Fed Funds Rate and Inflation in the US

The Financial Markets and the Coronavirus

Introduction

The Coronavirus is a pandemic that has swept the globe, causing widespread panic and financial instability. The virus originated in China and quickly spread to other countries, resulting in a significant death toll. Hospitals have been overwhelmed with patients and governments have implemented strict measures to contain the virus. The pandemic has also caused severe damage to the global economy, with stock markets plunging and businesses shutting down. Markets recovered and soared to new highs, however, as central banks around the world intervened with trillions in new liquidity. Now, interest rates are rising to combat soaring inflation, and the situation is still very much evolving. It remains to be seen how the world and financial markets will recover from this crisis.

Impact on the Economy & Stock Market

The Coronavirus pandemic has had a profound impact on the economy and stock market. The S&P 500 index, which is a gauge for the overall stock market, fell by over 30% when the pandemic began. Unemployment in the United States rose to over 10%, and GDP contracted by 3% in 2020. These impacts were felt across the globe, with economies in Europe and Asia also experiencing significant slowdown. 2020 was a rollercoaster year for the stock market, with the S&P 500 reaching an all-time high in February 18, 2020 before beginning its plunge the following week and through the first three weeks of March as the COVID-19 pandemic took hold (Yahoo! Finance, 2022). The market then regained some ground in April and May before consolidating in June and then again at a higher level from September to November. The market then broke out November 5, 2020, and rallied strongly through the end of the year, helped by news of promising vaccine trials and prospects for more fiscal stimulus from the incoming Biden administration. In total, the S&P 500 finished 2020 at its (then) all-time high, up nearly 60% from its pandemic lows reached on March 23, 2020. The recovery was v-shaped and quite rapid. As of today (September 26, 2022), the S&P 500 is at 3665, below where it ended in 2020 but still above its Feb 18, 2020 peak of 3385, having significantly sold off in 2022 due to a combination of the Fed Funds Rate rising and quantitative tightening beginning.

Unemployment spiked dramatically in 2020, from 3.5% in January to 14.7% in April 2020 (BLS, 2022). It peaked that same month and fell over the rest of the year to 6.7% by November-December 2020 (BLS, 2022). The low was 3.5% in Jan-Feb 2020, and the high was14.7% in Apr 2020 (BLS, 2022). Current unemployment according to the most recent survey from the BLS (2022) on Sept 26, 2022, is 3.7%--so roughly back to where it was before the lockdowns of 2020. The pandemic impact on employment varied according to industry, as payrolls for couriers and messengers rose 21.5% from Feb-Nov 2020 while payrolls fell 17.2% during the same time for bars and restaurants (Dougherty & Morath, 2020).

The US economy shrank 4.8% in the first quarter of 2020 (Torry, 2020a). This was the biggest drop since the first quarter of 2009, during the Great Recession. The wreck continued into the second quarter with GDP falling 9.5% year-over-year, its fastest rate of decline in 70 years (Torry, 2020b). Since Q2 2020, GDP has skyrocketed, from 19.477 in Q2 2020 to 24,882 in Q2 2022 (St. Louis Federal Reserve, 2022).

Days with Big Swings

During the week of March 8-13, 2020, the S&P 500 opened at 2863, closed at 2746; the next day it rebounded sharply to close at 2882. It then fell precipitously the next two days to close out the 12th at 2480. On the 13th, it gapped up on the open and closed at 2711. All of this was thanks to traders seeking safety in bonds while waiting for word from the Federal Reserve on what type of intervention the central bank would implement to save the crashing economy (Hoffman, 2020).

The events of March 16, 2020, were fueled by corporate treasurers and pension managers fearing the worst and needing to pull money from money market funds, forcing funds to sell bonds. It is a self-reinforcing feedback loop of liquidation. The Federal Reserve’s intervention of pushing rates to near zero and buying $700 billion in government and mortgage bonds was not seen as enough, and traders and fund managers panicked by selling (Baer, 2020).

On March 17, 2020, the Dow Jones Industrial Average rose by 10%, its biggest one-day percentage gain since 1933. The rally was driven by a surge in government bond prices and a decline in the value of the U.S. dollar but also by the fact that the Federal Reserve announced that it would pump $1.5 trillion into the financial system while the Trump Administration pledged stimulus support checks for Americans. These measures helped to calm fears about a possible recession (Langley et al., 2020).

On March 24th, the Dow rose 11%. Traders were optimistic that the bottom was in on the sell-off and that the government stimulus deal would signal a major reversal. It appeared the capitulation had occurred and now everyone was rushing to buy the market (Osipovich et al., 2020).

The Government’s Response

In response to the widespread economic impact of the pandemic lockdowns of 2020, the U.S. Federal government initiated a number of recovery programs to help stimulate the economy. One of the most significant programs was the Paycheck Protection Program (PPP), which provided loans to small businesses to help them keep their employees on payroll (Davidson & Timiraos, 2020). The program was hugely successful, with over five million businesses applying for loans totaling over $525 billion. Another key program was the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which provided $2 trillion in relief funding for individuals, businesses, and state and local governments (Deloitte, 2020). The CARES Act also included provisions for expanded unemployment benefits and direct payments to households. These and other recovery programs—like the bailout of the aviation industry (Sider & Davidson, 2020)—have helped to stabilize the economy in the face of unprecedented challenges, and have laid the foundation for a strong recovery in the months and years ahead.

The pros and cons are complicated when discussing these actions. The PPP has come under fire from some critics who argue that it is a bailout for large corporations, while others argue that it is necessary to prevent mass layoffs during the pandemic. The aviation industry has also been hard hit by the pandemic, and the CARES Act includes a $25 billion bailout for airlines. This bailout has been criticized by some who argue that it is unfair to bail out an industry that has been struggling for years, while others argue that the aviation industry is critical to the economy and should be supported during this time of crisis. The CARES Act is the largest economic stimulus package in U.S. history and is putting heaps of debt on the US—a con, but its relief measures for businesses and individuals impacted by the coronavirus pandemic were necessary—a pro.

The Federal Reserve’s Response

In March of 2020, in response to the COVID-19 pandemic, the Federal Reserve initiated several aggressive measures to stabilize the U.S. economy. These included lowering interest rates to near-zero levels, restarting its program of quantitative easing (QE), and creating new lending facilities to support businesses and households (Baer, 2020; Hoffman, 2020). The Federal Reserve also began issuing forward guidance to calm markets, backstopped money market mutual funds with its Money Market Mutual Fund Liquidity Facility, and expanding its repurchase agreement operations to calm the repo market (Milstein & Wessel, 2021). While the pros of these programs are that they temporarily helped to prop up the economy in the short term, there are some serious cons to them as well—for instance, they could create significant problems down the road. One worry is that these actions could lead to inflationary pressures, as the Federal Reserve has pumped large amounts of money into the financial system. In my opinion, by keeping interest rates low for an extended period of time and propping up markets with trillions in QE, the central bank encouraged asset bubbles in housing and stock prices.

The Federal Reserve and the World

One important action taken by the Federal Reserve was the buying of bonds and securities. When the Fed buys assets, this increases demand for them and pushes up prices. This has led to concerns about asset bubbles forming, particularly in housing markets. Higher asset prices also benefit US investors as their portfolios become worth more. This increases demand for the US dollar, pushing up its value relative to other currencies. This makes US exports more expensive and imports cheaper, which harms other countries' economies as they become less competitive against US products. In addition, as the US dollar becomes more expensive, debtors who have borrowed in dollars find it harder to repay their loans as their income is worth less in dollar terms. This can cause financial instability and even default, particularly in emerging markets where a lot of debt is denominated in dollars. For these reasons, the actions of the US Federal Reserve have far-reaching implications for other countries around the world. In the past, the Federal Reserve lent money to other countries through the discount window. In response to the pandemic market meltdown, the Federal Reserve enhanced international swap lines to improve dollar liquidity by lowering rates and extending maturity of the swaps (Milstein & Wessel, 2021).

Inflation

CPI for 2020 saw a high in January of 2.5 and a low in May of 0.1. In 2021, the low was in January at 1.4 and the high was in December at 7.0 (CPI only increased month-over-month for the entire year, save for June-September, when it hovered between 5.3 and 5.4). Inflation first rose above the Federal Reserve’s 2% target in March, 2021, when it reached 2.6. For July 2022, CPI was at 8.5. The core driver is energy, up over 30%. Yet the spike in energy is also due to government policies like green energy regulation and banning oil from Russia.

In 2022, the median projection is 2.3%. The Federal Reserve’s target for inflation is 2%, so this projection is slightly higher than what the Fed would like to see. In 2022, the median projection for the Federal Funds Rate is 3%. This is slightly higher than where the federal funds rate is currently at (2%). The trend in projections is upward.

According to the article by Timiraos (2020), it is apparent (although not explicitly stated) that the Federal Reserve is behind the curve in hemming in inflation. It will continue to keep rates low, according to the article. It will justify this decision by stating simply that it is changing how it sets interest rates—which means it is deliberately trying to ignore the elephant in the room. The motivation for this change is best illustrated by use of the casino metaphor: the markets are a casino; the pension funds (and other funds) are some of the big everyday players known as marks; the banks are sharks at the table; the central bank is the house. The sharks do not want the pension fund players to leave the table, so the house will keep them playing as long as possible, by sweet reassurances that inflation is only temporary, free drinks (low rates), and so on. When pension funds panic, as they are in England, the central banks will intervene with bailouts, as the BOE has done in England as of today (September 28, 2022).

Fed Balance Sheet, Interest Rates, and Policy Changes

Total assets of the Fed have more than doubled since the pandemic hit. From March 2020 to today, the increase in dollar amount is 4.6 billion.

In March 2022, the Fed raised interest rates for the first time since 2018, but being well behind the curve the move comes as too little and too late to curb inflation. The Fed changed its Fed Funds Rate target because it was time for the banks to begin squeezing market participants. Inflation was raging, consumers were tapped out, credit was tapped out—thus, the squeeze begins.

The Fed raised rates and planned to reduce its balance sheet through quantitative tightening (QT). When the Fed wants to stimulate the economy, it buys assets, which increases the money supply and lowers interest rates. Conversely, when the Fed wants to slow down the economy, it sells assets, which reduces the money supply and raises interest rates. The Fed wants to slow the economy to curb inflation, which will let the banks squeeze creditors, force liquidations, rinse, and repeat.

In June 2022, the large rate increase was due to CPI coming in hotter than expected. The central bank could no longer pretend to be ignorant on the inflation front.