Why Monetary Policy Matters

When I made the decision to study Economics, I did so because I saw economics as the base on which our society is built. No matter what you studied in college, be it Engineering, Philosophy, Actuarial Science, Business, Fashion, or anything else- your career invariably will tie to the state of the economy as a whole. Without a doubt, Macroeconomics is a complex topic, and no one person holds every answer to the many questions that surround it. Lately however, I have seen egregious oversimplifications of the way our economy works, and what factors really have an impact on it. This is an issue, because it leads to an ignorant exuberance where people formulate bold opinions off of snap judgements that, more often than not, are tethered to personal beliefs rather than facts. Hardline Trump supporters will give him credit for the economy, and hardline Obama supporters will bestow the same praise upon him. Both groups are wrong in doing this. As I’ve said before, our society suffers from horrendous short sightedness, in which we view trends in a one year window, when we should be viewing them in a 10 year window.

Just look at people try and explain the stock market’s activity. I guarantee you, that 99% of the opinions you hear begin with:

“Since Donald Trump was elected….”

What is the problem with this?

To begin, opinions that start off with those five words brazenly discount all the other factors that influence our markets like: interest rates, inflation levels, geopolitics, labor markets, aggregate demand, supply chain stability, business cycles and much more, but you get the point. Does Trump’s promise to cut taxes play a role in this rise? Of course it does, but when you reduce your entire explanation of the world’s financial system to one sentence, it tells people more about your intellectual laziness than it does anything else. Also, it is probably worth noting that the current administration has passed 0 legislation that would impact financial markets. I would like to follow that point up with the fact that this is not an “Anti-Trump” piece, as I believe that heaping praise on his predecessor for the stock market is equally as misguided. The only purpose of this piece is to give any curious mind a better understanding of the world they live in. In order to do that, it is important to remain impartial. 

This post will be broken down into two separate parts and a conclusion. Part one will focus on explaining what monetary policy is, and how it has recently been used. This will bring us back to the actions taken during and after the 2008 recession. In this section, important economic relationships will also be explained. In part two, we will take the information from part one and apply it towards a conversation about US inflation levels, and how they have impacted the stock market. By the end of part two, the real driving force behind the stock market’s recovery should become much clearer.  Hopefully, you can use the information in this piece as a springboard for your own curious endeavors into this topic. But before getting into it, let’s make one thing clear: Hard things are hard. The reason this perspective isn’t readily available on cable news is because this is a complicated subject, and it cannot easily be explained in a 30 second sound byte. It takes time to cultivate an understanding about complicated subjects, but I believe that the time spent doing that is time well spent. 

Part I: Monetary vs. Fiscal policy

Off the top of your head, can you answer what the difference between Monetary and Fiscal policy is? I’m sure some of you can, but I’d wager that some of you may struggle at first, and that is okay- this isn’t supposed to be easy. If you want to broaden your understanding of our markets beyond “Trump was elected then this happened”, then understanding the difference between these policy types is a great starting point. So, think of it like this: fiscal policy is anything a president can do. Think of things like tax cuts, tax increases, and regulations. Monetary policy is anything a Central Bank (like the US Federal Reserve) can do. Think of things like interest/discount rates, or Large Scale Asset Purchases (LSAPs) for the purpose of Quantitative Easing (more on what this means soon). Now, I would say that most of you already know a fair amount about fiscal policy, but you may not have the same background with monetary policy.

Before we get started, it is important to understand this point: Global monetary policy, not fiscal policy, is the driver of our financial markets. So the next time you hear “Since Donald Trump was elected”, remember that. If you do not agree with me, I ask you to counter the points I will make below.

Monetary policy in 2008

In 2008, the global economy was brought to its knees by a financial crisis rivaled only by the Great Depression. In order to support an economy that was truly in free fall, the Federal Reserve (monetary policy!) took a number of measures that we’ll touch on below. This is important, because understanding these points will allow you to understand what is going on in the market today:

  • Lowering of the Federal Funds Rate

When you go to the bank and take a loan out, you have to pay interest in order to borrow that money, right? Now, would you rather take out a loan if interest rates were 1% or 30%? Obviously, you’d prefer a 1% rate. So, similar to you and I, banks must also borrow in order to conduct their day to day operations, and they often times work together to ensure that they are able to meet liquidity demands. Often times, they will borrow from each other to do this. The Federal Funds Rate (set by the Federal Reserve) is the maximum interest rate depository institutions (banks) can charge each other for overnight lending. When the FFR is high, it costs more for banks to borrow from each other. This means that they must now charge their own borrowers (families and businesses) even higher rates. When rates are high, less people borrow and therefore, less money is moving the economy. This brings us to a fundamental point about the profitability of banks: Banks rely on the difference between interest rates to make money. In other words, if a bank borrows at a 1% interest rate, and lend at a 3% interest rate, then that 2% difference is their profit. Put simply, when banks borrow at a reduced rate, they can lend at a reduced rate, making money cheaper for everybody. Lowering interest rates is often times the first step the Federal Reserve takes to fight back during a recession, and now you know why.

However, something you must bear in mind is the relationship between interest rates and inflation, and the best way to describe this relationship is through a simplified example:

Say that there was only $1,000 dollars on earth. With such little money to go around, the prices of goods would be quite cheap, right? Perhaps a car would cost $3. Now, what do you suppose happens when we take that $1,000 and increase it to $1 Billion? Do you think a car would still cost $3? Absolutely not. In this made up world where $3 used to be enough to buy a car, increasing the total supply of money to $1 billion has the effect of making those $3 dollars worth far, far less. This is how inflation works.

So, when interest rates are low, more money gets pumped into the system. With more money in the system, each dollar is worth less and less. That is a simplified explanation of the relationship between interest rates and inflation. Remember this, because this is critical to what is happening right now.

2) LSAPs

Before talking about the Fed’s LSAP program, it is important to discuss the relationship between stocks and bonds:

Investors are always trying to find the balance between growth and security. While stocks are better suited to provide growth, bonds are seen as a “safe space” for your money. Usually, investment portfolios are comprised of a mix of stocks and bonds, with the specific allotments determined by the investors own goals (do they want a lot of growth, or do they want a lot of stability?). As you can see, this is a trade off, and when the stock market is too risky to justify potential returns, investors turn to bonds to ensure their money is safe. Conversely, when bond yields are too low to justify the stability they offer, investors turn to stocks.

Q: But why are treasury bonds safer?

Treasury bonds are safer because they are essentially a loan to the US Government, and loans must always be paid back. Investments? If you invest in a company, they are not responsible for paying you back should you lose your money.

Q: How are they Priced?

Bond yields are set by issuers to compete with average stock market returns. For example, if the Dow Jones is giving investors a return of 10%, bond issuers will offer bonds that provide a similar return.

“This bond guarantees an income of $1,000, and we’ll let you own it for $900. When the bond matures, and you give it back to us, you will have made a profit of $100, or 10%”.

That is a grossly oversimplified version of how bonds work, but now you get the idea. Just remember: bonds are loans, and stocks are investments. There is a big difference.

Now we can actually get into LSAPs.

After the Fed lowered interest rates, they began purchasing a record amount of assets in the private market. These assets included long term securities issued by the government (bonds) as well as mortgage securities issued by government sponsored entities like Fannie Mae and Freddie Mac. As a general rule, it is important to remember that when the Fed wants to increase money supply during a recession, they will buy bonds off the market.

Even if you didn’t study Economics, you are probably familiar with the law of “supply and demand”. Let’s put that familiarity into practice right now.

Generally, prices for an asset increase when one of two things happen: either supply goes down, or demand goes up. When the Federal Reserve bought these bonds, supply went down, and price went up. So, take that bond with a face value of $1,000 we mentioned earlier. Because of the decline in supply, the price of the bond increases to, say,  $950, cutting your returns in half. Remember what we said about bond yields being too low? Can you guess what investors do when this happens?

Correct, they buy stocks!

Now, what happens when the demand for stocks go up?

2/2! The price of stocks will increase!

What has happened to stock prices since the Federal Reserve lowered interest rates and purchased assets?

3/3 you stud! They’ve gone up dramatically!

Part II: Inflation

Now that we know a few of the underlying relationships that have impacted the stock market since 2008, we can talk about them in practice. Since 2009, the US stock market has skyrocketed for reasons we just discussed. One of the most important things we spoke about was the relationship between interest rates and inflation. This relationship is taught in Economics classrooms as a near certainty; however, a look at inflation levels today seem to challenge this lesson.

What does this mean?

In part one, inflation was accurately described as a phenomenon that has the effect of lowering the value of each dollar. Historically, interest rates have been used to tame inflation, and you can read about that here. However, while many would have expected our low interest rates to lead to an increased rate of inflation, we’ve actually seen the opposite happen when we look at the rate of inflation from 2009 to now:

Screen Shot 2017-10-18 at 9.59.02 AM.png

As you can see from the table above, the rate of inflation decreased from 3% in 2011 to nearly 0 in 2015, before picking up in 2016.

Why does this matter?

Earlier, we discussed how low interest rates result in more money in the system, and how more money in the system should lead to higher levels of inflation. However, we have just proven that even though we have relatively more money in our system, inflation levels have not kept up.

So, ask yourself: Do you think this could have anything to do with companies having record high valuations in 2017? In other words, if we have more dollars to invest, and inflation hasn’t really eaten away at the value of each dollar, is it irrational to say that this would lead to increased stock valuations?

I certainly don’t think so.

Conclusion

God bless you if you’ve made it this far. Honestly, thank you for reading.

Let us go back to the “Trump argument”. While the stock market has reacted positively at the thought of lower tax rates, this is far from the main driver of our financial markets. As I said at the beginning of this piece, we are doing ourselves a great disservice when we choose to view the world in an oversimplified 6 month or 1-year window. What we are seeing in the stock market today, is the manifestation of years of Quantitative Easing in reaction to the 2008 recession, not a reaction to an election. When interest rates are in fact brought back to normal levels, it will be very interesting to see just how quickly the president and his supporters take credit for the subsequent fall in equity prices. 

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