One of the biggest challenges of monetary policy is to get the financial market to believe in the message that a central bank is trying to communicate. Jerome Powell, the Chairman of the US Federal Reserve, has been talking about the importance of raising interest rates and controlling inflation for a while now. But the financial markets, in particular the stock market, seemed to have been ignoring his message.
On Friday, Powell reiterated his message. He said that the Fed’s overarching focus is to bring inflation back down to 2% because, without price stability, the economy does not work for anyone. This time the stock market took Powell’s message seriously and the Dow Jones Industrial Average fell by 3% or around 1,008 points to a level of 32,283.
The question is why was the stock market not buying Powell’s message up until now.
The Fed tries to influence short-term interest rates by raising or lowering the federal funds rate, the interest rate at which commercial banks carry out overnight borrowing and lending to each other. The Fed has been raising the federal funds rate this year.
Over the years, the Fed has also been trying to influence the long-term rates, and in the process, the size of its balance sheet has burgeoned. Towards the end of August 2008, a few weeks before the financial crisis broke out, Fed’s balance sheet size had stood at around $910 billion. As of 24 August, it stood at $8.85 trillion.
Typically, the size of a central bank’s balance sheet should increase at a pace which is more or less similar to its overall economic growth. In 2008, the gross domestic product (GDP) of the United States was at $14.77 trillion. In 2021, the GDP inched up to $23 trillion, which is an increase of 56% since 2008.
Since 2008, while the Fed’s balance sheet has increased close to nine times, the size of the American economy has increased by just a little over half.
This increase has happened because the Fed has been printing money and pumping it into the financial system by buying bonds. It did so between 2008 and 2014 to first rescue many financial institutions which were in trouble and later to drive down long-term interest rates so that people and firms would borrow and spend money and help push up economic growth.
The Fed started to repeat the formula in late 2019, even before the Covid had struck, to drive up economic growth. Once Covid started spreading, Fed’s money printing and bond buying went up as well.
While central banks can print all the money they want to, they have no control over where this money ends up. A lot of this money found its way into stock markets, real estate markets and cryptocurrencies. A pricier real estate market led to home rents increasing at a fast pace. Home rents are a major constituent of how retail inflation is calculated in the US. And among other things, high-home rents have pushed up retail inflation in the US to decadal high levels.
In order to control retail inflation, it’s important for the Fed to raise long-term interest rates. In May, to raise long-term interest rates, the Fed announced that it will gradually take out the money it has printed and pumped into the financial system.
The plan was to take out $47.5 billion per month between June and August and then $95 billion thereon. This meant that between June and August close to $143 billion dollars should have been taken out and the Fed’s balance sheet should have shrunk by an equivalent amount. Nonetheless, from June 1 to August 24, the size of the balance sheet has shrunk by around $64 billion. This explains why many large stock market investors hadn’t taken Fed’s repeated statements about raising interest rates very seriously.
Along with raising the federal funds rate, the Fed also needs to shrink its balance sheet at the same pace that it had announced. Only then will the stock market buy its message of how serious it’s about controlling inflation.
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