One of the biggest challenges of monetary policy is that the financial market has to trust the message that a central bank is trying to communicate. US Federal Reserve Chairman Jerome Powell has been talking about the importance of raising interest rates and controlling inflation for some time now. But the financial markets, especially the stock markets, were ignoring his message.
On Friday, Powell reiterated his message. He added that the Fed’s utmost focus is on bringing inflation back to 2%, because without price stability, the economy works for no one. This time the stock market took Powell’s message seriously and the Dow Jones Industrial Average fell 3% or about 1,008 points to 32,283 level.
The question is why the stock market wasn’t 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 borrow and lend to each other overnight. The Fed is raising the federal funds rate this year.
For years, the Fed has been trying to influence longer-term rates, and in the process, the size of its balance sheet has increased. At the end of August 2008, weeks before the financial crisis began, the size of the Fed’s balance sheet was approximately $910 billion. As of August 24, it was $8.85 trillion.
Typically, the size of a central bank’s balance sheet should grow at a pace that is more or less the same as its overall economic growth. In 2008, the gross domestic product (GDP) of the United States was $14.77 trillion. In 2021, GDP rose to $23 trillion, a 56% increase since 2008.
Since 2008, while the Fed’s balance sheet has grown close to nine times, the size of the US economy has grown by just a little over half.
This increase is because the Fed is printing money and pumping it into the financial system by buying bonds. It did this between 2008 and 2014, first to protect many financial institutions that were in crisis and later to lower long-term interest rates so that people and firms could borrow and spend money and further economic growth. to help increase.
To accelerate economic growth, the Fed began repeating the formula in late 2019, even before the arrival of Covid. Once Covid began to spread, so did the Fed’s money printing and bond purchases.
While central banks can print all the money they want, they have no control over where this money ends up. A large portion of this money found its way into the stock markets, real estate markets and cryptocurrencies. A valuable real estate market increased home rents at a rapid pace. Home rent is a major component of how retail inflation is calculated in the US. And among other things, high-home rents have driven retail inflation in the US to decade highs.
To control retail inflation, it is important for the Fed to raise long-term interest rates. In May, to raise longer-term interest rates, the Fed announced that it would gradually withdraw the money it has printed and pumped into the financial system.
The plan was to withdraw $47.5 billion per month between June and August, and $95 billion after that. This meant that some $143 billion should have been withdrawn between June and August and the Fed’s balance sheet should have shrunk by an equal amount. Nonetheless, from June 1 to August 24, the size of the balance sheet has decreased by approximately $64 billion. This explains why many large stock market investors did not take the Fed’s repeated statements about raising interest rates seriously.
Along with raising the federal funds rate, the Fed also needs to shrink its balance sheet at the same pace it announced. Only then the stock market will give a message about how serious it is to control inflation.
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