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Fed Tapering of Easy Money Policies

The Fed has been using low interest rates to stimulate the economy

Shortly after the 2008 Financial Crisis, the Federal Reserve began buying corporate bonds as a way to stimulate the U.S. economy. This is how it works…[i]

  • Buying corporate bonds increases demand for those bonds.
  • Increased demand causes bond prices to rise.
  • Higher bond prices cause the interest rates of those bonds to fall.
  • Lower interest rates make it less expensive for businesses to borrow money by issuing corporate bonds.
  • Businesses use this debt to support and expand their operations.
  • Growing businesses stimulate the overall economy.

The Fed also attempted to stimulate the economy by lowering its Federal Funds Rate. This is how it works…[ii] 

  • In order to ensure that banks maintain a safety margin on their lending activities, the Fed requires banks to keep a certain amount of capital on deposit with a Federal Reserve Bank. These deposits are known as “Federal Funds.”
  • The amount of reserves each bank has on deposit with the Fed varies day to day based on the bank’s loans outstanding (its assets) and its deposits (liabilities). As a result, on any given day some banks may have excess capital on deposit at the Fed, and other banks may fall a little short.
  • The Fed permits banks that have excess reserves on deposit to loan them to other banks that are falling short through “overnight” loans. The interest rate at which these loans are made is called the “Federal Funds Rate.”
  • The Fed doesn’t set a specific Federal Funds Rate. These rates are negotiated between the lending bank and the borrowing bank. But the Fed does let their opinion be known by setting a target rate which is usually given as a range. If the rates banks are negotiating fall outside the target range, then the Fed takes steps—known as “open market operations”—to bring the rates into line with their target.
  • When the Fed lowers their Federal Funds Rate, it makes it less expensive for banks to borrow from each other. This, in turn, allows banks to charge lower interest rates for loans which they make to people and businesses.
  • People and businesses borrow more money from banks since it is now less expensive to do so. They then spend this extra money which stimulates our overall economy.

However, the Fed may soon change its low interest rate policies

In March of 2021, the Federal Reserve announced that it intends to keep the Federal Funds Rate very low until 2023.

In July of 2021, the Federal Reserve suggested that it might begin tapering its corporate bond purchases as soon as the end of 2021. The Fed has signaled that the recovery of the U.S. jobs market will help to determine when it begins to taper bond purchases. The faster employment grows, the more likely that the Fed will taper bond purchases sooner rather than later.[iii]

In August of 2021, Fed Chair Jerome Powell reminded everyone that the Fed reducing its bond purchases may not necessarily result in rising interest rates. Powell also suggested that the status of the U.S. economy would need to reach “a much higher threshold” before the Fed would take such an action as raising the Federal Funds Rate.[iv]

In September of 2021, the Fed reiterated its intentions to begin tapering its corporate bond purchases as soon as the end of 2021.

This could temporarily hurt the bond and stock markets

The stock market’s meteoric rise over the past 12 years is largely due to the Fed pushing investors towards stocks by forcing bond investments to offer unenticing, ultra-low interest rates. If the Fed were to allow interest rates to rise, then we would likely see investors move a significant portion of their assets from higher risk stocks to lower risk bonds over time. This exodus from stocks could temporarily hurt the value of stock investments.

Rising interest rates can temporarily lower the value of bond investments.[v] For instance, let’s assume that your portfolio held bond investments which offered an interest rate of 1% on a day when interest rates rose to 2%. New bond investments would then offer a 2% interest rate to investors which would be significantly higher than the 1% interest rate offered by the bonds you own. As a result, your bonds would now sell for less because they offer a lower return on investment than newer bonds.

Bad news for our economy may be good news for the markets 

Normally, good news about our economy will cause the stock markets to improve. However, we are currently living in an upside-down world thanks to the Fed’s policies. Now when investors hear bad news about our economy, they often become hopeful that the Fed will continue to carry out its low interest rate policies which have been bolstering the stock markets. This hope causes investors to invest more into the stock market, which results in the stock market rising in response to bad news.

How might this affect inflation? 

Inflation has begun to rise in recent months for several reasons[vi]... 

  • The U.S. government’s major fiscal stimulus program.
  • Labor and supply shortages.
  • Housing inflation.
  • Rising oil and gasoline prices.

The Fed has argued that its move to gradually raise interest rates will help to keep inflation under control. The Fed believes this because raising interest rates helps to curb inflation caused by excessive borrowing and spending. As interest rates increase, consumers tend to save because returns from savings are higher. With less disposable income being spent, the economy slows and inflation decreases.[vii]

However, many experts argue that this may not be the case. The inflation which we are currently experiencing is being at least partially caused by supply shortages. The Covid pandemic has led to supply chain interruptions across the planet which are making it increasingly difficult for people and businesses to acquire the goods which they need. As a result, the prices are increasing for the fewer goods which do happen to be available. Raising interest rates may therefore have little effect on this type of inflation since it has less to do with excessive borrowing and spending and more to do with a lack of goods in the market place.

References

[i] https://www.thestreet.com/video/federal-reserve-bond-buying-explained

[ii] https://www.americanexpress.com/en-us/business/trends-and-insights/articles/how-the-federal-reserve-sets-interest-rates/

[iii] https://www.morningstar.com/news/dow-jones/202109022861/european-midday-briefing-stocks-rise-ahead-of-us-economic-data

[iv] Life Strategies Analytics IPC Meeting Minutes 8-30-2021 

[v] https://www.morningstar.com/articles/948326/how-do-interest-rates-affect-your-bonds

[vi] https://www.morningstar.com/news/dow-jones/2021101213857/fed-is-behind-the-curve-on-countering-runaway-inflation-risks-summers-says

[vii] https://www.investopedia.com/ask/answers/12/inflation-interest-rate-relationship.asp


The views expressed are those of the author as of the date noted, are subject to change based on market and other various conditions, are not a solicitation to purchase or sell any security and may not reflect the views of United Planners Financial Services. Keep in mind that current and historical facts may not be indicative of future results.