The Federal Reserve has a dual mandate. Its job is to limit inflation and/or prevent deflation (the monetary aspects of its mandate) and to ensure unemployment doesn’t get too high or too low (the markets aspect of its mandate). The Fed is always criticized by one group or another for how it goes about reaching these two goals, but within the Fed economists use a variety of complex econometric tools as well as a dash of more qualitative analysis to decide what the Fed as a central bank should do.
We’re now almost a decade away from the last U.S. recession, and the Fed has spent a much longer time helping the American economy get back to normal. Usually significant Fed interventions in the economy last a couple of years; this time it’s been 9 years and counting. For that reason, there are a lot of people in finance who cannot remember an era when central bank intervention was not normal.
It also means the Fed’s position in the market has become extremely important in several ways. The first is the way it sets interest rates. The Fed’s decision on interest rates moves stock markets more now than it typically has in the past—although its impact has been declining in the past year or so. Similarly, the Fed has a substantial collection of holdings on its balance sheet—a lot of debts from the U.S. Treasury remain owed. Now, the Fed is working to cancel those debts in a roughly mechanical process where it retires the debt in exchange for printed currency from the Treasury—what’s really an accounting trick, but one that could have a significant impact on the economy because, at least in theory, it could lower the money supply and the velocity of money (i.e. how fast money moves through the market).
On top of the Fed’s balance sheet moves, the central bank is also considering raising interest rates considerably to historic norms. We’ve seen interest rates below 1% for nearly a year, but before the crisis 4% and higher interest rate targets were the norm for the Fed. The Fed doesn’t plan to get to that level anytime soon, but the central bank is hoping to get to 3% or more from its current 1.25% rate by 2020. That’s a feasible goal, but it will also mean making lending more expensive for a lot of the economy.
More expensive lending has a variety of implications for the economy. Higher interest rates on loans may lower consumer spending. It may make some businesses less profitable or not profitable at all. It could also change the way people invest. If Treasuries start yielding over 2% and the S&P 500 yields less than 2%, what’s the point in buying volatile stocks if you can buy much less volatile Treasuries instead?
That’s not to say that the Fed’s upcoming actions will be bad for stocks or the economy. But the risks of such an impact have been an obsession of markets since 2013, and many ink has been spilled already on whether those risks are already priced into financial markets. Nonetheless, understanding how the Fed’s balance sheet and interest rate targets impact individuals in a complex economy is essential to understanding the financial markets we are about to see over the next few years.