Answers to key questions about the Fed and the economic and investment impacts of Fed policy.
As the U.S. economy deals with generationally high inflation and flirts with a potential recession, the U.S. Federal Reserve, commonly referred to as the Fed, is generating the most attention since former Fed Chairman Alan Greenspan warned investors against “irrational exuberance” in 1996. In an effort to snuff out surging inflation, the Fed has raised its target for short-term interest rates by 4.75 percent in the last year, one of the most aggressive starts to a rate tightening campaign in decades.
The Fed has much influence over the performance of the economy and capital markets. But what exactly is the central bank’s mission, how does it seek to achieve stable growth, and why should we pay attention? To help you gain a better understanding of the Fed and how it is seeking to engineer a “soft landing” for the economy, our chief investment officer, Brian Dorn, explains what you need to know.
What is the Fed?
The U.S. Federal Reserve System consists of three parts, the Federal Reserve Board of Governors, 12 regional Federal Reserve Banks, and the Federal Open Market Committee (FOMC). The Board, which runs the system, consists of seven individuals nominated by the President of the United States and confirmed by the U.S. Senate. Board members serve staggered 14-year terms. The Board Chairman (currently Jerome Powell) and Vice Chairman (Richard Clarida) are also nominated by the President and confirmed by the Senate but serve only four-year terms.
When people say “the Fed” today, they are typically referring to the FOMC, a group of 12 members who set monetary policy and conduct what they call “market operations.” The FOMC is comprised of the Fed Chair, the seven Fed Governors, the president of the Federal Reserve Bank of New York, and four of the remaining 11 Reserve Bank presidents. The 12 Reserve Banks support member commercial banks in their geographic regions and are the direct link between the Federal Reserve and the private sector.
Interestingly, the Fed is not funded by Congress but instead finances its operations through the interest earned on the securities it lends. This is one way in which the central bank operates independent of political influence. And unlike the U.S. Treasury and other Cabinet departments, the Fed is not overseen or given formal policy guidance by the White House.
What are the Fed’s goals? What is its mandate for the economy?
The overall goal of the Fed is to foster the efficient functioning of the U.S. economy and stability of the U.S. financial system. It has supervisory and regulatory authority over many banking institutions with its Reserve Banks monitoring the financial conditions of individual banks in their geographic regions and evaluating their compliance with industry laws and regulations. The Reserve Banks provide liquidity by facilitating lending among entities to ensure a well operating banking system, while also promoting financial consumer protection and community development.
The Fed’s recent moves to stem damage from the failure of two regional banks—Silicon Valley Bank (SVB) and Signature Bank—demonstrate its supervisory role within the banking system. While responsible for the system, the Fed doesn’t manage smaller banks or dictate how those banks invest their deposits. SVB had too much saved in their “hold to maturity” government bonds relative to their “available for sale” bonds, which forced the bank to sell off long-term holdings at losses and ignited a panic among depositors. The FOMC carries out the central bank’s dual mandates of promoting maximum employment and stable prices. It was created during the Great Depression to foster greater collaboration and better coordinate monetary policy, a function previously carried out by the 12 Reserve Banks. The FOMC’s latest targets for the economy are to maintain an unemployment rate of 4%, as measured by the monthly report from the Labor Department, and an average inflation rate of 2%, as measured by the personal consumption expenditures or PCE index, the inflation gauge favored by the Fed for its broader coverage of prices than the Consumer Price Index.
What tools does the Fed use to achieve its goals?
The most well-known tool in the Fed’s arsenal is control of a short-term interest rate known as the federal funds rate. This rate, which banks charge each other for overnight loans, influences other rates throughout the economy, including mortgages, credit cards, as well as the yields offered for certificates of deposit, money market accounts, and government and corporate bonds.
By raising rates, the Fed increases the cost of borrowing with the intention of slowing the supply of money (and activity) coursing through the economy. Conversely, the Fed can lower rates, cheapening the cost of borrowing, which should increase the money supply and support growth. In an effort to tame stubbornly high inflation, the FOMC has hiked the federal funds rate eight times since last March, including four consecutive increases of 0.75% between June and November, raising the cost of borrowing from virtually zero to close to 5%.
The Fed can also buy or sell fixed income securities in an effort to raise or lower bond yields. The buying of government bonds, also called quantitative easing, raises bond prices, forcing yields lower. The Fed can also deposit the value of those bonds into the reserves of member banks, which is considered “printing money,” because it increases the funds capital banks can lend out. Quantitative tightening, on the other hand, involves selling bonds from the Fed’s balance sheet, sending bond prices lower and yields higher. The FOMC is currently involved in a quantitative tightening campaign.
The other primary way the FOMC seeks to accomplish its policy goals is by communicating its intentions. This is done through the release of Fed minutes from recent policy meetings and its Beige Book reports of regional economic activity. The remarks of Chairman Powell and other Fed governors at public events are another way to convey policy. Investors seek consistency of messaging from the Fed and listen for signs of hawkish or dovish remarks.
What is a “soft landing” and how does it differ from a “hard landing”?
When inflation gets too high or unemployment so low as to foment inflation, as is the case today, the Fed seeks to slow the economy just enough to cool inflation and drive unemployment to a sustainable level without causing a recession. When the Fed is able to accomplish this feat, it has achieved a “soft landing” for the economy. A soft landing is possible when employment remains at a level where consumers maintain normal spending patterns while inflation cools to a point where purchases remain affordable and businesses continue to spend and hire. The Fed pulled off this feat in 1994 and 1995, raising rates from 3% to 6% to slow economic growth while hiring remained healthy.
Unfortunately, the Fed has a track record of going too far when it comes to tightening financial conditions. Instead of simply slowing down economic growth, its policy actions can send the economy into a recession, considered a “hard landing.” These recessions could be mild or severe, but they do result in a broad contraction of economic activity and higher unemployment. According to University of Chicago economist Austan Goolsbee, two thirds of recessions since World War II have been caused by an overly aggressive Fed.
At Leelyn Smith, we continue to monitor the developments at the Fed and how they could influence your wealth and investments. In an uncertain environment, we remain focused on investing in high-quality companies with strong competitive moats to withstand a potential recession. We are always seeking to invest in assets that represent good value, leading us to favor both blue chip stocks and high-quality, shorter-term bonds. We also remain cognizant of the common wisdom, “Don’t fight the Fed.” This means we don’t suggest taking positions that go against the Fed’s stated policy goals, such as buying long-duration investments like 30-year Treasury bonds or speculative, profitless growth stocks.
The torrent of information available to us every day can inflate the role of the Fed and the market’s reaction to its every move. Instead, we believe understanding the role of the nation’s central bank and being aware of the economic risks that it is targeting provides a sound foundation to make long-term investment decisions. Managing the unique risks each of you face will always be our priority. At the same time, we maintain our search for areas of the stock and bond markets where we can take advantage of the long-term investment opportunities that the current environment presents.
To discuss Fed policy and how it may affect your specific situation, please don’t hesitate to contact your Leelyn Smith advisor.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
 NPR “The Fed’s mission improbable: Beating inflation without causing a recession” July 24, 2022.