What is the Federal Reserve and Why Should My Generation Care?
The Federal Reserve, simply put, is a bank for our banks. When I need some money for a business or a mortgage to purchase a home, I go to my local bank and apply for a loan. Founded in 1913 with the purpose of alleviating financial crises, the Fed was was born. The initial thinking behind the creation of the Federal Reserve was to help regulate inflation by having a central bank to which banks could go for loans. That’s definitely not all the Fed does, however. The stated purpose of the Fed is as follows:
- Conducts the nations monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy.
- Promotes the stability of the financial system and seeks to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad.
- Promote the safety and soundness of individual financial institutions and monitor their impact on the financial system as a whole.
- Fosters payment and settlement system safety through services to the banking industry and the U.S. government.
- Promotes consumer protection and community development through supervision, economic development activities, and the administration of consumer laws and regulation.
So, the Federal Reserve basically lends banks money, accepts deposits from member banks, and tries its best to monitor risks and promote consumer protection via economic stimulus activity and regulation.
Clearly, if you’ve been paying attention to our economy since the Fed was created, they haven’t necessarily done a terrific job with the monitoring of risks since 1913 (Great Depression, 2008 Financial Crisis, and Covid-19), but it has been argued without the Fed those economic disasters would have been the end of our economy as we know it.
Covid-19 was an unprecedented (in modern times) global event that wreaked absolute havoc on arguably the greatest American economy we had ever seen. The United States went from a 50 year low 3.5% unemployment in February, 2020 to 14.7% in April — an all-time high. We also saw the S&P 500 fall from an all-time high of $3,386 (ES-Mini Future Contract price) to a March low of $2,237 — a 33.9% drop.
What has happened since has been even stranger, to those with a knowledge of how the New York Stock Exchange works and the history of the Fed’s second function stated above (promotes the stability of the financial system and seeks to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad). The Federal Reserve began buying corporate bonds and junk bonds, as well as indirect purchases of U.S. ETFs (via a special purpose vehicle as the Federal Reserve cannot own actual shares of U.S. stocks). This has never been done by the Federal Reserve in their 100+ year history. Using these special purpose vehicles, the Fed has purchased over $750 billion dollars worth of bonds and ETF’s over the past 8 weeks.
Below I outline the issue most people under age 40 I have directly and indirectly spoken with have with this change in policy…
Traditionally stock markets go through cycles, we have periods of growth called “bull markets” and periods of regression (either “bear markets”, “recessions”, or “depressions”).
Almost every single market analyst believed we were headed for a depression, and at the very least a recession, due to the forced temporary closure of the majority of small business in the United States and the loss of 40 million jobs.
This would have been the healthy time for a recession regardless, as we were at the end of a 10 year bull market which was on its final legs. This was the longest bull market in U.S. history, and a strong correction was due from a technical viewpoint. Although no one likes recessions, they are necessary to allow the next generation of purchasers to enter the stock market at low prices, feeling confident that their money will grow over time as it did for the generations before us.
However, when money is printed (and the U.S. Treasury has digitally printed over 7 trillion dollars this year to avoid a depression) in order to artificially hold up markets and stimulate growth, stagflation becomes a serious risk. We saw this happen in Japan, and then in Europe, as central banks printed money and created negative interest rates to avoid depressions, leading to increased inflation and decreased economic output as their larger generations left the workforce. Stagflation means that the market never returns to all-time lows, but it also never creates new all-time highs. It is, in essence, range bound. In order to protect the assets of the wealthy, older generations those markets protected themselves from depressions at all costs, and neither have set a new high in the last 15 years. Japan’s Nikkei market peaked in 1989, Europe’s EURO STOXX peaked in 2000.
While this modern monetary policy certainly helped protect those nearing retirement from losing everything, it also meant the generations that came after them no longer trusted their stock markets for long term growth. Instead, they invested elsewhere. Are we now at an increased risk of stagflation in the United States? Of course we are, if inflation were to suddenly rise due to another economic crisis, stagflation would almost certainly be the outcome if we continued to print money to artificially avoid another crash.
Let’s hope that doesn’t happen.
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About the Fed