Why the stock market didn’t buy the US Fed’s warnings

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One of the biggest challenges in 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 for a while about the importance of raising interest rates and controlling inflation. However, the financial markets seem to have ignored his message.

On Friday, Powell reiterated his message and said the Fed’s primary goal was to bring inflation down to 2% because the economy doesn’t work for anyone without price stability. 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.

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Mammoth ratio

The question is why the stock market hasn’t bought Powell’s message so far. 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 raised the federal funds rate this year.

Over the years, the Fed has also tried to influence long-term rates, and in doing so, the size of its balance sheet has exploded. Towards the end of August 2008, a few weeks before the financial crisis hit, the size of the Fed’s balance sheet was around $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 rate more or less similar to its overall economic growth. The gross domestic product (GDP) of the United States was $14.77 trillion in 2008. In 2021, the GDP was $23 trillion, an increase of 56% since 2008.

Since 2008, when the Fed’s balance sheet grew almost ninefold, the size of the US economy has grown by just over half.

This increase occurred because the Fed printed money and injected it into the financial system by buying bonds. He did this between 2008 and 2014 to rescue struggling financial institutions and later to lower long-term interest rates so people and businesses could borrow, spend money and contribute to economic growth. .

The Fed repeated the formula in late 2019, before the coronavirus outbreak, to boost economic growth. Once covid started to spread, money printing and bond buying by the Fed also increased.

Central banks can print all the money they want but have no control over where it goes. As a result, much of that money ended up in stock markets, real estate, and cryptocurrencies. An expensive real estate market has led to a rapid increase in rents. House rents are a major component of how retail inflation is calculated in the United States. Among other things, high house rents have fueled US retail price inflation to decade highs.

It is important for the Fed to raise long-term interest rates to contain retail inflation. In May, the Fed said it would withdraw the money it was printing and pumping into the financial system. It was about driving up long-term rates. The plan was to take $47.5 billion each month from June through August and $95 billion on top of that. This meant that from June to August, almost $143 billion would have had to be withdrawn, and the Fed’s balance sheet would have had to contract by an equivalent amount. Nevertheless, from June 1 to August 24, the size of the balance sheet shrunk by about $64 billion. This is why major investors had not taken the Fed’s statements on interest rates seriously.

Along with the increase in the fed funds rate, the Fed must reduce its balance sheet at the same rate as it had announced. That, combined with an aggressive increase in the fed funds rate, will have the stock market buying its message about how serious it is about controlling inflation.

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