The Great Mistake: How the Fed Missed the Mark

2022 has been an unusual year for the US economy; inflation and deflation have been occurring at the same time. Prices in the goods markets are currently increasing at about 8.5% which is causing short-term inflation, but the prices of financial securities have been decreasing, or are deflationary. Equity markets were down over 20% by the end of the second quarter, and long-term government bonds were down about 20%.

What’s more puzzling is the lack of the normal, negatively correlated relationship of equity markets and bond markets. Normally, the relationship between the two is that investors will sell bonds to buy equities (causing bond prices to decrease and equities prices to increase) or sell equities to buy bonds (causing equities prices to decrease and bond prices to increase).

The relationship is a useful one as it allows for valuable portfolio risk-return properties for both markets because the actions of each counterbalance, or hedge, the other, acting like a kind of insurance. We see this relationship employed in the creation of target-date funds which is part of why these funds have been popular with investors. Unfortunately, in the environment we find ourselves in now, the normal relationship between equities and bonds does not exist – both have been dropping in unison – which has removed the benefit of the hedging properties.

The question is then, why are we in this situation, how did we arrive here, and to the point, could the Federal Reserve (Fed) have done something to prevent it, or at the very least reduce it?

As a review, the Fed has two jobs (this is called the dual mandate), which are price stability (avoid high inflation or deflation and target 2% annual inflation) and maximum sustainable employment. Sometimes these two can conflict with each other which forces the Fed into difficult decisions, but we will go into this in more detail later.

The Fed uses two mechanisms predominantly to achieve the dual mandate. The first and more traditional of the two is adjusting short-term interest rates, and the second is directly intervening in the bond markets, commonly known as ‘quantitative easing.’

Of all the short-term interest rates, the most important is the Fed Funds rate. The Fed Funds rate is the overnight interest rate (it’s called overnight but is quoted on an annualized basis) that banks use when lending to each other (un-collateralized). As of the end of July, the Fed Funds rate was 2.35%. (1) Just shortly before then, in late June, the Fed revised the rate upward by 75 basis points (0.75%) and did so again in late July. The target range for the Fed Funds rate is now 2.25% to 2.50%. (2)

The cap on the Fed Funds rate is achieved by allowing banks to borrow directly from the Fed (un-collateralized) at the top end of the target range if the Fed Funds rate ever is above the range. Currently, banks can borrow directly from the Fed at 2.50% - the “Fed Discount rate.” (3) So rather than borrow from other banks above the range when the Fed Funds rate is above the range, banks will borrow at the top of the range from the Fed and the Fed achieves the cap.

The floor on the Fed Funds range is maintained through changes in the interest rate on reserve balances, those funds deposited by banks with the Fed. How this works is that when the Fed Funds rate drops below the target range, it is more profitable for lending banks to deposit funds with the Fed than to lend them to another bank at the Fed Funds rate.

The Fed Funds rate affects many other interest rates throughout the economy (including the Libor and Prime rates from which rates on floating-rate and commercial loans are determined, credit card APR’s and other short-term consumer loans (uncollateralized)). So, through the action of increasing or decreasing the Fed Funds rate, the Fed has significant control over the cost of short-term credit in the economy. When the cost of debt is increasing, so is the aggregate cost of capital for firms, which causes firms to reduce capital expenditures on average. This, in turn, causes a decrease in aggregate spending and a subsequent decrease in aggregate growth.

Finally, with aggregate spending and growth decreasing so should price increases (if all goes according to plan). This then can lead to lower inflation and greater stability of prices, but possibly at the cost of reduced economic growth and lower employment. Going in the opposite direction, as the cost of debt is decreasing and capital expenditures are increasing, aggregate growth and employment will increase but so does the potential for inflation.

The Fed Funds rate has been the tool-of-choice for the Fed for most of its history. This changed, though, during the Great Financial Crisis of 2008 – 2012; the Fed began using another tool, which is to influence long-term interest rates by transacting in the mid-term and long-term Treasury and mortgage bond markets. This is what is commonly referred to and known as quantitative easing.

Intervening in the mid-term and long-term Treasury and mortgage bond markets is part of the price stability mandate. Without the Fed transacting in those markets, the markets would be illiquid resulting in a higher degree of price instability. (4) So, the Fed directly intervenes to ensure liquidity. Since the beginning of the Great Financial Crisis the Fed has intervened to tune of about $9 trillion of purchases in Treasuries and mortgage bonds (when you hear about the expansion of the Federal balance sheet, this is what is being referred to). An important note regarding this, this action by the Fed does not result in the printing of money or the creation of additional money as it is often presented in the financial media. (5)

As you probably guessed, all this intervention by the Fed results in higher bond prices as well as lower long-term interest rates. (6) How much lower rates would be if the Fed did not intervene is difficult to determine, but we can get a rough idea through one example:

When the Covid-19 pandemic began, equity markets dropped significantly. The S&P 500 decreased by about 32%. Over the same period of time, bond markets did what they normally do and the long-term interest rate dropped from 2.30% to 1.18% (representing an increase in price). After the drop in equities was over, prices increased for about five months straight resulting in a return of about 52%. But rather than do what bonds normally do in this situation (decrease in price) the 30-year interest rate was about flat and moved only from 1.18% to 1.23%. Part of the reason for why bond prices didn’t fall (and interest rates increase) was the Fed intervening in the Treasury market. The Fed purchased about $3 trillion in Treasury bonds during that five-month period. So, rather than the natural rise in long-term rates and drop in long-term bond prices occurring there was a very dampened change in prices and rates. As expected, with interest rates so low, an acceleration of economic growth occurred which also helped increase equity prices further. Of course, given the possible economic outcomes of an environment (7) such as this, in this case there was also an increase in inflation.

There’s no nice way to put it, with inflation currently at over 8%, the Fed has failed to achieve one of its two mandates: price stability, in general, and specifically the long-run target inflation rate of 2%. Additionally, this is not something new. Inflation has been elevated for quite some time. For reference, inflation was at 4.2% (110% above target) over a year and a half ago, and it was trending up at that point. At the time however, the Fed simply waved its hands and attributed inflation to supply chain disruptions and chose to continue as it had been. The Fed Funds rate stayed low and quantitative easing purchases carried on.

In retrospect, in June of 2020 the Fed could have stopped buying Treasury bonds as much of the liquidity issues in bond markets had resolved. (8) Had that happened, inflation would likely (not potentially) be lower today (and perhaps much lower). This is because in this scenario without the Fed intervening markets would have pushed the price of bonds down and interest rates up, and this would have resulted in a higher aggregate cost of capital through the entire economy. Following this would have been less aggressive economic expansion and reduced stock market growth. Higher prices (for capital) and the effect of lower investment returns on wealth would have caused the economy to cool off and inflation with it.

Looking back, we can also see that the markets were signaling something was off from the Fed allowing the economy to run so hot. In May of 2021, the short-term T-bill yield (which is usually just below the Fed Funds rate) was 0.02% (9) and inflation was 4.1% at the next release date in April of 2021. Based on these two data points the implication is that the short-term real interest rate was -4%. (10) Usually, this is a warning sign that all is not well with the economy. And in uncertain times, investors will trade purchasing power for some amount of certain returns, even if those returns are negative. Taken together, this should have shown the Fed that something was off - whether it was the economy or the markets – and that something needed to be done about it, and quickly.

What was causing the disconnect was the Fed’s actions. The Fed was aggressively distorting short-term interest rates in the opposite direction of where they needed to be. Usually, the short-term T-bill yield is slightly above the rate of inflation. This results in a positive real interest rate. Yet, the Fed was holding the Fed Funds rate much lower than the rate of inflation. T-bills trade near the repo rate (the rate on a Treasury-collateralized loan), which is always lower than the Fed Funds rate (which is an un-collateralized loan). But, because the Fed was keeping the Fed Funds rate artificially low, it was also indirectly keeping the T-bill yield low as well. And this caused the short-term real interest rates to be negative by a large degree.

This was the second mistake made by the Fed. Rather than do what it did, the Fed should have started to raise the Fed Funds rate around May of 2021. Instead, it decided to wave its hands at the soaring inflation numbers under the hope that the inflation would be transitory and focus its efforts on ensuring maximum employment. To note, the unemployment rate in May of 2021 had already decreased from the pandemic high of 14.7% to 5.8%. Again, the Fed was hoping that the high inflation rate to come down as issues with supply chains eventually were resolved but as the well-known saying goes, hope is not a strategy. The predicament we find ourselves in now has shown that the Fed’s hope was misplaced.

So, now the Fed is in something of a panic mode and has been increasing the Fed Funds rate at a historically rapid pace, while also no longer purchases bonds but rather sells bonds back into the market to get the inflation rate back to its long-run target of 2%. The difficulty with this is that inflation is around 8.5% currently and it may be very difficult to bring it back to 2% without failing at the second half of the dual mandate – to maximum sustainable employment. As we wrote about in the previous financial viewpoint, the Chairman of the Fed, Jerome Powell, stated that he would consider it a success if the Fed was able to get inflation back to its target of 2% and only cause unemployment to increase to 4.1%, which translated to roughly 800,000 additional unemployed people. So far this year, the US economy has experienced 6 months of mild economic contraction, and the unemployment rate has declined from 4% at the beginning of the year to 3.5% as of July.

As we arrive at the end of the viewpoint, we should ask ourselves a new question, what did we learn from the Fed’s mistakes? The Fed needs to realize that satisfying dual and often conflicting mandates is not an especially easy task. It may be best to prioritize one of them. Back in 2012, the Fed released what it called the “Statement of Longer Run Goals and Policy Strategy.” In this statement, the Fed adopted its long-run inflation target of 2% but it didn’t address the employment mandate with as much clarity. Instead, is describe employment as,

“Largely determined by nonmonetary factors […].”

In making this statement, the Fed admitted in essence that it has much more ability to achieve price stability than it does to achieve maximum employment. It is not beyond reason than that Fed may be better off by focusing on price stability as its top priority, and letting maximum employment be its second priority. By doing so, the goal of maximum employment will fall more to fiscal policy rather than monetary policy. This would clarify the Fed’s goals and reduce the chances of a repeat of the situation that we face today.

Footnotes

[1] Therefore, the actual interest rate for one night would be approximately 2.35% divided by 365 days per year.

[2] There is another short-term interest rate at which banks can borrow: the overnight “repo” rate. The repo rate is the overnight collateralized (using Treasury bills) borrowing rate for banks, both from each other as well as from the Fed.

[3] Borrowing from the Fed is called accessing the “discount window,” and banks typically don’t do this. Doing so is an indication the bank cannot access funds from other banks at lower rates within the Fed Funds target range, a signal of potential financial distress.

[4] Lack of liquidity leads to greater price volatility (instability) in securities prices.

[5] A simple way to think about this process is that the Fed simply purchases a Treasury bond from the balance sheet of one of the banks it supervises. Accordingly, the asset side of the Fed’s balance sheet increases by the amount of the Treasury (in accounting parlance, it debits Treasury holdings on its asset side). To balance the balance sheet, the Fed credits the bank’s deposits on the liability side of its balance sheet (it credits bank deposits). And that is it — the Fed has just purchased a Treasury security. It has also increased liquidity because the bank from which it purchased the Treasury now has cash balances available for its use.

[6] Bond prices and interest rates are the inverses of each other, so when one goes up the other comes down, by definition.

[7] To be fair, the Fed was right to intervene in bond markets at the start of the Covid pandemic. The bond markets were experiencing liquidity issues at the start of the pandemic, and the Fed intervened to prevent any instability in the financial system. However, by the Fed’s own metrics, the liquidity problems were gone by mid-2020. So, further quantitative easing was unnecessary, but the Fed kept intervening in the Treasury markets for another 2 years and purchased $2 trillion more of Treasuries.

[8] Using either Bloomberg’s Liquidity Index or the Fed’s own National Financial Conditions Index, liquidity issues became significant in March, 2020 at the start of the Covid-19 outbreak, but were mostly resolved by June, 2020.

[9] Using the 1-month annualized T-bill yield. Even if one used a longer maturity such as the 5-year, the yield was only 0.84%.

[10] This can also be confirmed by looking at the TIPS market, where the 5-year real interest rate was -1.8% — still substantially negative, though higher because the market expects real interest rates to be positive in the long-run.

[11] Even the “core” inflation rate, which excludes typically volatile food and energy costs, is at 5.9%.