What is the Fed thinking?

Over the past few months, the Federal Reserve has struck a very different tone in its comments and actions from the previous couple of years. The Fed seems to view inflation as a serious threat and is planning a campaign of raising interest rates. What can expect out of the Fed over the rest of the year?

The Fed is now ending a long period of highly accommodative economic policy.

The Fed is concerned enough about inflation that it’s effectively ending a long period during which it was engaged in an aggressive policy of quantitative easing (QE) designed to bolster the economy and protect against catastrophe.

QE means that the Fed purchases securities with the intent to reduce interest rates and effectively increase money supply, which should (theoretically – not everyone agrees on the effectiveness of QE) drive more borrowing by consumers and businesses.

In essence, they’re trying to pump liquidity into the financial system. During the pandemic, we also saw a form of QE with large amounts of fiscal stimulus delivered through direct stimulus checks and programs like the business-oriented Paycheck Protection Program (PPP).

Altogether, that level of accommodation has contributed to asset price inflation, and in turn actual services and goods inflation, which has then been exacerbated by war in Ukraine and various supply chain challenges. It’s part of the reason why inflation in the U.S. hit 8.5% in March, the highest rate in four decades.

In response, the Fed is now moving away from its accommodative stance.

In March, it increased the federal funds rate by 25 basis points for the first time since December 2018 and indicated it would continue increasing rates through 2022. Then, in early April, it suggested it will soon begin reducing its balance sheet through a process of Quantitative Tightening (QT). QT is the opposite of QE, and its intent is to effectively reduce money supply, thereby having a deflationary impact (again, this is theoretical – there’s disagreement on whether QT actually works and under what circumstances).

The Fed is now in something of a delicate position, which is increasing uncertainty and volatility.

How to end that long period of accommodative policy isn’t necessarily clear. The Fed itself may not be sure. That makes investors nervous and uncertain and has likely contributed to volatility in the market.

It’s likely that QE has helped to avert catastrophic economic outcomes, both after the Great Recession and during the pandemic, but it also resulted in some strange and probably unhealthy things happening. The meme stock craze, NFT and cryptocurrency surges, businesses seeing undue valuations – those are the kind of things that happen when you have excess liquidity (“money to burn”). If the central bank sends very strong signals and tells participants that it’s going to buy assets and keep rates low, as a byproduct the market will expect good economic growth with the Fed as a tailwind. The market will spend more money and take more risks.

But once the Fed starts acting differently, then the market takes the view that economic growth will slow, and the Fed is becoming a headwind. That's forcing market participants to discount something that they haven't had to discount for a long period of time, which in turn can create a speculative environment and a lot of volatility.

In other words, a market that is very accustomed to accommodative policy is now struggling to make sense of the Fed pumping the brakes.

It’s possible, maybe even likely, that the Fed had its foot on accelerator longer than they should have. The Fed employs some of the world’s smartest economists whose entire jobs are focused on keeping up with the economy, but we’ve been living through unprecedented times, and economics is a pretty inexact business to begin with. Managing that volatility is very tough, even for the Fed itself.

Think of the Fed like the economics equivalent of meteorologists trying to predict the weather.

We make jokes about meteorologists getting the weather wrong, but meteorology is actually a pretty solid science these days. However, as a science, meteorology is based on a sophisticated understanding of past weather patterns, so when the current pattern is so new, different, and unusual, it can leave even experts floundering.

That, in turn, pushes them behind the curve simply because their predictions have a lot more uncertainty built into them than normal. (For what it’s worth, this is genuinely an issue for climate science, as it becomes harder to predict weather patterns).

Something analogous plays out in economics. Economists, including those at the Fed, use a sophisticated understanding of past economic events and trends to model future performance; but with COVID-19 and the supply chain acting in ways for which there was no historical playbook, the Fed has been left with less visibility into the current cycle than it normally has.

For example, our supply chain isn't designed to deal with huge economic volatility like a contraction of 30% followed by huge growth, and it has been behaving in unpredictable ways that are hard to model or predict.

All of that has left the Fed as unmoored as anyone else when it comes to trying to understand and predict what comes next. In a lot of ways, they're just dealing with a very new, untested playbook.

All of that said, there’s a limit to how much the Fed’s activities matter – especially for value investors.

For my part, I’m middle of road when it comes to Fed. Others are much more vocal about Fed policy and its role in trying to "manage" asset prices. In my view, putting too much emphasis on what the Fed does or doesn’t do can lead you into short-term thinking where you make decisions trying to play the Fed.

If you invest with an eye on long-term value generating, like a value investor, Fed policy shouldn’t really be a determinant if you own the right businesses over a long period of time. If you identify the great businesses in any decade and just made judgments about those businesses, Fed policy would not have derailed any of those arguments one way or another except over the short-term.

Thus, while it’s worth being aware of the Fed’s moves, the Fed just has limited impact on investors focused on long-term investments, and we shouldn’t become overly focused on it.