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Plenty of money in the US

The US Federal Reserve has been propping up markets with a wall of money. Is this sufficient to support markets as companies start to face the new reality?

US dollar notes

by
John Redwood

in Features

28.05.2020

Last year, Donald Trump continued his battle against the Federal Reserve Board. It thought the economic cycle was well advanced, employment was strong, and were looking to raise interest rates as they entered 2019. In December 2018 it increased rates to 2.25-2.5% and was signalling three more rises the following year.

The board wanted to tighten money conditions, make credit a bit more expensive, and be in good shape to prevent any inflation as the cycle matured. The President looked at his electoral timetable, remembered his pledge of faster growth, and saw a world of low interest rates and low inflation all around him. Why couldn't the US have some of those zero interest rates that Japan and Europe set? Why wasn't it right to offer cheaper credit so more people could invest, build and buy properties, and purchase new cars?

The Fed, in late January, realised that it was making a mistake, and announced it would pause its rate rises. The economy was not growing as quickly as it thought, and inflation was not on the rise.  It also started looking into its plans to reduce the size of its balance sheet, swollen by purchases of government debt through its past Quantitative Easing programme.

The Fed gets onboard

As the year advanced, the Fed moved closer to the President's view, cutting rates and deciding it should not try to cut its balance sheet so quickly. As a result, the US economy had a reasonable year, consumer inflation did not get out of control, and the stock market performed very well. Money growth spurted forwards, hitting 8% for 2019 compared with the more normal 4%. The President liked the combination of asset-price inflation and modest consumer price rises – and wanted the Fed to do even more.

When various states entered severe lockdowns to combat the pandemic, which hit early in 2020, the Fed decided it wished to join the Administration in orchestrating a massive monetary and fiscal response. There was plenty of deflation to offset, with a surge in unemployment hitting consumer incomes and the shutdown of substantial parts of the economy hitting supply as well as demand.

The Fed went for rate cuts, driving interest rates down towards zero, and instigated a big expansion of Quantitative Easing. The Fed also worked up joint programmes with the Treasury to give itself the legal powers to buy-up company debts as well as government bonds.

There was a big successful effort to prevent a meltdown in credit markets, as people became nervous about the creditworthiness of many companies. This was no ordinary recession where companies could lose a quarter or a third of their income. It was for many a sudden loss of all their income, which would soon lead to insolvency without financial support.

Unchartered territory

As a result, we have now lived through the most extraordinary three months in US money policy history. By the end of April, M2 money had grown by 18% in just three months. There has been further fast growth in May. Once the Fed had turned the bond markets from their extreme pessimism, some of this money found its way into share markets to fuel a rally. Despite the bleak news background for many companies, enough investors sold bonds to the Fed and then reinvested some of the cash into shares.    

Most commentators focus understandably on the short-term outlook for inflation. That is set to move downwards, as weak oil and commodity prices feed through, and as many businesses struggle to sell anything very much against the depressed demand background. It is difficult constructing an accurate price index for April or May, for what is the effective price of a flight or theatre ticket or cinema seat?

What next?

As we come out of lockdown, will there be substantial price cutting in discretionary spending areas to woo people back to the High Streets and restaurants? Whilst there is a big boost to the quantity of money, the velocity of its circulation can continue to fall if people and companies just decide to hold on to more cash for comfort.

The issue is what happens a bit later, as more economic activity develops and as some more consumer and investor confidence returns?  Could there be inflation of asset prices and more generally of popular goods and services?

There is likely to be plenty of money around for those fortunate to have avoided bankruptcy and job loss during the Covid-19 recession. So far, the avalanche of money has been sufficient to prevent a collapse of share prices – and has left the US market outperforming most of the rest of the world.

The US market has also benefitted from having more of the companies that power the digital and medical markets that are in demand during the pandemic. There could be more to come, all the time the Fed is more worried about deflation than inflation.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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