The Fed is Tricking Us

I’ve been hit-or-miss on whether I’ve believed the Fed has done a good job over the past few years.? I think they missed a big opportunity to raise rates in the 2015-2020 years, I think they handled the Covid stuff pretty well, I think they waited too long to start raising rates after 2021, and I think they’ve done a decent job of quashing inflation once they got off their butts and started doing something. ?

But, for the past 15 years, I’ve felt like the Fed has been in reaction mode – responding to crises instead of making policy that leads the economy in the right direction.? ?

Until now.? After the last Fed meeting – over the past couple days – I’m fairly convinced that Jerome Powell and the Fed actually have things under control and are taking steps to lead the economy forward instead of just responding to it. ?

And they’re doing it by getting us to focus on what they’re saying, while ignoring what they’re doing. ?

Specifically, comments from Jerome Powell after this week’s meeting sent three messages:

1.? First, Powell was very clear that inflation has been more stubborn than expected.? He appropriately set the stage for keeping rates higher for longer.? This normally would have rocked markets.? Except for what came next...

2. Next, Powell indicated that that the Fed has not changed their guidance on how many rate cuts to expect this year.? According the Fed, the consensus is that we will still see three cuts in 2024, with the average expectation among Fed members that rates should be around 4.6% (down from about 5.25%) by the end of the year. ?

Now, while the first point alone likely would have spooked investors and sent markets tumbling, following up with the declaration that the Fed members still see us on track for 3 rate cuts completely negated that original message. ?

Basically, Powell was able to keep optimism and exuberance alive while basically saying, “Inflation is a problem.? But interest rates will come down!” ?

At first glance, it seems contradictory to believe that both of these statements could be true simultaneously.? But, there was the third message that Powell sent (and has been sending for a while) that I believe reconciles those two conflicting messages above:

3.? In the middle of his speech yesterday, Powell threw in this:? “The Committee decided at today’s meeting to … continue the process of significantly reducing our securities holdings.” ?

You see, while we often focus on interest rates as the primary tool the Fed uses to control inflation and the economy, there is another tool at their disposal.? ?

By buying and selling assets off their balance sheet, the Fed can control the money supply.? And a reduction in the money supply acts exactly as an interest rate increase would – it makes things less affordable, and drives down demand. ?

While everyone is focused on what the Fed is doing with interest rates, Powell and his team are working behind the scenes to pull on the other lever they have to drive the direction of the economy.?

Powell can legitimately tell us that inflation is still a problem (it is!), while also truthfully forecasting that interest will still come down (they likely will!). ?

And Powell can honestly say this because the Fed is successfully selling/rolling off assets from their balance sheet and reducing the money supply, which will almost certainly curb demand and continue to put downward pressure on inflation. ?

Here are a couple graphs that clearly indicate what the Fed is quietly accomplishing… ?

First, this is the Fed balance sheet:

As you can see, over $1.4T have been rolled off since the peak in June 2022.?

When the Fed sells off assets from their balance sheet, this removes money from circulation, which is effectively the same as raising interest rates. ?

Need a more direct relationship between the Fed balance sheet and how it impacts consumers? ?

Here is the M2 money supply.? Note that it has only decreased appreciably 4 times in our nation's history, and the last time was after the Great Depression (not the Great Recession!).? Until now: ?

As you can see, nearly a trillion dollars has been removed from the money supply since 2022. ?

While the 5 point increase in interest rates over the past two years has certainly contributed to inflation coming under control, the fact that the Fed is focused on this monetary tightening is also a huge contributing factor – despite most people not even recognizing it happening. ?

So, long story short, while inflation is being more persistent than expected, as long as the Fed keeps their foot on the monetary tightening gas pedal, there’s a reasonable chance that we could continue to see a reduction in inflation – to the point where the Fed can lower interest rates without concern.

At least for now, I’m giving the Fed credit for successfully tricking us into keeping the markets optimistic, while simultaneously fighting persistent inflation.