In this episode of “Investment Management Foundations,” Gary Quinzel, Vice President of Portfolio Consulting at Wealth Enhancement, discusses the significance of monetary policy, highlighting its impact on interest rates, economic stability, and investment market behavior.

VIDEO TRANSCRIPT BELOW

Hello everyone. Welcome to the latest segment of “Investment Management Foundations.” My name is Gary Quinzel, Vice President of Portfolio Consulting at Wealth Enhancement. Today's topic is why monetary policy matters. I'm going to outline three reasons why we think that monetary policy matters.

First, monetary policy impacts everything from the interest rate that you pay on your mortgage, to how much yield you get in your savings account. Almost every interest rate in the world is tied in some degree to the rates that are set by the Federal Reserve and other major central banks around the world. The second reason that monetary policy matters is because it has become incredibly important, as it's helped rescue the economy from deeper peril during periods of heightened uncertainty and financial instability. Without the significant rescue packages that were issued during periods like the global financial crisis, such as the Troubled Asset Relief Program, it's hard to imagine how much worse the global financial crisis may have become. The third reason why monetary policy matters is because it's become an incredibly important driver of the markets, and more importantly, the communication about monetary policy has become an important driver of markets. As an example, if we think back to the fourth quarter of 2023, when the Fed first signaled that they were done raising interest rates, that marked a turning point. The market has considerably rallied on the anticipation of lower rates, which are looked at as a positive or beneficial for markets and for equity markets, as well as fixed income.

So, let's look a little closer at what exactly the Fed does. Central banks use monetary policy to help achieve price stability as well as maximum employment. Central banks enact monetary policy by influencing the supply of money. By increasing the supply of money, they put more money into the financial system, which encourages spending and thereby boosts economic growth. But of course, it can also put upward pressure on inflation. Conversely, if central banks decrease the supply of money, this makes money more scarce or expensive, which could then slow down spending with the intention of decreasing inflation. But then, of course, the byproduct of that is it can decrease money supply, and you can actually push the economy into a recession.

So, how does the Fed and other central banks increase or decrease the supply of money? They use open-market operations, which is essentially the buying and selling of government bonds and treasuries and agencies, and when the Fed conducts large-scale purchases, this can be referred to as quantitative easing, as it expands the Fed's balance sheet. If we take a look at the first chart, we can see some notable examples of when the Fed has increased their balance sheet in the past. We can see that leading up to around 2008, the Fed's balance sheet was under $1 trillion, and it was very consistent and steady up until the crisis, when it more than doubled in just a few months. We then see that it increased up to around $4.5 trillion after multiple rounds of quantitative easing, finally started to decrease around 2018, and then, of course, we saw a significant increase in the balance sheet due to the rescue packages affiliated with the Covid pandemic rescue.

The Fed, of course, also influences money supply through their open market operations, which determines the federal funds rate. So, this is the target rate by which commercial banks borrow and lend their excessive reserves to each other overnight. And the FOMC is the policy-making body of the Federal Reserve. What we can see from the second graph is that the federal funds rate has been a fairly reliable indicator in that it has helped suggest when different recessions have occurred. Now, it's not a perfect indicator, as we can see from the chart, in the mid-90s, we saw the Fed stop raising rates, and then started to come back down again without a recession occurring till later in 2000. But overall, what we can see from the pattern is that once the Fed has gone from being done raising rates to starting to cut rates, a recession has occurred after that. So, the takeaway here is that we are now at a point where the Fed is done raising interest rates, or at least they've communicated that, and they signaled that rates have started to come down.

So, the question is, do we have a recession coming right now? The economic data and evidence that we see does not suggest that, but of course, time will tell, and we will continue to look for more evidence that that will help suggest when the next economic downturn will occur. But we do know that monetary policy is incredibly important for all the reasons mentioned, because it helps rescue the economy, it helps it influence the markets, and of course, it helps set the interest rates that we pay on our mortgages and other spending. We hope you found this information segment useful, and we hope you can join us on future episodes of “Investment Management Foundations.”

This information is not intended as a recommendation. The opinions are subject to change at any time and no forecasts can be guaranteed. Investment decisions should always be made based on an investor's specific circumstances. Investing involves risk, including possible loss of principal.

2024-4844