Travis Gallton, The Daily Record Newswire
“Change is the law of life. And those who look only to the past or present are certain to miss the future.”
— John F. Kennedy
The Federal Reserve is the central banking system of the United States that was created in 1913. Over the years its responsibilities have transformed, but for the most part its dual mandate has been to have maximum employment while maintaining stable prices. However, sometimes over the short-run these mandates can have conflicting characteristics, which leaves the Fed with the dilemma of focusing on a single mandate.
First, it’s worthy to know exactly what the Fed means when they define these mandates. Price stability refers to having long-run inflation expectations anchored around 2 percent to reduce risk erosion of the dollar’s value in order to foster saving and capital formation. Maximum employment is largely a factor of the labor market. This is where the Fed’s committee has some discretion on determining what they feel is appropriate based on current market conditions.
Now that we have covered the Fed’s dual mandates, let’s quickly discuss how these objectives are carried out. As stated earlier, the Fed’s goal is to influence and monitor the amount of money and credit in the U.S. economy. The Fed has three instruments or tools of monetary policy: open market operations with setting the Federal funds rate, the discount rate, and reserve requirements. “By trading government securities, the Fed affects the federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight.” If the Fed determines the economy needs accommodative monetary support, they will purchase government securities; which essentially increases credit, lowers interest rates, and pushes investors into more risky assets in an attempt to stimulate growth.
During the financial crisis of five years ago and in the period since, the Fed has been extremely accommodative, even reverting to unconventional tools with large purchase programs called quantitative easing. The economy has been making progress, albeit it’s still been plagued with slow real growth.
In December 2012, the Fed announced adding a new specific objective in its plan to continue to suppress interest rates. Currently, the Federal Open Market Committee minutes state that as long as the unemployment rate remains above 6.5 percent, the Fed will continue to target zero to a quarter percent fed funds rate.
A logical assumption of such stimulus of this nature would be a massive infusion of assets in the banking system until unemployment begins to drop. The ultimate fear being the supply of money increases too rapidly; the result could be rampant inflation. The Fed’s balance sheet expanded from $840 billion in 2008, to over $3.185 trillion at the end of March 2013, an increase of 279 percent of the monetary base. However, the money supply has not followed suit as measured by M2, which has only increased by 37 percent over the same time period.
Why is money supply not increasing?
The issue rests with the velocity of money, or the rate of turnover at which money is used for purchasing goods and services. In essence, the consumer plays a key role in the velocity of money. If people feel good about their job security and income expectations they will make purchases and drive money supply up, vice versa if they are feeling lousy about their income and current job status.
The Fed is striving to do just that with accommodative policy; which has pushed financial assets higher. When individuals notice that their retirement accounts and house values have increased, theoretically the wealth effect will drive them to spend more.
The ultimate question is how far can the Fed continue to go with such unprecedented stimulus and are they ultimately creating a bubble in financial assets? Many can argue that the QE programs have had diminishing marginal returns. The Fed’s eventual exit strategy will be to cease purchasing government securities, provide forward guidance for the path of fed funds rate, and then begin to raise the target fed funds rate.
Although this still may be many months away, in the meantime the Fed will continue to make a strong case for investors to hold equities while injecting potent amounts of liquidity into the market.
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Travis M. Gallton, CFA, is a senior equity portfolio manager for Karpus Investment Management, a local, independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, NY 14534; or call (585) 586-4680.
