by Massi De Santis
The Federal Reserve Bank (“the Fed”) has been in the spotlight since the start of Covid-19, taking a number of actions to help the economy weather the pandemic. You have heard about easy money, zero interest rates, reverse repos, quantitative easing, and you may wonder what it all means for your investments, particularly with inflation making headlines again when we thought it was a thing of the past.
Inflation is an important risk to consider in any financial plan, and even more so for retirement plans, where the planning horizon is longer. While we hope these actions by the Fed are for the best, some of the Fed’s monetary policy tools are new and less intuitive, and discussion of them in the news may have amplified inflation concerns. Let’s review the tools the Fed uses to control inflation, and evaluate them in the context of a financial plan.
The Fed’s Tools of Monetary Policy
High and unpredictable inflation is not only bad for your plan, but also bad for the economy as a whole. Research shows that over periods and across countries with low and stable inflation, economic growth is typically higher compared to periods and countries with higher inflation. In addition, inflation is linked to monetary policy and the quantity of money in the economy. In periods and countries with high money growth, inflation is higher and less predictable compared to periods and countries with lower and stable money growth.
The relationship between the money supply, inflation and economic growth in the US is controlled by the Federal Reserve Bank System or “the Fed”. The Fed is mandated by Congress to use monetary policy to promote both maximum employment and price stability.
The Fed controls the money supply by targeting a key interest rate, called the federal funds rate. This is a rate at which banks lend money to each other. Banks lend and borrow cash reserves routinely to meet their needs of funds for lending activities and risk management purposes. Intervention in the federal funds rate market has been a classic primary tool of monetary policy of the Fed.
When the Fed lowers its target for the federal funds rate, it creates additional cash reserves for banks to use. The way the Fed does it is through so-called open market operations. For example, when the Fed wants to lower the federal funds rate, it can buy Treasury bonds from a commercial bank. By doing that, the Fed sends money to the commercial bank, and the bank has additional reserves to lend to other banks. The additional supply of money has the effect of lowering the federal funds rate and potentially increasing bank lending, which may be a positive when you try to stimulate the economy.
This is what we normally call an expansionary policy. The drop in interest rates increases the money supply. If the increased money supply does stimulate the economy, there may be little or no inflation. However, if the economy does not produce more goods and services, more money chasing the same goods and services will result in higher prices and inflation. Currently, the Fed thinks the economy needs a federal funds rate target between zero and 0.25 percent, which is low by historical standards.
During the financial crisis of 2007-2008, the Fed realized that with low interest rates and with acute problems in some parts of the economy, old tools like open market operations to affect the federal funds rate alone may not be effective. So the Fed designed new tools. Some of these are Interest on Bank Reserves, Quantitative Easing, and Reverse Repurchase Agreements. The same approach has been used since the onset of Covid-19.
Interest on Bank Reserves
Think of the Fed as the bank of banks. Commercial banks keep their cash reserves in an account with the Fed and the Fed pays them an interest rate on the reserves. Paying an interest on reserves helps the Fed maintain the federal funds rate within the desired target. This is because banks will be reluctant to lend reserves to other banks at a rate lower than what the Fed offers them. If the Fed wants to lower interest rates in the federal funds rate market, it will lower the interest rate on bank reserves so that banks may lend more in the federal funds rate market, which will lower the federal funds rate. Viceversa, the Fed can increase the interest rate on reserves when it desires to increase the federal funds rate.
The Fed engages in quantitative easing (“QE”) when it is ready to swap money for certain financial assets. In a traditional open market operation, the Fed buys or sells government securities like Treasury bills. In a quantitative easing operation, the Fed can buy or sell mortgage securities, long-term bonds, and other types of loans from commercial banks and other financial institutions.
QE injects cash into commercial banks and the economy, similar to traditional open market operations. In addition, by targeting particular markets like the market for mortgages and others, it can directly provide liquidity and stability to the target markets.
Reverse Repurchase Agreements
Reverse purchase agreements have been a recent subject of discussion in the news and, among the new tools, they are probably the least intuitive. In a reverse repurchase agreement, or reverse repo, the Fed can sell a financial security to a financial institution like a money market fund or a government agency with the promise to buy it back the next day. From the perspective of a money market fund, this is a way to deposit some cash at the Fed and earn some interest overnight, until a more suitable investment is found. The interest rate paid on the reserves is set by the Fed in the agreement.
Because the reverse repo is a risk-free investment for the money market fund, the fund will be unwilling to lend the funds for less than what the Fed offers to a commercial bank (in the federal funds rate market). So, effectively, the reverse repo is a tool of the Fed to make sure the federal funds rate does not drop below a desired level. Increasing or decreasing the interest rates on these agreements helps the Fed maintain the federal funds rate within a desired range. Reverse repos are particularly effective because they are available to a broader set of financial institutions than just commercial banks.
Using the New Tools
When the Fed wants to achieve and maintain a target federal funds rate, it will use a number of available tools to do so, including open market operations, the interest rate on reserves, and reverse repos. Maintenance of the target may require changes, particularly to reverse repo activity, which affects a broader set of financial institutions than just commercial banks. Lately, the Fed has increased reverse repo activity. When the Fed increases this activity, it tends to slow the growth rate of the money supply because it incentivizes financial firms to deposit money back with the Feds.
However, we do not know if this activity will change current interest rates on other investments or bring down inflation. All we can assume is that the Fed is doing what they think is best to achieve their dual mandate of maximum employment and price stability. Interest rates and inflation will change as a result of many factors, including the Fed’s actions.
Inflation, the Fed, and Financial Planning
Over the last 100 years or so for which we have good economic data, the performance of the Fed in managing the money supply has been mixed, as our past experience includes periods of high and unpredictable inflation and periods of low and stable inflation. While past experience may not help us predict where inflation is headed, it does provide a range of scenarios, and a good financial plan should take them into account. Determining how much to save for retirement, how much to spend in retirement, and your investment allocation should all consider the risk of potential inflation.
What this means is that while the Fed and inflation can make headlines, it’s not obvious that you should be changing your long-term financial plan and your investments as a result of short-term changes in inflation and monetary policy, assuming you have a robust plan. If the current inflation has you worried, here are some suggestions to alleviate its short term effects.
- Postpone some of your big-ticket purchases. For example, keep your car a year longer than expected to avoid the price increase we experienced this year due to shortages, which may be temporary.
- Drive slower and less often by combining trips. You will notice a nice increase in mpg and a drop in weekly gas costs. Your tires, brakes, and other car parts will also last longer.
- Buy used. For most big-ticket and entertainment items, the local Facebook marketplace or craigslist are great options. You don't really need a brand new stand-up paddleboard or digital SLR camera in most cases.
- Review and revise your allocation to government, inflation-protected securities, like TIPS or I-Savings Bonds. These are government-issued bonds with payments that adjust with the consumer price index (“CPI”). TIPS can be purchased directly from the Treasury or through bond mutual funds and ETFs. There are limits to how much you can invest in I-Savings bonds, but they have very attractive interest rates that will adjust for inflation.
Inflation is an important risk to consider when making a long-term financial plan. A good plan should already take the impact of inflation risk into account, based on historical experience. With such a plan in hand, it is unlikely that you will need to make drastic changes to your investments or your spending behavior in response to short-term changes in monetary policy or the news. Rushing to buy gold or other commodities may not be in your best interest. Instead, make sure you have a solid plan in place, and seek the help of an advisor to help you do so.
About the author
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.