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First, Do No Harm...

• The Fed utilizes several policy tools to pursue their dual mandate of “maximum employment” and “stable prices”. 

• These tools are generally “blunt instruments” and their use is not without risks and secondary impacts to the economy.

• Inflation will likely be persistent for the foreseeable future and the Fed may take a cautious approach, beginning with rate hikes and a modest pace of liquidity drain before pausing to assess its efficacy.


“First, Do No Harm” is often attributed as part of the Hippocratic Oath for doctors but most will agree this has evolved to mean “Do treatments for which the potential benefits outweigh the risks of harm”. This is sage advice the Fed is well aware of given its often counterbalancing dual mandate of “maximum employment” and “stable prices”.

But the Fed now finds itself, like a surgeon in the preoperative stage, prepping its patient, the economy, for its upcoming procedures. The economy has rebounded very strongly post-COVID but is experiencing a dramatic, broad-based increase in inflation. If these higher levels of inflation continue and become embedded in longer term inflation expectations that will likely be detrimental to the overall health of the economy and the markets.

At the same time, the available cures (tools the Fed can use to impact demand, credit or money supply) impact inflation indirectly, with varying and unknown degrees as to their economic impacts. In other words, there is no magic elixir to just bring down inflation without impacting other parts of the economy or the markets, but they are going to try anyways.

So what are the main tools the Fed plans to use? How effective are they in fighting inflation?

Below are some of the key tools in the Fed “toolbox,” listed in likely order of usage.

Federal Reserve “Toolbox”

Tool Description Delivery/Effectiveness Inflation Impact/Risks
Forward Guidance Communication from the Fed about the state of the economy and the likely course of monetary policy Typically observed from Fed meeting minutes, Congressional reports and from the plethora of voting Fed members running around the country at speaking engagements. Can be very effective in moving rates ahead of actions and preparing markets. Indirect, but impactful. For example, multiple rate hikes are already built in, and mortgage rates are up. Demand can inadvertently be brought forward to avoid rate hikes, and credibility can be at stake if the Fed misreads the economy or doesn’t follow through with planned actions.
Fed Fund Rate Hikes Raising the Federal Funds Rate Typically announced at scheduled Fed meetings. The Fed announces the target range for overnight bank borrowing/lending of bank reserves. The effectiveness of the rate hike is judged well after the event, but there is immediate impact on those rates that are tied to it directly (All overnight borrowing rates, and most notably the prime rate, which can set other consumer and corporate rates). The “Go-To-Tool” for first line inflation defense. Direct, but not immediate impacts. It takes time to work through system to impact consumer borrowing and savings rates. Banks, which borrow in overnight markets, are directly impacted. It is a blunt tool, akin to chemotherapy, to slow aggregate demand via impacting credit and making borrowing more expensive. Risks are in raising too much, too quickly.
IORB Interest on Reserve Balances This is the administered rate the Fed sets to keep Federal Funds within the suggested range when they raise rates. It is an important technical adjustment given that tweaks reserve balances and borrowings (The Fed’s Reverse Repo Facility) are so large. Indirect but useful tool that can be used to control the bank reserves outside of open market operations, and keep policy rates where they are intended. Observations outside this rate indicate there could be problems in the funding and credit markets.
Open Market Operations The book-entry purchasing or selling securities from member banks Quantitative Tightening (known as QT) is the opposite of Quantitative Easing (QE). QT involves letting Fed-owned securities on their balance sheet mature and/or be sold back to the banks (market). This is a book-entry method that has the effect of lowering bank reserves (i.e. less money in the system) while indirectly increasing supply in the hands of the banks/public. Direct and immediate. Likely the strongest tool and direct tool to control liquidity and money supply but with the least observable impacts on inflation.

 

Are the New Tools Better than Rate Hikes?

The M2 Money Stock (M2) vs Inflation chart nearby illustrates an interesting story, with arguments for and against reserve balance manipulation.

20220426-chartHowever, Quantitative Easing/Quantitative Tightening and Interest on Reserve Balances (IORB) are relatively new tools borne out of the 2008 financial crises and are yet unproven in reducing inflation of this magnitude. With a press of a button the Fed can add tremendous amounts of liquidity in the system (they were able to add approximately 25% during COVID), but liquidity can also be drained quickly. Therefore, this might wind up being the Fed’s Go-To if initial rate hikes prove ineffective. In any event, the M2 growth rate is slowing now, which might begin to affect the demand-side driven inflation.

What Are Some Potential Adverse Side Effects?

While the economy appears on firm footing to handle rate hikes and a “neutral” accommodative policy, we must remember that these tools work on the demand-side to “get things into balance”. The inflation we have today is driven by global supply chain and cost-push factors as well. The Fed will be watching for these side-effects:

  • Rising trade or inventory financing costs could instead raise prices further in the supply-chain.
  • The labor market is tight even though the participation rate has not fully recovered from the pandemic. If businesses begin to lay-off workers unemployment could go up faster than is anticipated.

So What Do We Think?

There are no easy answers for the Fed in this “fight” against multi-factor inflation sources (supply-chain, demand-driven and wage-driven). To be sure, higher than normal inflation is a better alternative than its alter-ego deflation, but if wage-price spirals akin to the ‘70s are allowed to take hold then longer and deeper recessions are likely to occur and more draconian policy actions will be advisable.

The Federal Reserve is now on board with reducing inflation, recognizing it isn’t transitory was a good first step. Next, the forward guidance given has been appropriate and has allowed the Fed flexibility in not only raising rates, but allowing QT to begin to “normalize” policy. The Federal Reserve will most likely take advantage of this opportunity to take what the market is giving them by raising rates 50 bps in May and likely another 50 bps in June (as Q2 2022 core inflation numbers will not be available), begin its balance sheet wind-down with existing maturities, and then re-assess the inflation and unemployment data.

That said, we continue to feel inflation will be a prolonged, multi-year fight to get to the Fed’s stated mandate of 2% PCE (Personal Consumption Expenditures) growth. It probably is best to be cautious given the Fed’s history of inflation fighting. They don’t want the cure to be worse than the symptoms.

Important Disclosures & Definitions

Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.

Liquidity: the degree to which an asset or security can be bought or sold in the market without affecting the asset's price.

M2 Money Supply: a measure of the money supply that includes cash, checking deposits, and easily-convertible near money.

Quantitative Easing: a monetary policy strategy used by central banks where they purchase securities in an attempt to reduce interest rates, increase the supply of money and drive more lending to consumers and businesses.

Quantitative Tightening: a monetary policy strategy used by central banks where they reduce the pace of reinvestment of proceeds from maturing government bonds in an attempt to raise interest rates, decrease the supply of money, and reduce lending to consumers and businesses.

ALPS Advisors, Inc. is affiliated with ALPS Portfolio Solutions Distributor, Inc.

ALPS Portfolio Solutions Distributor, Inc., FINRA Member.

APS001966  05/31/2023

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