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What May Be in Store as the Fed Cuts Back on the Easy Money

The world has been awash in trillions of dollars in easy money since early in 2020. Now, some of that money is going away.

The gush of funds has helped alleviate the suffering inflicted by the coronavirus pandemic and propelled the global economy. But powerful growth — the U.S. economy expanded at a 6.9 percent annualized pace in the last three months of 2021 — has been accompanied by sizzling inflation. Consumers and investors experienced increases in the prices of millions of items and services, ranging from houses, apartment rents and gasoline to the stocks in their portfolios.

As government aid programs wind down, some of the fiscal stimulus has already begun to ebb. And on Wednesday the Federal Reserve said it planned to reverse the monetary stimulus under its control.

These changes have enormous implications for financial markets, which haven’t been handling the news especially well so far. While Jerome H. Powell, the Fed chair, told reporters about the bank’s intentions on Wednesday afternoon, stocks plummeted, continuing a decline that began on Jan. 3 amid a spreading presumption that Fed policy was shifting.

The Fed is, in a sense, the central bank for the world, and when it changes course, the stakes are high for the entire planet. How far the Fed will go, and what will happen to inflation, economic growth and employment, are crucial questions.

Inflation hasn’t been ‘transitory.’

Inflation is driving the Fed’s shift. The Consumer Price Index in December rose at a 7 percent annual rate, the fastest pace in 40 years.

How much of this inflation has been caused by government and central bank stimulus policies and how much by bottlenecks and behavioral changes set off by the pandemic is the subject of a vigorous debate. The Fed had sided with the camp that said the problem was mainly “transitory” and would ease when the pandemic did. But both the pandemic and inflation have been stubbornly persistent, as Mr. Powell acknowledged on Wednesday. Rising prices are causing hardships for people living paycheck to paycheck, he said, and eroding the wealth of many investors.

Understand Inflation in the U.S.

  • Inflation 101: What is inflation, why is it up and whom does it hurt? Our guide explains it all.
  • Your Questions, Answered: We asked readers to send questions about inflation. Top experts and economists weighed in.
  • What’s to Blame: Did the stimulus cause prices to rise? Or did pandemic lockdowns and shortages lead to inflation? A debate is heating up in Washington.
  • Supply Chain’s Role: A key factor in rising inflation is the continuing turmoil in the global supply chain. Here’s how the crisis unfolded.

First, the Fed plans to raise interest rates.

To combat inflation, the Fed plans to start by raising the Fed funds rate, its benchmark short-term interest rate, which it has held near zero since March 2020. It’s likely to start in March. How high that rate will go, and how quickly, isn’t clear.

The Fed lowered rates to the “zero bound” for the first time during the financial crisis of 2008. It was part of a great experiment, an effort to rescue the shaken financial system and the sinking economy when Ben S. Bernanke was chair.

But the experiment never really ended. Because the economy remained weak, the Fed didn’t begin raising rates until December 2015, and it never got far.

By 2019, when Mr. Powell was chair, the Fed funds rate had reached only 2.50 percent before signs of economic weakness made the Fed stop. In March 2020, it fell back to nearly zero. By contrast, the Fed funds rate was as high as 6.60 percent as recently as July 2000.

So there is reason for skepticism about how far the Fed will be able to go this time. Rising interest rates tend to reduce economic activity, which, in turn, tends to reduce the rate of inflation. Interest on car loans and some credit card loans will rise along with short-term rates, for example. That can be expected to cut demand for cars and, perhaps, thwart further big price increases.

But if the economy weakens too much, the Fed might reverse itself once more. Yet if inflation keeps rising, the central bank could be forced into far harsher measures than it now contemplates.

Next, the $8.9 trillion balance sheet.

After the Fed starts to raise rates, Mr. Powell said, it will use another tool: paring the bonds and other securities on its huge balance sheet.

The assets owned by the Fed swelled in another grand experiment of 2008, known as quantitative easing, in which the Fed began buying bonds and mortgage-backed securities. Those purchases had the effect of lowering interest rates in the bond market.

A broad range of investments by families, private businesses and giant corporations are tied to those rates. And low bond market rates helped to make stocks comparatively attractive and to set off a bull market, which is threatened now by the Fed’s imminent policy reversal: quantitative tightening.

The amounts involved in the Fed’s quantitative easing have been staggering. Back in 2008, the Fed’s balance sheet had assets of $820 billion. They reached $4.5 trillion — yes, trillion — in 2015 and dropped only as low as $3.76 trillion in the summer of 2019. With the coronavirus financial crisis, they have ballooned again, to $8.9 trillion, and may swell a bit more before the spigot shuts. Assets held by the Fed are already more than 10 times their size in 2008, and bigger, as a proportion of gross domestic product, than at any time since World War II.

The Fed’s monetary stimulus accompanied a total of roughly $5 trillion in pandemic fiscal relief by the federal government. Governments and central banks around the world engaged in emergency relief spending, too. The global fiscal and monetary stimulus total amounts to $25 trillion, according to Chris Dillon, a global investment specialist with T. Rowe Price, the asset management company based in Baltimore. This year, that flow is being reduced to a comparative trickle.

Inflation F.A.Q.


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What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar will not go as far tomorrow as it did today. It is typically expressed as the annual change in prices for everyday goods and services such as food, furniture, apparel, transportation and toys.

What causes inflation? It can be the result of rising consumer demand. But inflation can also rise and fall based on developments that have little to do with economic conditions, such as limited oil production and supply chain problems.

Where is inflation headed? Officials say they do not yet see evidence that rapid inflation is turning into a permanent feature of the economic landscape, even as prices rise very quickly. There are plenty of reasons to believe that the inflationary burst will fade, but some concerning signs suggest it may last.

Is inflation bad? It depends on the circumstances. Fast price increases spell trouble, but moderate price gains can lead to higher wages and job growth.

How does inflation affect the poor? Inflation can be especially hard to shoulder for poor households because they spend a bigger chunk of their budgets on necessities like food, housing and gas.

Can inflation affect the stock market? Rapid inflation typically spells trouble for stocks. Financial assets in general have historically fared badly during inflation booms, while tangible assets like houses have held their value better.

The risks of moving at the wrong pace.

Calibrating the combined effects of quantitative tightening and interest rate increases in real time is exceedingly difficult. Cut off stimulus too rapidly and the Fed could further unnerve financial markets. It could conceivably cause a spike in unemployment and a sharp slowdown in growth, plunging the United States into a recession.

Move too gingerly, on the other hand, and the Fed could allow elevated inflation expectations to become embedded, making high inflation even more damaging. The last time that happened, when Paul A. Volcker was Fed chairman from 1979 until 1987, it took brutally high interest rates, soaring unemployment and two recessions to wring high inflation out of the national psyche.

No wonder Mr. Powell said the Fed would need to proceed with “humility.”

The Fed’s task is fraught with risk, said Kathy Jones, chief fixed-income strategist with the Schwab Center for Financial Research. The bottlenecks in the economy could clear up if the coronavirus ebbs, which could solve part of the inflation problem.

Through control of the Fed funds rate and its ability to adjust the pace and type of securities it sells when it reduces its balance sheet, the Fed can affect a broad spectrum of interest rates.

Even if the Fed manages to avoid a recession that throws a lot of people out of work, the path ahead is unlikely to be smooth.

For investors, high-quality bonds should help to buffer volatility, and big losses, in stocks. And you could try adjusting your stock holdings. In this environment, for example, T. Rowe Price suggests emphasizing value stocks like AIG, Bank of America and General Electric over growth stocks like Microsoft, Amazon, Visa and Nvidia, and investing globally, especially in emerging markets. Whether those moves will really help, I can’t say.

Fixed-income investors might want to tilt some holdings toward securities of shorter duration, Ms. Jones said. That’s because as interest rates rise, bond prices, which move in the opposite direction, can fall enough to lead to losses, especially for long-term securities. Still, over several years, as bonds are reinvested at higher rates, returns will increase in many bond funds, offsetting short-term losses.

Doing nothing may be a good option if you can afford to withstand some blows and have a diversified portfolio. I’ve been investing in stock and bond funds for decades and believe I’m sufficiently fortified with cash, in case things become really nasty.

If you aren’t ready, it may make sense to sell off some holdings. It’s always smart to be well prepared, even if trouble never shows up at your door.

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