Let me apologize ahead of time; I’m afraid this column may be a tough. Maybe even a sleeper. But the topic is timely and extremely significant so I’m going to do it anyway. Once again, sorry.
This week the Federal Reserve began its well anticipated process of what is called “quantitative tightening,” which is the mechanism the central bank will use to attempt to reduce the supply of money in the economy.
The flip side of this coin, quantitative easing, has been discussed many times in this column previously and is when the Fed creates new money to buy bonds, or as someone cynics call it, “printing money,” although the process no longer involves any actual printing and is done entirely electronically. Quantitative easing is quite popular with investors as it serves to liquify markets and tends to drive interest rates lower and stock markets higher. Which then begs the question, if stocks tend to love quantitative easing, how will they react to quantitative tightening?
First, it’s interesting, and I guess important, to understand how this quantitative tightening actually occurs. The Fed will not go out and procure cash and then take this cash and shred or burn it. It will not reach into anyone's financial accounts and make balances disappear. The Fed holds trillions of dollars in bonds, real bonds, just like the bonds owned by banks, mutual funds and pension funds. The real bond portfolio owned by the Fed has its own maturity schedule and receives interest (coupons) like any other bond portfolio. When the Fed is in quantitative easing mode, the proceeds from maturing bonds and the interest paid by bonds is recirculated into the financial system by purchasing new bonds.
When the Fed is doing quantitative tightening, however, as its bond portfolio receives interest and as bonds mature and return capital the proceeds from these payments are not recirculated, they simply go away. As this money "retires," it ceases to exist, and the overall supply of money is reduced. Less money in existence, theoretically means less money to be used for goods and services, which then also theoretically means the prices on goods and services will go down, or at least not go up as fast, which of course is the definition of inflation, and inflation is public enemy number one right now.
The Fed’s plan at this point is to “retire” $47.5 billion per month for the next three months, and then increase the pace of reduction to $95 billion until the overall supply of money returns to roughly pre-COVID levels or inflation is tamed, or both.
This process of tightening actually began in 2017, but was considerably interrupted by the economic policies related to COVID, and the process must now attempt to pick up where it started, only after increasing the size of its bond portfolio by over 100% since March 2020, the job at hand is now much larger in scope.
So, what does all this wonky econo-speak really mean for the rest of us? Well, the Fed must slow down the rate of inflation. Price increases at the current pace, aka inflation, have the capacity to undermine confidence in the entire economic and financial system, and when inflation stays high for too long, bad things can happen.
The primary tools in the Fed’s toolbox — interest rates, and now quantitative tightening — are designed to shrink the overall pool of money, which is likely to have a host of perhaps intended consequences. One of which should be expected to be lower asset prices, with assets in this case being stock prices and real estate values.
It’s a little tough to think about, but when a stock price goes down, or a home loses value, the owner of these assets has less money. Does this mean, however, that someone else gained the money that was lost? Not really, the price went down, the money is simply gone and no one “got it.” In a very real way, policies that result in lower asset prices are an extremely effective tool of reducing the overall money supply in an economy.
While it could be argued that lower interest rates are only indirectly targeted at lower asset prices, it's harder to make that case about quantitative tightening. In order to address inflation, the Fed needs less money in the economy. Starting this week, the writing is on the wall, as every investor has at some point heard, “don’t fight the Fed.”
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stock investing includes risks, including fluctuating prices and loss of principal. Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at firstname.lastname@example.org. Securities offered through LPL Financial, member FINRA/SIPC.