Is the Federal Reserve’s new muscle unjust? Or is it just right?
If you are a markets junkie like me, the past half-year can be explained by looking at what the Federal Reserve — the most powerful nonelected institution in the country — has been doing.
The Fed came around to the view that inflation was not “transitory” (a late 2021 theory) but rather “dangerous” (the 2022 reality). And everything that has happened in financial markets since roughly March is a result of this shift.
Wall Street wisdom holds that stock and bond investors should “never fight the Fed,” which essentially means that at certain periods of time, stock and bond markets will move in the direction the Fed wants because the Fed is too damn strong to defy. Second-guess their power at your peril.
Right now, the Fed wants interest rates higher — hence, bond prices lower — and financial assets lower, meaning lower stock prices, too. The Fed desires this combination of economic conditions not because it is cruel and wants people to suffer, but because one of its two central mandates — to keep inflation in check — is at risk, putting its credibility on the line. Inflation got too high, and the Fed’s Board of Governors is united in signaling that until inflation returns to normal, it will raise rates and restrict the money supply.
The beatings will continue until morale improves.
In this context, I recently read “The Fed Unbound: Central Banking in a Time of Crisis,” a slim 2022 book by law professor and former Treasury official Lev Menand.
Menand argues that the 2008 financial crisis and the 2020 pandemic response expanded the Federal Reserve’s powers in expected and possibly unauthorized ways that go well beyond the Fed’s traditional mandate.
Menand’s book describes the primary mechanisms by which the Federal Reserve sets interest rates and determines the pace of money creation — buying and selling bonds, paying interest on bank reserves and setting the rate at which banks lend money to each other, via the Fed Funds rate.
But the new part, which explains what happened over the last two years, is worth the price of admission. I most enjoyed Menand’s 2022 review of recent Fed history, particularly the extraordinary measures taken in the beginning of the COVID-19 pandemic. This is worth monitoring. While our eyes were focused on masks, vaccines, Paycheck Protection Program bailouts and direct payments, the Fed was making unprecedented moves in the background plumbing of financial markets.
These included never-beforeattempted extraordinary moves:
• Direct purchases of corporate bonds from the largest corporations in the country, as well as direct purchases of bond mutual funds;
• Direct loans from the Fed to giant corporations and midsize Main Street firms;
• A massive increase in the ownership of financial assets by the Federal Reserve, expanding its balance sheet from $4 trillion pre-pandemic to $9 trillion at the end of the pandemic.
Anyway, back to markets and where we are in the cycle of beatings from the Fed.
The Fed Funds rate, which is the the primary interest rate, began 2022 at zero because of the pandemic, despite evidence of significant inflation in 2021. The Fed then raised interest rates in March, May, June and July by a quarter-point, halfpoint and twice by three-quarters of a point, respectively. This is very fast and aggressive by traditional Fed standards. The Fed has further signaled a willingness and likelihood to implement additional rate hikes
at its September, November and December meetings as evidence of inflation continues. Markets currently expect at least an additional 1.5 percentage points in combined rate hikes through the end of the year.
In spring 2020, in a response to the pandemic, Fed Chairman Jerome Powell signaled unlimited support for buying financial assets to prop up a shut-down economy. Now, to preserve that tool for the future, the Fed essentially needs to reload the money gun.
The other big trend in restricting the money supply and fighting inflation is known as quantitative tightening. This term refers to the Federal Reserve reducing the amount of financial assets it holds, which effectively drains money from the financial system.
Beginning this month, the Fed will reduce its holdings by $90 billion per month, to pare down its $9 trillion balance sheet built up during the pandemic. After 2.5 years at this schedule, the Fed has indicated it will have trimmed holdings by $2.5 trillion, and it will reevaluate its pace of sales. Since this is the first time the Fed has embarked on a slim-down like this, the effects are not completely known, although the direction should be to reduce inflation and increase interest rates, and reduce the supply of money sloshing through the economy.
Your dollars retain greater value without an unlimited supply of money pumping through the economy. Rate hikes and quantitative tightening will likely reduce the goofy money-creation schemes of meme stocks, cryptocurrencies, nonfungible tokens and special purpose acquisition companies that dominated the 2021 financial landscape.
The Fed’s great strength is its independence — significantly insulated from political pressure or democratic processes. This affords it the freedom to act as it sees fit, such as raising interest rates to curb inflation, even when doing so is likely to cause economic pain and to hurt the party in power.
On the other hand, Menand raises a key question: As the Fed exercises increasing authority with new crises, at what point does a purposefully undemocratic institution expand into unchecked power?
In the meantime, we know the economic beatings will continue until inflation is curbed.