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The FED’s 3 Tools to Save or Sink the Economy

The FED's 3 Tools To Save or Sink the Economy

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“We interrupt this program for an important news break” –
John Duffy, CEO, was featured on WGN-TV Evening News! Catch the replay here!

“When your neighbor loses their job, it’s a recession.  When you lose your job, that is a depression!” President Harry S. Truman

WHERE WE ARE

With inflation still high, the jobs numbers ok, the Market down for the third week in a row and S&P at 3,924 (down 872 from 4,796 on 1/3/22), the Fed is ready to increase interest rates again….and keep increasing them until, well, it hurts.

Powell said there would be pain.

In addition, the bond market is struggling too. “The Treasury market has lost over 10% in 2022, putting it on pace for its deepest annual loss and first back-to-back yearly declines since at least the early 1970s, according to a Bloomberg index.”

So the FED has its work cut out for it.  Aspirin, anyone?

WHAT ACTUALLY IS THE “FED” AND WHAT DOES IT DO FOR US?

Many people have said they don’t really know that much about the FED and what it does.

Since it can have a very major impact on our lives, both directly and indirectly, here is a short description of the FED, its functions, entities and audiences.

It will serve as important backdrop, as we look at the tools it will use to save…and not sink….the economy on its way to bringing inflation back to the 2% range.

THE FEDERAL RESERVE – THE FED

A particularly severe panic in 1907 resulted in bank runs that wreaked havoc on the fragile banking system. Banks needed a source of emergency reserves. This led Congress, in 1913, to write the Federal Reserve Act.

The Federal Reserve system is not an agency of the federal government although it is accountable to the government and certain positions within the FED are appointed by the President of the United States and approved by the Congress.

I realize that sounds ‘unusual’ but those are the facts.

The FED has a dual mandate: maximum employment and price stability (aka little to no inflation).

This requires an excellent balancing act. The Flying Wallendas would be challenged.

Three Audiences

There are 12 Regional Reserve Banks and their activities serve primarily three audiences—bankers, the U.S. Treasury, and the public:

  • Federal Reserve Banks are often called the “bankers’ banks”, providing services to commercial banks similar to the services that commercial banks provide for their customers. They distribute currency and coin to banks, lend money to them, and process electronic payments.
  • Reserve Banks also serve as fiscal agents for the U.S. government by maintaining accounts for the U.S. Treasury, processing government checks, and conducting government securities auctions.
  • Reserve Banks conduct research on the regional, national, and international economies;

Three Entities

The Federal Reserve is composed of 3 main Entities, that work together to promote the health of the U.S. Economy and the Stability of the U.S. Financial System.   Those 3 Entities are:

1.    the Board of Governors – manage the Reserve Banks; attend FOMC* meetings
2.    the Federal Reserve Banks – 12 Regional Banks that support the commercial banks in their regions.
3.    the *Federal Open Market Committee – Buys and/or Sells Government Securities.

WHAT THE FED DOES

The Federal Reserve was established to accomplish 5 main functions.

These functions are highly complex and to successfully accomplish them requires knowledge, experience, cooperation, finesse and perhaps a good deal of grit.

Five Functions of the Federal Reserve system

  1. Conduct the nation’s Monetary Policy
  2. Regulate the nation’s banking institutions
  3. Monitoring and Protecting the Credit Rights of Consumers
  4. Maintaining the Stability of the nation’s Financial System
  5. Providing Financial the Services to the U.S. Government

A lengthy description of each of these Functions, is not necessary for today’s purpose and we will save that for another day.

What we are really interested in knowing is exactly how the Fed impacts the business community and the investing public.

And in particular, how will the FED get inflation under control and avoid a Recession?

The Fed is tasked by Congress to use its tools and influence to help promote maximum employment, and stable prices.

Stable prices would infer low inflation.   And maximum employment would infer economic growth and stability.

They may sound easy, but they are tall orders.

There is an old adage that applies to the Fed’s situation, and the challenges it is facing in today’s economic environment.  It is 2 parts: “You can lead a horse to water, but you can’t make it drink.”

In this case, what it means is  that it is much easier to slow the economy down, (‘you can lead a horse to water’)- but it is very difficult to get the economy moving forward again, (you can’t make it drink) once you have figuratively stopped it,

THE RISK

The challenge facing the Fed today is to slow the U.S. economy down without pushing it into a Recession or worse.  Because, once in a Recession, it is hard to get the economy moving again. It will eventually happen but the depth and duration are not predictable and can be Very painful, indeed.

This is not an image of a Recession. It is the image of many years of economic Feast and a few years of Famine – otherwise known as the Covid outbreak.

This image (see below) is the reason that the ‘cure’ for the high inflation we are experiencing will be painful.  We are just not used to hard economic times.

However, Covid has taught us we can not only endure but manage stress and even be energized by new circumstances.

Excluding the Covid outbreak in 2020, we have gotten used to the Market going in one direction – Up.

Imagine a 5-locomotive train with 150+ cars – flat beds, refrigerated, multi-modal, etc. and it is barreling down the track at 100mph.

You need to quickly slowdown that train to a crawl because there is a problem on the track up ahead. Imagine the energy that would take?

You are able to bring the speed down to 5 mph, the obstruction has been removed in time, but now the train has to speed up to reach its destination on time.

I’m not an engineer but I can imagine that it will take a great deal of effort to stop reducing speed and begin speeding up.

The Fed is currently in the process of “leading the horse to water or slowing down the speeding train” as is takes actions to slow inflation.  Originally, the FED thought the inflation would be ‘transitory’ and we would experience a ‘soft landing’. A lot like walking that horse towards the water.

They finally realized they were dealing with a speeding train.

The FEDs actions will, no doubt, eventually slow down the economy and subdue inflation.

But at what cost. Are they using a dull axe or a scalpel?

Even more important than slowly down the economy and getting control of inflation is not over-shooting the mark and pushing the economy in to Recession.

The total economy is incredibly complex. If individuals, companies, investors feel the pain too severely when the FED’s actions to put the brakes on are successful, they may not have the resources to move the economy forward for a long time.

Stay with me and we’ll take a high-level look at what the Fed can do to slow the economy while trying to maintain maximum employment and stable prices.

The following is intended as a high-level overview of how the Fed might operate in a variety of situations, and not necessarily a summary of exactly what the Fed is doing today.

THE THREE TOOLS – Axe or Scalpel

The Fed essentially has 3 “tools” that it can use to either energize or slow the economy and thereby promote maximum employment and stable prices. And any of them can be used like an axe or a scalpel. They are:

1. Adjust the Reserve Ratio

The Fed can adjust the Reserve Ratio.  When you deposit your $10,000 bonus check into the bank, the bank is only required, by the Fed, to keep a small portion of that money “in house”.

It can then lend the rest of the money to borrowers who are prepared to pay the bank more money in interest than the bank is paying you for the use of your money.

That small portion that the Fed requires the bank to hold is determined by the Reserve Ratio.

If today the Reserve Ratio is 10%, then the bank will have to hold $1,000 and it can lend out $9,000.

If the Fed wants to get the economy moving, it can lower the Reserve Ratio to perhaps 5%.   Thereby allowing the bank to lend more of your money.

To slow the economy, the Fed would simply raise the Reserve Ration to say 20%.  Thereby restricting the amount of your money the bank could loan.

2. Buy or Sell Government Securities

The Fed can Buy or Sell government securities.   When the Fed wants to slow the economy, it sells securities (Treasury bonds, Notes and Bills) to the banks.

In so doing it reduces the amount of money available to be loaned to individuals and businesses.

When it wants to help the economy grow, it begins to buy securities, thereby adding money back into the economy and hopefully promoting more lending

As I said, hopefully promoting more lending.  There is no guarantee the new money will lead to an increase in lending. The banks have to lend at a rate that is favorable to them and people and businesses  want to borrow at a rate they can tolerate.

3. Raise Or Lower The Discount Rate

The Fed can raise or lower the “discount rate“. This is the rate banks have to pay to borrow money from the Fed.

If the Fed raises the discount rate, banks will tend to borrow less and therefore, they will have less to lend to individuals and businesses.

Of course, if the Fed lowers the discount rate, that should encourage banks to borrow more so that they can make more loans to individuals and businesses, but as you now know, there is no guarantee that the banks will borrow more as the discount rate is lowered.

It might not be lowered enough to be appealing to both the bank and to borrowers.

The FED would love to use a “scalpel” to fine tune the economy and bring down inflation. That might not be possible at this point.

WHAT IS THE FED DOING NOW

With that background, let’s take a closer look at the recent Fed actions.

For starters, the federal government has been spending vast sums of money at an accelerating rate.  And that money in circulation eventually ends up causing higher prices for everything, that is, it can cause inflation.

Another part of the problem has been low interest rates. Although it certainly did not feel that way at the time!

For some time now the Fed has promoted low interest rates.  This encourages the behavior that leads to more borrowing, less savings and more investing.

In the beginning, these low interest rates for home purchases allowed many people to buy their first homes or upgrade to larger homes. However, in the process they have driven the price of homes to new highs which then put them out of reach of many people.

The Fed can’t control the government’s propensity to spend more, thereby putting more money into the economy.  So, it has to take counter measures.

The Fed can take steps to indirectly reduce the amount of money in circulation in the market and take steps to increase the interest rate which will eventually slow spending at most levels.

Several months ago the Fed began a program of raising the interest rate every few months by .75 percent (also known as 75 basis points).

When the Fed raises interest rates, it can impact the amount you pay for your mortgage or on other loans.

Does it raise the interest you earn in your bank account?  No.

When the Fed raises the rate, it refers to the rate that the Fed charges member banks who borrow money in order to make more loans to businesses and individuals.

So when the Fed raises the rate by .75% that only directly impacts the price the banks pay to borrow money.  It indirectly effects the borrower. The bank decides whether or not to create a loan.

If it does, it adds its overhead to the new loan rate in order to cover the cost of the Fed rate increase and provide a reasonable profit for the bank.

The Fed has made a number of .75% rate increases in the recent past.  A year ago the rate was 0.25%. Today it is 2.50%!

It is expected that the FED will raise the rate another .75%.

Why not raise the rate 2.25% or more and be done with it.

The reason goes back to the fact that the Fed has the power to slow the economy to a crawl.

But given human emotion, the Fed is never sure just how much tightening is enough.

So they announce another .75% rate increase and then wait to measure the impact.

If it deems the results as satisfactory, it ceases or reduces any further increases.

However, if the economy shakes the rate increase off, and continues to move ahead, the Fed will add another measured increase and another, if necessary, until they feel the economy has slowed to a point where they are satisfied.

The risk in the Fed plan is that they may go to far and push the economy into Recession.  This would be most regrettable. People lose jobs. Businesses close. Financial and personal stress are high. No one wants a Recession, least of all the FED.

If you are younger than 35 years old, it is likely that you have little or no recollection of the 2008 Financial Crisis downturn.

The stock market plummeted as did real estate values. Foreclosures occurred everywhere.

Large companies went out of business and small Mom and Pop businesses shut down.

Recessions can cause considerable hardship.

Businesses cut back on raises, bonuses and investment in new tooling.

They may stop hiring or lay employees off if the impact is great enough.

People reduce their spending because they may have been laid off or are concerned that they will be. It is a vicious circle.

Everyone, individuals and businesses alike, horde their financial resources because there is no way to know when the recession will end.

“A recession is when your neighbor loses his job. A depression is when you lose your job.”

Once in recession, the Fed has the tools, as we have seen, that may help, but only if the banks and the Community at large are willing and able to participate.

The banks can only lend money if there is a demand for loans by individuals and businesses.

In times of trouble most businesses are cautious and will wait to see who, among competitors and customers,  will make the first move.  It can be a long wait.

IS THERE AN OPPORTUNITY?

Of course.

You might be saying to yourself, when everything is down, it should be a good time to invest in companies whose stock price is now very attractive.

This is true and there are stocks that are trending even in economic uncertainty.

While this may be true, when the market is going down due to a downturn or a Recession, no one knows where the bottom will be. There is a lot of speculation, but no one knows.

According to David Lowell, Managing Director of Swan Global Investments, “Traditional portfolio construction, coupling stocks and bonds in a 60/40 proportion will be hard pressed to duplicate historic returns and risk management. As a possible signal of things to come, January 2022 saw simultaneous losses in both stocks and bonds.”

Without other knowledge, many investors simply chose to ride the market down.

If they do, they will have little or no extra funds to take advantage of those bargains and make those investments.

A better choice is to understand the real value of risk management.

Make use of risk mitigation tools like trailing stop loss orders, proper position sizing, etc., in order to take the emotion out of the process.

Individual investors, in times like these, can be sitting on the sidelines with most of their cash ready to take advantage of those great ‘buy on the dip’ opportunities.

We learned these lessons the hard way.  You do not have to.

Powell says ‘there will be pain.” Reduce the pain as much as is possible.

Consider a trend following strategy. There is a great deal of information on that strategy in our Knowledge Hub. We did Not invent it but we did make it easier!

Seriously consider emotion-free risk management.

The Knowledge Hub will show you how or come to our Office Hours every Wednesday at Noon Central time.  Reply to this email for information.

All of us may ‘take a haircut’ but we do not have to be scalped.  Not now or ever.

Remember – Ride Your Winners and Cut Your Losses!

There is a 4 week Free Trial just waiting for You!  Go here to learn more.

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