Why the Fed and Monetary Policy Matter–Made Simple

It is difficult to understand monetary policy on a good day.  Most of us don’t.  But we get a glimpse of insight when we, say, refinance our home and discover that thirty-year mortgage rates are below 4.0%. Suddenly we realize our monthly payment is going to be much cheaper than it used to be.  We might even be able to afford a bigger house with a bigger mortgage.  For most of us with finite budgets, it is all about the cash flow.

Not so for the federal government or the Federal Reserve Bank (Fed). They create cash flow.

You may have read that the Fed is buying approximately $80B in Treasuries and mortgage-backed securities each month.  This is referred to as QE (quantitative easing) 1,2,3 etc.  QE has been aggressively implemented by the Fed since 2008 and these purchases have grown the Fed’s balance sheet from $1 trillion in 08 to close to $3 trillion today.  But here is the important part for investors and taxpayers.

The federal government (think Washington D.C.) is borrowing money from individuals, foreign governments and corporations when it issues Treasury bills, bonds and notes.  If you own a treasury bond or treasury bond fund you are lending your money to the federal government.  But lately the appetite for U.S. treasuries–particularly among foreign governments has declined.  Here is where the Fed comes in.

Since each of the twelve Reserve Banks (that comprise the Fed) is authorized by the Federal Reserve Act to issue currency, when the U.S. government issues an excess of treasuries (borrowing), the Fed is able to print money to buy up the excess treasuries the public doesn’t purchase.  To the tune of almost $1trillion per year since 2008.  Currently the Fed is buying about 57% of the treasuries issued because the demand for U.S. government debt has declined just as our government’s spending has ramped up.

In the real world the transaction might look something like this:  You want to buy a new car.  But you can’t afford the car and you don’t have the money.  So, you decide to lend yourself money with money you don’t have to make the purchase.  You write yourself a check from an account with insufficient funds (in other words you print your own money–kind of), deposit the check in another account, run down to the car dealership and  pay for the car out of the account with the kited funds.You go to jail.

But for the government it is completely legal.

So why do we care about this?  Two reasons.  The first is that while I am a long-term bull on the U.S. equity market, in the short-term, much of the appreciation in stocks which began in 2009  has been fueled by QE. By keeping interest rates so low the Fed is encouraging investors to turn to the stock market for higher returns.   The second reason is that flooding the economy with currency to fund unchecked government spending (recall that the Senate hadn’t passed a budget for the previous four years until a few weeks ago) can lead to inflation and very slow growth in the real economy.

So don’t get caught up in the short-term, day-trading hype propagated by the financial media.  Stay the course.  Buy great companies for the long-term. Over a reasonable period of time the stock market averages approximately 9% per year even when all the bear markets are included.  But, buy quality.  Oh, and use real money to fund your purchase.

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