other Items Neglected

Money Printing 100 US Dollar Banknotes Illustration. 3D render

Trade Deficit: One of the many things I neglected to mention is how inflation can increase inflation without the Federal Reserve. For example, the trade deficit, and a high level of migration, result in U.S. Dollars leaving the United States. Those U.S. Dollars eventually end up in the hands of the governments that exchange them with the owners for local currency. Those foreign governments do not simply sit on the money. They use it to buy U.S. debt, invest in the U.S. economy, or buy U.S. goods and services. There is enough USD held by foreign entities to become an outside factor that can affect inflation.

Government Spending: Another way inflation can increase is through government spending. Outside of taxation, the government can borrow money to spend on bloated budgets which injects additional money into the economy. This too can lead to additional inflation. Not only through the supply of money, but the imbalance it creates as governments compete for goods and services against the private sector.

Minimum Wage Increases: Government Policies can likewise result in a sharp increase in inflation. One that comes to mind is the proposed $15 federally mandated minimum wage. Should the U.S. Government pass such a proposal, it will no doubt result in a sudden imbalance in wages and incentives. Small to moderate sized businesses who compete against large corporate conglomerates and lack the economies of scale of large corporations will be less likely to compete, resulting solidifying the power of near monopolies who can later increase prices with little to no competition to maintain competitive pricing.

Wages across the economic spectrum will necessarily need to increase amid a $15 minimum wage. Employers of middle-class skilled labor who enjoy $15 and hour or more for completing skilled labor jobs, are less likely to be able to recruit employees when the starting wage is the same as that of a bagger at a grocery store. Therefore, an raise in the minimum wage to $15 an hour will increase the wages of those already making $15 an hour, lest their employer wish to remain uncompetitive for skilled labor. With the resulting increase in blue collar wages, white collar wages will necessarily need to increase as well, and so on. The resulting increase in the cost of labor will induce a higher quantity of goods and services demanded by employees with higher salaries, which will increase scarcity of goods and services, resulting in increased prices.

Moreover, wages are the largest businesses expense in any company already, which means businesses will naturally need to pass on the increased cost of labor to the consumer in the form of price increases, or cuts in benefits to employees. Of course, this phenomenon is amplified when it increases the amount of tax a business pays. After all, Social Security taxes and Medicare taxes, are expenses that are matched by the employer. Every dollar you pay in these two taxes is matched by your employer. And those costs will likewise be passed to the consumer.

When things eventually even out you will find that increasing the minimum wage to $15 an hour will result in little more than the current real value of wages matching the previous real value of wages. In short, everyone will be making more, but as they’re paying more for goods and services, it won’t really matter. That’s just another name for inflation. A $15 minimum wage is a great talking point to the economically illiterate for votes during an election, however it makes little in the form of real economic sense. Unless, of course, you are a large business with a highly efficient economies of scale looking to create barriers to entry for your smaller competition. For this reason, many large businesses and unions not only lobby for an increased minimum wage, but back politicians who advocate for a higher minimum wage as well. For big business it cripples small and medium sized competitors. For unions it harms their non-union competition which has a competitive advantage over expensive unionized labor. For high tax high minimum wage States like New York and California, it can eliminate the incentive for jobs to leave to lower cost lower wage States. However, a $15 minimum wage will increase the incentive for larger companies to outsource production overseas, which can also lead to additional inflation. And this on top of a number of other negative economic consequences.  

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