The Federal Reserve is having a tough time deciding on the best path forward. As with everyone, I am sure Fed Chairman Jerome Powell wishes he had a crystal ball that worked.
In a long-ago article, I explained the function of the Fed and I will do a short synopsis here to help explain their quandary. The Fed was set up by President Woodrow Wilson in 1913 and its role is to create a stable and secure financial system. Today, it has the following mandates: maximum employment, stable prices and moderate long term interest rates. While the seven-member panel of the Fed Board of Governors, led by its chair, is appointed by the president and approved by the Senate, the job is supposed to be non-political.
The Federal Reserve controls the Fed Funds Rate, which is the rate that depository institutions (banks and the like) trade federal funds with Federal Reserve Banks overnight. The Fed adjusts the rate to control growth and inflation. The Federal Reserve is trying for a not-too-hot, not-too-cold, or Goldilocks, economy. When the economy has high inflation, meaning the costs of goods and services are going up dramatically, it moves the Federal Rate higher to dampen the speed of the economy. Theoretically, when the Fed Rate is higher, it costs more to finance projects and there is more incentive to save rather than to borrow or spend. The Federal Rate has been at 0-.25% (the lowest in history) since March 15, 2020 to help strengthen the economy during the heights of the pandemic.
The Federal Reserve set an inflation goal of 2%, which they believe is a healthy level for the U.S. economy. The problem is that for years inflation was tame, until the pandemic recovery. With unusually high demand for goods and corresponding supply chain problems limiting supply, inflation has hit its highest level in 40 years. Rather than the 2% goal, the November 2021 inflation rate rose to 6.8%.
The Federal Reserve has been sticking to its “transitory inflation” until its meeting last week when it admitted inflation was spreading throughout the economy. While maintaining the low Fed Funds Rate for now, they are tapering their buying of bonds, which is their second tool for managing the U.S. economy (one they use in emergency situations like a pandemic or the Great Recession). They slowed their buying pace in June 2020 to a mere $120 billion a month and then reduced it another $15 billion per month for November and December. Their balance sheet now totals $8 trillion (a couple trillion here and there and soon, we are talking real money).
The Fed now shows the expectation is for three rate increases in 2022 with the year-end Fed Rate at .9%. This is their way of stabilizing prices, which is one of their mandates. The Bank of England hiked interest rates this past week to fight inflation, so we are among many countries facing an inflation surge.
Fed Chairman Jerome Powell did clarify that their other mandate, full employment, is still in the works. Fed will keep rates low until full employment is met. It is heading in the right direction, with 378,000 jobs on average added in the past three months and the unemployment rate is at 3.5%.
Wait, the world is still in the middle of a pandemic! This puts the Fed in a tough position. Could they hit the brakes too quickly and derail the recovery? Could the spread of the Omicron variant cause another setback to our economy and the world?
These are the questions that the Federal Reserve can’t answer. They have made the declaration that inflation is a problem and are slowing the pace of bond buying. Thus, they are taking a cautious approach and basically pulling their foot off the gas but not hitting the brakes yet with interest rate increases. With any decision, we will know if it’s enough, not enough or too much given time.
Judy Loy is a Registered Investment Advisor, ChFC®, RICP® and CEO of Nestlerode & Loy, Inc.
All investing is subject to risk, including possible loss of the money you invest. Nothing in this article should be construed as investment or retirement advice. Always consult with a professional advisor and consider your risk tolerance and time to invest when making investment decisions. Review your personal situation with a professional before planning any gifting or estate planning.
