It has a dual mandate of maximising employment and controlling Inflation
Since the GFC (great financial crash) in 2008 the FED provide liquidity to the Credit Markets by buying US Corporate Debt and US Government Debt, this is known as Quantitative Easing. By buying Bonds they ensure that the credit markets are working (all crises arise when participants stop lending to one and other). The GFC and Covid Crisis have caused dramatic slowdowns in the Economy and threated serious deflation. Deflation is considered by economists to be the worst condition an economy could have.
To fight Deflation the FED, use the Monetary policy tools of lower Interest rates and QE.
They try to achieve their goals by changing the rate at which they lend to Banks – low rates when there is a financial crisis or the threat of Deflation and high rates when there is a threat of Inflation. Low interest rates benefit US corporations and help maximise employment. Cheap finance helps the housing and car finance markets.
They seem to have widened their mandate, unofficially, to include protection of the financial markets. The reasons they do this are
- A strong stock market helps consumer confidence
- A weak stock market or a crash would take money out of consumers pockets.
How does all this work?
The board of the FED meet regularly throughout the year (every 6 weeks approx.) under the guise of the FOMC (the federal open market committee).
That committee analyses the state of the US economy and sets interest rates and latterly QE amounts. They issue a statement at 7 pm Irish time on completion of the 2-day meeting. In this statement they announce the Federal Funds rate (the rate they lend to banks overnight) this rate affects the rate at which Banks lends to customers and the yield on US government bonds.
They also announce how much Gov and Corporate Bonds they will buy in the coming months. The figure has been $60b Gov Bonds and $60b corporate bonds pm since the March 2020 Covid Crisis.
At 7.30 the Chairman reads the statement and takes questions from the Press.
At previous meetings they announced they would stop buying bonds completely in March 2022 stating that the economy and employment had recovered and did not need so much monetary stimulus.
Economic theory tells us that too much supply of money in the system leads to inflation. The remedy to Inflation is to reduce the supply and reduce the demand by putting up the price!!!! The FED originally had said that they thought Inflation, as measured by the monthly CPI stats, was transitory. This is proven not to be the case. Annual inflation in the US is hitting 30-year highs and is persistent every month.
The FOMC release minutes of their meeting approx. 3 weeks after their meetings.
The December minutes were unusually Hawkish saying that they would likely have to Increase rates a minimum of 3 times in 2022 and cease QE maybe sooner than March and probably sell back existing bonds towards the end of 22
All this is relevant to stock markets, as frankly, the Supply of Free money has created a Bubble. This is shown up in the number of IPOs and SPACs issued last year. The Free money has increased the value of property and the value of stocks (as measured by the Price Earnings ratio) to the highest level ever.
The FED have achieved their goal of saving the US economy and now must stand down using its Monetary tools. They are sensitive to what this will do to the stock markets and would prefer it seems to proceed slowly, however they are late in dealing with Inflation and will have to move quickly.
The fear of no free money and higher interest rates rightly will cause a reduction in the stock market’s overall value as less no QE funds will be available and increasing interest rates and the Inflation itself will likely reduce corporate activity.
Can the FED play a balancing act tomorrow? In my view they must fight Inflation fiercely if they don’t Inflation will cause considerable social and economic issues.
FED Scenarios
- They will say they are data dependant, and this could mean that if Inflation modifies, they will not Increase rates. This would be read as Bullish for stocks.
- Sticking to their plans of stopping QE in March and not bringing it forward would be bullish for stocks
- Saying that they would only Increase rates once a quarter this year, depending on the Economic conditions would also be bullish for stocks
- They go ALL-IN – halt bond buying immediately, increase Fed funds rate by .5% and say that they will increases rates 3 further times this year. Also mention probability of QT. SELL EVERYTHING
Conclusion
Markets are fearful that what made them strong will be taken away abruptly. The FED will try not to upset financial markets by being heavy handed, however the Punch Bowl will be taken away and can the party continue without it???
JPM is confident tomorrow will be non-event
the Fed won’t end QE early,
the Fed won’t start liftoff early
the Fed won’t hike 50 bps.
The rest is priced in
I think, the Market has overreacted in the past days and will be placated and rally in the short term. However, the tightened financial conditions will over time lead to lower valuations.
Colin Gregan 8 pm 25 Jan. 22