Why the stock market wasn’t buying US Fed’s warnings

One of the biggest challenges of monetary policy is getting the financial market to believe the message that a central bank is trying to communicate. Jerome Powell, chairman of the US Federal Reserve, has been talking about the importance of raising interest rates and controlling inflation for a while. However, the financial markets seem to have ignored his message.

On Friday, Powell reiterated his message and said the Fed’s overarching focus is to bring inflation back to 2% because the economy does not work for anyone without price stability. This time, the stock market took Powell’s message seriously and the Dow Jones Industrial Average fell by 3% or around 1,008 points, to 32,283.

View Full Image

Mammoth proportion

The question is why the stock market was not buying Powell’s message until now. The Fed tries to influence short-term interest rates by raising or lowering the federal funds rate, the interest rate at which commercial banks carry out overnight borrowing and lending to each other. The Fed has been raising the federal funds rate this year.

Over the years, the Fed has also been trying to influence long-term rates and, in the process, the size of its balance sheet has burgeoned. Towards the end of August 2008, a few weeks before the financial crisis broke out, the Fed’s balance sheet size was around $910 billion. As of 24 August, it was $8.85 trillion.

Typically, the size of a central bank’s balance sheet should increase at a pace more or less similar to its overall economic growth. The gross domestic product (GDP) of the US was $14.77 trillion in 2008. In 2021, the GDP was $23 trillion, a 56% increase since 2008.

Since 2008, while the Fed’s balance sheet has increased close to nine times, the size of the American economy has grown by just a little over half.

This increase has happened because the Fed has been printing money and pumping it into the financial system by buying bonds. It did so between 2008 and 2014 to rescue financial institutions in trouble and later to drive down long-term interest rates so that people and firms would borrow, spend money, and help economic growth.

The Fed repeated the formula in late 2019, before the coronavirus outbreak, to drive economic growth. Once covid started spreading, the Fed’s money printing and bond buying went up as well.

Central banks can print all the money they want to but have no control over where this ends up. As a result, a lot of this money found its way into stock markets, real estate, and cryptocurrencies. A costly real estate market led to home rents increasing fast. Home rents are a major constituent of how retail inflation is calculated in the US. Among other things, high home rents have stoked retail inflation in the US to decadal highs.

It is important for the Fed to raise long-term interest rates to contain retail inflation. In May, the Fed said it would take out the money it printed and pumped into the financial system. This was to push up long-term rates. The plan was to take out $47.5 billion every month from June to August and $95 billion thereon. This meant that from June to August close to $143 billion should have been taken out, and the Fed’s balance sheet should have shrunk by an equivalent amount. Nonetheless, from 1 June to 24 August, the size of the balance sheet has shrunk by around $64 billion. This is why large investors hadn’t taken the Fed’s statements about interest rates seriously.

Along with raising the federal funds rate, the Fed needs to shrink its balance sheet at the same pace it had announced. That, along with raising the federal funds rate aggressively, will push the stock market to buy its message of how serious it is about controlling inflation.

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint.
Download The Mint News App to get Daily Market Updates.

More
Less

Subscribe to Mint Newsletters

* Enter a valid email

* Thank you for subscribing to our newsletter.

First article

Leave a Reply

Your email address will not be published.