Council Post: How Does The Federal Reserve Influence Monetary Policy, Inflation And Unemployment?

Chief Investment Officer at Cetera Financial Group (@CeteraFinancial). Find more insights at Cetera Investment Management (@CeteraIM)

Some forces in life may be powerful and obvious, yet remain a bit mysterious—think of weather systems, consumer trends and, yes, the Federal Reserve. The Fed, as it is colloquially known, does have a clear, twofold mandate: maximize employment while maintaining price stability. In other words, the Fed’s job is to make sure the job market stays healthy and inflation stays in check.

But because this is such a complex task, the inner workings of the Fed can often seem opaque.

How Does The Fed Influence Monetary Policy?

The Fed accomplishes its dual tasks through monetary policy, which influences the availability of money and credit throughout the economy. This is in contrast to fiscal policy, which usually addresses government spending and taxation, and is primarily driven by government legislation.

While the Fed has many monetary tools to use to achieve its dual mandate, its primary tool—and the one that gets the most press—is managing the level of short-term interest by raising or lowering the federal funds rate. The fed funds rate is “the average rate that banks pay when borrowing from each other overnight,” and it impacts short-term and long-term interest rates throughout the economy.

How Do Fed Actions Impact Inflation?

In Economics 101, we learned that supply and demand largely drive the economy. The Fed cannot influence supply. For example, it cannot refine more oil or build more houses. But it can influence demand by raising and lowering interest rates to slow the economy or speed it up.

For example, if the economy is growing too fast and inflation starts to surge above the targeted 2% rate, the Fed may raise the federal funds rate, which should cause other borrowing costs to rise, as well. Higher borrowing costs increases the cost to purchase goods and services, which reduces demand. Mortgage rates also might rise, and this would force some homebuyers out of the market, slowing home sales and reducing home prices.

Eventually, tightening the money flow should lead to less price pressure and, ideally, lower inflation.

How Does The Fed Influence Unemployment?

On the other hand, if the economy is growing too slowly and the unemployment rate starts to tick up, the Fed might lower its funds rate. This makes it less costly to borrow money, making it easier for businesses to obtain loans and thus hire more workers, build new offices or increase production. And as borrowing costs decline, the costs to purchase goods also decline, which in theory, should stimulate demand. Greater demand increases economic output and leads companies to hire more workers to meet this demand.

When the Fed lowers interest rates, the stock market tends to rise, as investors become optimistic, or bullish, that the economy will grow and corporate profits will increase. When the Fed raises interest rates, however, equity investors tend to get bearish, as they anticipate financing costs to rise, economic growth to slow and corporate profits to decrease.

Can We Predict The Fed’s Possible Direction?

With cracks emerging in the economy from high inflation, bank system stress and the rapid pace of interest rate increases, it is increasingly challenging to understand the path of Fed policy and to see how those decisions may ultimately impact investor portfolios. There is also mounting uncertainty as a result of diverging market expectations and Fed messaging.

While many expect rate cuts this year, the Fed has indicated it will not cut rates until at least early 2024. Usually, when the Fed sees a recession coming, it cuts rates. Unfortunately, inflation is still above the Fed’s target levels, so it may not be able to cut rates.

Even so, I do expect the Fed to begin pausing and possibly cutting rates as we begin to see more evidence of inflation slowing. Over the next few months, I expect we’ll see key inflation measures come down, as I believe food, energy and rent have peaked.

What Signals From The Fed Should Investors Watch?

Signals to watch include the Fed meeting minutes, commentary from key Fed members and press conferences from Fed Chair Jerome Powell after each Fed meeting. All three should give insight into what the Fed is planning.

Outside of the Fed, data indicators to watch include the two-year U.S. treasury yield, which is considered a proxy of where the Fed funds rate will be one year from now, as well as ISM survey data, which measures the Purchasing Managers’ Index for manufacturing and non-manufacturing industries, and weekly jobless claims, which may show the direction of the labor market.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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