Federal Reserve 101: Tools for Fighting Inflation

Federal Reserve 101: Tools for Fighting Inflation

With inflation fears dominating the financial news, you’ve probably been hearing a lot about the Federal Reserve. And if you’ve been wondering what exactly the central bank is, and how it functions as a key player in the U.S. and global economy, you’re not alone.

What Is the Fed’s Role?

Created by Congress in 1913, the Federal Reserve System acts as the central bank of the United States with the mission to provide “a safer, more flexible and more stable monetary and financial system.”

Despite its outsized prominence among investors, the Fed does not control the economy or regulate the markets. Its Congressional mandate, as per the 1977 Federal Reserve Reform Act, is to pursue monetary policy in order to achieve maximum employment, stable inflation and moderate long-term interest rates.

As an independent agency, the Fed does not require approval from the president or Capitol Hill on its policy decisions, though its policymakers periodically testify before Congress.

The Federal Reserve System performs three broad functions:

1. Overseeing the stability of the financial system to minimize and contain systemic risks—including unexpected events, such as the 2008 financial crisis and the COVID-19 pandemic, that can threaten entire economies.

2. Monitoring the safety and soundness of individual banks and lenders, while ensuring that the payment and settlement system between them is safe and efficient.

3. Determining the country’s monetary policy—setting interest rates and overseeing the money supply in accordance with its Congressional directive to promote maximum employment and stable prices (controlling inflation).

(Monetary policy is the vehicle through which policymakers carry out their mandate. Note that “monetary policy” differs from “fiscal policy”—i.e., spending and taxes, which is overseen by Congress.)

Who Determines the Course of Monetary Policy?

Think of the Federal Reserve System as three main entities:

The Federal Reserve Board of Governors in Washington, D.C., is an independent agency that supervises all Fed operations. Its seven-member board (operating with six at present) is nominated by the president and confirmed by the Senate. The Board’s current chair, Jerome “Jay” Powell, was nominated by former President Trump in 2018.

There are also 12 regional Federal Reserve Banks in districts around the country—Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco—that oversee the central bank’s day-to-day operations and represent the interests of local banks, businesses and consumers.

Finally, the 12-person Federal Open Market Committee (FOMC) consists of the seven Board members, the president of the Federal Reserve Bank of New York, and four other Federal Reserve Bank presidents serving one-year terms on a rotating basis. When you hear about a Fed meeting, it refers to the FOMC convening to debate and vote on monetary policy and share their assessments of economic conditions nationwide.

The FOMC has a number of monetary policy tools at its disposal. For instance, it can buy bonds and specify reserve requirements (the minimum amount of cash commercial banks need to have on hand). Among its more powerful tools to influence the economy and markets is the power to raise (“tighten”) or lower (“ease”) short-term borrowing costs with the fed funds rate.

What Is the Fed Funds Rate?

Banks take in and dispense cash throughout the day and are required to have a minimum reserve amount on hand after business closes. On any given day, some banks will come up short, but others will have excess cash to lend to those below the minimum. The fed funds rate is the target interest rate at which banks lend money to each other overnight.

Financial institutions also use that rate as the benchmark to calculate interest rates at which they are willing to lend money to borrowers like homebuyers or small businesses.

Interest rates have a massive effect on economic activity—when they’re low, consumers are motivated to borrow more money for major purchases and businesses feel confident spending more. When rates are high, consumers and companies are likely to keep cash in savings accounts.

So when the Fed wants to stimulate economic activity, it will ease the fed funds rate. When it wants to slow things down or no longer needs to encourage activity, it tightens the fed funds rate. This, in turn, affects short- and long-term rates, foreign exchange rates, the availability of money and credit, and ultimately the economic factors in its mandate—employment and the stability of prices of goods and services. The latter is where inflation comes in.

How Does Fed Policy Control Inflation?

The Fed’s favorite inflation measure is the Personal Consumption Expenditures Price Index (PCE). This hovered around the central bank’s target of 2% for 25 years or so—until last year, when the pandemic delivered an unprecedented shock. The annualized PCE (excluding volatile energy and food prices) fell at a 1.0% annualized rate in March 2020 from the same time in 2019 (down from a 1.9% gain in February, before the pandemic impact hit). In April 2020, that PCE inflation measure fell a whopping 4.6% from the same period in 2019.

Anticipating this severe economic pain as businesses closed in the early days of the COVID-19 pandemic, Fed policymakers held an emergency FOMC meeting on March 15, 2020. They slashed the fed funds rates to a 0.00%–0.25% range from 1.00%–1.25% as a stimulative economic support system—helping encourage companies to borrow money to keep people employed and spending to stabilize falling prices. The rate remains in that range today.

As the pandemic recedes and the economy reopens more fully, we’re seeing inflation figures rise as quickly as they fell in spring 2020. This May, the Consumer Price Index (CPI), another inflation gauge, rose by 5% compared to the same month in 2020.

Does this mean inflation is actually running at 5% and about to start soaring higher, and the central bank needs to take immediate action to douse the flames? Hardly, and the Fed knows it.

That 5% figure from May 2021 is significantly impacted by the base effect—when we compare current numbers to those from the extreme days of the pandemic shutdowns when CPI inflation was running at 0.1% year-over-year (and the annualized rate of inflation for the three-month period suggested deflation of 4.4%).

At the FOMC meeting last month, Fed Chair Powell said policymakers were “talking about talking about” raising the fed funds rate, an apt way to tiptoe toward the day when the Fed will look to put the brakes on the economy and rein in inflation by tightening. Powell sees inflation heading back toward the Fed’s 2% target next year. Other Fed officials aren’t so sure, with a number of FOMC members commenting publicly that they see a slower return to target—with the implication that the fed funds rate should be raised sooner.

Our Take

We’re not overly concerned or convinced that sharp and sustained inflation will occur (though we’re also not dismissive of the possibility), and we’re pleased at the reasoned and patient approach the Fed is taking. While it can be hard to put a highly inflationary genie back in the bottle, current policymakers are well-versed in history and have proven ready and willing to act to control price spirals. The rapid pace of economic recovery in the U.S. has given rise to transitory inflation and is likely to push the central bank to raise interest rates a little earlier than many initially expected. But we’re talking about a rate rise that is likely to occur fairly far in the future—late 2022 or early 2023—and this shouldn’t change anyone’s investment thesis.

For more on our inflation stance, please check out our podcast below on the subject!

Robinhood Slapped With Record FINRA Fine

Regulators continue to take aim at Robinhood, the popular digital trading app. Back in December, we looked at the $65 million fine that the Securities and Exchange Commission levied on Robinhood for failing to disclose profits made through agreements with high-speed trading operators.

Last week, the Financial Industry Regulatory Authority (FINRA) took its swing at the merry men.

FINRA, a private corporation authorized by Congress to regulate brokerage firms and exchange markets, announced on June 30 that it had fined Robinhood $57 million and ordered the company to pay $12.6 million in restitution, plus interest, to thousands of its customers.

The combined $70 million penalty marked the largest fine in FINRA’s 14-year history.

According to FINRA, counter to Robinhood’s stated mission to “demystify” investing, the app communicated “false or misleading” information to investors. The regulating authority also cited Robinhood’s failure to exercise due diligence before approving customers’ ability to place options trades—using algorithms with little human oversight to review options-trading eligibility.

Finally, FINRA slammed Robinhood for a series of outages between 2018 and late 2020 that left customers unable to execute trades. Most notably, Robinhood’s website and mobile app crashed during the height of the market turmoil in early March 2020. One notable outage froze users out of their accounts for nearly the entire trading day on March 3, 2020, when the Dow posted its biggest one-day gain since March 23, 2009.

“All FINRA member firms, regardless of their size or business model, must comply with the rules that govern the brokerage industry, rules which are designed to protect investors and the integrity of our markets,” said Jessica Hopper, head of FINRA’s Department of Enforcement. “Compliance with these rules is not optional and cannot be sacrificed for the sake of innovation or a willingness to ‘break things’ and fix them later.”

Do-it-yourself options and online investment start-ups promising lower barriers to entry, cheaper trades and an engaging user experience can seem awfully appealing—especially to young people who may find themselves with some summer savings to play with. We’re certainly in favor of young people getting a taste for investing (and compounding in particular), but we’d caution against trusting your money to apps that are still getting their acts together. 

Podcast: Fighting Inflation Fears

Will inflation rise? How will the Federal Reserve react? Can it halt the recovery? Questions like these have dominated the financial press so far in 2021. Adviser Investments’ bond experts, Chris Keith and Jen Yousif, sat down with Charlie Toole to talk about what’s behind those headlines. They discuss:

• What inflation is
• Why bond investors worry about it
• What’s driving the big inflation spike we’re seeing now
• Why we still think the inflation threat will fade in time

Understanding how inflation can impact your portfolio is essential for any fixed-income investor. Click now to listen, learn and prepare.

Adviser Investments’ Today’s Market Takeaways

There’s no shortage of hyperbolic headlines and provocative punditry in the financial media. But you won’t find such hysterics here. In Today’s Market Takeaways, members of our investment team provide timely videos that clearly and concisely explain what we’re seeing in the markets.

Recently, Research Analyst Liz Laprade discussed some remarkable rallies in equities and cryptocurrencies, while Vice President Steve Johnson reminded us how uncommonly good the markets have been.

We hope you find these episodes engaging and accessible. If there are any topics you’d like us to address, please send an email to info@adviserinvestments.com!

About Adviser Investments

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