The Federal Reserve Board (the Fed) is holding one of its planned policy meetings as I am writing this. In June, the Fed stated that inflation is below its 2% target, and we are near full employment in the U.S. Despite this fact, it raised the federal funds rate (FFR) by 0.25% to between 1% and 1.25%. Its reasoning is that, even though inflation is below its target rate (and projected to stay below 2%), the Fed still wants to get back to more “normal” interest rates (3-4%). As we all remember so well, during the recession of ‘08-‘09, the Fed lowered the FFR from over 5% to effectively zero. Now that the economy has recovered, the goal is to unwind all of the measures that were enacted during the recession without starting another one, which is the tricky part.
Not only does the Fed want to try and get back to more normal interest rates, it also announced in its June meeting that it will begin to let some of its government bonds “roll-off” its balance sheet. So what does this mean? While the global economy was reeling from the financial crisis, the Fed took extreme measures never tried before by buying billions of dollars of treasury bonds and government bonds backed by mortgages (U.S. debt). As part of its normal operations, the Fed will own bonds to manage U.S. monetary policy. Prior to the financial crisis, this was in the $750 billion range. The Fed now owns approximately $4.5 trillion dollars of government debt. So how does it get back to a more “normal” level? The strategy it announced in June is to let bonds begin to mature in September and not to reinvest the proceeds back into new bonds. This effectively removes liquidity from the economy, which has the potential to slow economic growth. I’ll talk more on this in a minute.
When the Fed began its policy of buying government bonds (Quantitative Easing or QE) back in December 2008, we were at the height of the financial crisis. It had lowered interest rates and felt like it had to do more to stop the panic that was spreading around the world. Therefore, it also began a policy of selling U.S. debt to raise money so it could buy more U.S. debt. It sounds crazy, but the thought was that the policy would create more global liquidity which was so badly needed at that point. Now that we are no longer in crisis mode, it’s time to let these bonds mature and remove this liquidity from the global economy. This is where the Fed must tread very lightly. The global economy is still not experiencing robust growth, which is when the Fed would normally raise rates (tighten).
So what does all of this mean to you as an investor? Ultimately, I believe it is a positive for the global economy to begin to unwind these crisis policies. It will take several years and, more than likely, increase volatility in financial markets. This is to be expected as we go through a period of Fed tightening. The hope is that it will not move too fast and create another recession.
I hope you have found this helpful. As usual, please let us know if you would like to discuss this further.
Brett S. Carleton