The federal reserve of the United States recently announced new measures to stimulate the economy and maintain economic order in these troubled times due to the coronavirus.

You may be confused about why the stock market is so bullish when the entire economy appears to be shut down. In this article, we will discuss some of those measures and examine the disconnect between the stock market and the current market sentiment.

What is the federal reserve?

The federal reserve can be thought of as the central bank of the United States. Their main job is to ensure the functioning of the economy, as well as serve as a financial reserve in times of economic need for banks and businesses.

They achieve this through various means, the primary one being the adjustment of federal reserve interest rates. To understand this concept, let us first start with the federal reserve requirement.

All banks are required to hold a minimum amount of money with the federal reserve at the end of each day, known as the federal reserve requirement. This is to ensure that if people want to withdraw money, they are able to do so from the bank.

A bank's primary business is to loan out money and earn through the interests derived from those loans. If there wasn't this federal reserve requirement, banks would attempt to loan out as much money as possible to make more interest, causing problems if people want to withdraw money from the bank. To prevent such a situation from happening, the federal reserve requirement was created.

Not all banks can hit the federal reserve requirement at the end of the day. Therefore, to ensure they follow regulations, they can borrow money from other banks with excess cash to make up for their deficit. The interest rate they have to pay the other bank is fixed by the federal reserve, and is known as the federal reserve rate.

Since this rate concerns the interest that banks have to pay out to loan money from one another (hence losing money), it directly affects all other interest rates that banks use with their own loans to businesses and individuals (the way they make money).

This makes sense because if you were taking loans at an interest rate of say 0.5%, you would definitely want to give out loans at a higher interest rate to ensure that you were still making money.

Therefore, the lower the federal reserve rate, the lower the interest rates on bank loans to businesses and individuals and vice versa. In times of crisis, where businesses are in desperate need of cash due to a lack of profit, the federal reserve tends to reduce their rates so that banks can loan out money at a lower interest rate, enticing more businesses to loan money without overtaxing their finances.

This helps to circulate money in the economy as businesses get a line of credit and cash flow, allowing them to stay afloat. Hopefully, when the crisis tides over, the businesses survives and is able to resume normal operation like hiring more people and contribute to economic growth again.

Remember when we mentioned the federal reserve requirement - the percentage amount of cash banks have to hold with the federal reserve every night (so they can't loan it out) to ensure that people can withdraw money?

In times of crisis, it is more important to get cash out there into the economy to keep businesses and individuals who need loans afloat. Therefore, the federal reserve will reduce the requirement during times of crisis to allow banks to loan out more of their money to stimulate the economy.

In fact, the federal reserve recently announced that it was lowering the requirement to zero. This means that banks can effectively loan out all of their money to ensure that the economy stays intact!

The federal reserve has also lowered their federal rate to 0%-0.25%. This is as low as interest rates go, and they are really encouraging banks to start loaning money at low interest rates.

Federal reserve measures

In our past article examining why the markets are still doing well, we had a basic exploration of the federal reserve and quantitative easing. Do check it out!

As mentioned above, two key measures of the federal reserve to stimulate the economy includes lowering the federal interest rate as well as lowering the federal reserve requirement to encourage more loans to businesses.

Some other measures of the federal reserve include:

  • Extending lines of credit to businesses to borrow
  • Quantitative easing by purchasing treasuries and bonds, essentially providing cash to these entities that are selling these bonds
  • Bailing out companies with low interest loans
  • Providing bursaries to companies to discourage layoff of employees
  • Providing aid to affected individuals and unemployed residents through disbursement of funds

Do check out this article by CNBC to see some of measures the federal reserve has already taken. Hint - it's most, if not all of the measures.

As you can imagine, all of these measures have a direct impact on the economy as a whole. While a business alone might not have a large effect on the economy, this is the federal reserve we're talking about. They are the central bank representing the United States, the largest economy in the world.

As a result, they are able to move a lot of money, and when there isn't enough money, they can create money. They can implement these measures and keep pumping out money to ensure that businesses stay afloat throughout the crisis. As always, there are more explanations in our past article.

Disconnect between the stock market and the economy

If you have been following the markets for quite some time, you would have realized a serious disconnect between the stock market and the current economy.

As of the writing of this article, US's unemployment claims reach 30.3 million (that's the amount of people unemployed), and there are estimates that the US unemployment rate will hit 15.1%. The current unemployment rate is 4.4%, unseen since the last recession. If it does reach 15%, it will be the worst unemployment rate in the history of the US.

Graph of unemployment rates in the US
Unemployment rates in the US (spike circled in red due to coronavirus)

With key infrastructure shut down, spending has ground to a halt, and only online-enabled businesses are still thriving. The US's first quarter GDP contracted by 4.8%, the worst since the last recession.

In all aspects, the economy should be falling sharply, but the stock markets are still doing pretty well.

This is a key issue caused by the quantitative easing measures of the federal reserve, as explained in our past article.

In fact, a reporter asked Jerome Powell, chairman of the federal reserve about this disconnect between the current state of the economy and the stock markets, and whether this will prove to be a problem. The response is rather interesting.

Essentially, Powell mentioned that it is more important to keep businesses afloat right now than to worry about a disconnect in the markets and the economy affecting financial stability.

He said that the federal reserve remains confident that the economy will bounce back quickly when the virus comes under control.

When the spread of the virus is under control, businesses will reopen, and people will come back to work. There is every reason to believe that the economic rebound, when it comes, can be robust. - Jerome Powell

This makes sense. Most of the economy is predicated on the fact that there are large businesses hiring a majority of the people in the country. This gives the people spending power, which in turns goes back into the economy as spending, and that's how businesses grow.

Since businesses are key in ensuring the financial stability of an economy, it is imperative to keep them operational and running. If, with some help, the majority of key businesses are able to tide through this crisis, then the rebound can be quick if these businesses recover operations and resume hiring.

Therefore, in an ideal scenario, the main priority of the federal reserve is to ensure the stability of the following entities in order:

  1. Banks/States
  2. Large businesses
  3. Medium/Small Businesses
  4. Individuals

This is in relation to their pure economic importance. Firstly, if banks or states run out of money, then it is impossible to help businesses and individuals recover since it will be difficult to extend lines of credit outwards to businesses.

Secondly, if large businesses fail, the economic ramifications will be immense. A key sector of the industry will crumble, and since large businesses have huge workforce, the unemployment rate will skyrocket. The hole left behind by the businesses will also take time to fill, resulting in subpar products or complicated restructuring, further hurting the rebound of the economy.

Thirdly, medium and small businesses, while hiring a smaller number of employees, make up a large part of the population purely due to their numbers. There are a lot of these home run businesses or companies which are active in a certain city serving as the livelihood of many people.

While some of these shutting down will not make much of an impact, a large collapse would definitely affect the economy pretty heavily. So while some can shut down, a majority must stay afloat to improve economic recovery.

Finally, individuals. As individuals ourselves, it can be stifling to see large businesses get help before us, but the fact of the matter is that it makes sense from an economic standpoint.

Sure, the government is rolling out measures to give individuals handouts to tide them over this crisis. After all, with unemployment rates rising, claims are rising as well. Individuals actually form a key part of economic recovery.

After all, for the economy to recover, spending has to improve. However, because not all individuals are needed for economic recovery, from an economic standpoint, it is more important to tide businesses through this crisis. As long as businesses can recover and hire sufficient individuals, the economy will recover.

The sad truth is that the remaining unemployed people will not affect the economy as much as the employed people under businesses that survive through this coronavirus crisis.

Of course, the federal reserve is still providing reliefs targeted as individuals, but one should note that their priority remains on large businesses. Powell has said that the line of credit for large businesses is almost ready, while mid to small businesses line of credit will still take some time.

In summary, the federal reserve is more focused on keeping businesses afloat than worrying about the disconnect between the stock markets and the economy right now. They are even willing to do this at all costs - which means infinite money printing.

Therefore, one should not expect the markets to behave rationally anytime soon, and one can even expect the markets to continue to rise. Don't fight the federal reserve - they are functioning with the entire US economy behind them.

The problem of inflation and deflation

With infinite quantitative easing and other measures, a key concern of economists has turned to the issue of inflation and deflation.

Firstly, let's address the issue of inflation. Inflation occurs when prices of goods and services rise, either due to increased demand from higher spending power or other reasons. You can read more about inflation in our guide here.

The concern here is that with the amount of quantitative easing the federal reserve is pumping into the economy, inflation will rise dramatically. This is because many businesses are taking on loans to stay afloat, but those loans are coming from money created by the federal reserve.

With so much money produced from nowhere, it is inevitable that the value of money will drop since there's an abundance of money.

However, that is a problem in the long term. In the short term, since people are not going out and spending money, goods and services are reducing their prices in a bid to encourage people to continue buying even in these troubled times.

Experts predict inflation rates of 1% by next year, lower than the 2% that the federal reserve is trying to achieve. The inflation rate is the increase in general prices of goods and services. The annual inflation rate was 2.3% last year, and is currently at around 1.5% as of March 2020.

Since most businesses and infrastructure are shut down due to the coronavirus lock down, inflation rates are actually dropping.

In the long term, if businesses reopen and people are employed, the spending power will go up. Then, if people start spending and the economy recovers, the abundance of money brought about by the quantitative easing may start showing its problems.

The cost of goods and services will quickly rise to meet the increased demand due to the huge influx of cash during this coronavirus crisis, causing higher than usual inflation rates. To that end, Powell said:

The federal reserve is strongly committed to maintaining 2% inflation over time, so we'll be there to work on that.

Therefore, we can assume that if inflation rates do jump sharply after the coronavirus lock down, they will have a new set of measure to deal with that.

The main problem now is deflation. Deflation occurs when people start to hoard cash instead of spending. This reduced spending hurts the economy since money is not circulating in the economy, causing economic stagnation.

As a result, the prices of goods and services will drop continuously due to lack of spending, reaching negative inflation rates - or deflation.

This could happen in a financial crisis, where everyone is holding on to their cash and waiting for prices to drop lower and get better deals, or simply to wait out the crisis. This also happens when the country is in lock down mode to deal with the coronavirus and spending is forcefully halted.

The good news is, according to Powell:

During the global financial crisis, there was a concern that we might see deflation, but it didn't happen. Inflation tended to move down a little bit as it will when demand is weak, but inflation expectations didn't move strongly down here in the United States. I would say as long as inflation expectations remains anchored, then we wouldn't see deflation.

Now, we all say that history doesn't predict the future, but it does serve as a learning point. The federal reserve is committed to maintaining a 2% inflation rate. While we are currently below that value, this is expected during the lock down as people literally cannot spend.

It is unlikely that deflation occurs as this was a recession brought about by the coronavirus, as discussed in our previous article. This was not a recession brought about by a crash, causing a natural reduction in spending as people hoard money. As a result, if one removes the virus and businesses resume, people should start spending.

Even in the last global financial crisis, which was a result of huge multi-national market crashes, deflation did not occur, meaning that inflation was above 0 and goods and services still increase in prices, signalling that there was still stable spending.

Chart of inflation rates over time in the US
Inflation rates of the US (0.09% during 2008 financial crisis)

In fact, the lowest it got was around 0.09% inflation rate during the last global financial crisis in 2008-2009. Well, that's pretty close to 0, but it's still a positive inflation rate.

In this unnatural recession triggered by the coronavirus lock down, we should expect even less of a chance of deflation as people are still willing to spend - just that they are not given a chance to.

The possibly of deflation could occur if this lock down period continues on for quite a long time and a vaccine is not found. It could also happen if a second wave of coronavirus strikes after the lock down is lifted, causing mass panic once again. Then, we would need to worry about deflation.

Summary

In summary, the markets are really irrational right now because they are following the federal reserve's measures. As individual investors, we should expect the markets to continue going up due to infinite quantitative easing, instead of following the general economic outlook.

We can also expect inflation to reduce, but we should not be expecting deflation to occur unless the coronavirus becomes worse or continues for a longer period. It is definitely a possibility - but we shouldn't expect it for now.

As a result, we can kind of say that yes, the dip happened a few weeks back, and it is all "priced in" now. Unless a second wave of coronavirus occurs or the current situation gets worse, that should be the case.

If the situation does get worse, then the possibility of deflation is extremely high. It is unknown if the federal reserve, with all its measures, would be able to keep the economy afloat at that point.

After all, while infinite quantitative easing works in the short term, infinite money cannot be loaned out to businesses and individuals. At some point, something has to break - loans have to be paid back. If that does not happen, then the economy will collapse sooner or later, and mass deflation will occur.

This could have severe repercussions on the economy. If the coronavirus crisis is solved, or a vaccine is found now, then recovery should be quick as people will resume spending normally. All this quantitative easing, absurd as it might seem, can be dealt with using other measures to curb inflation.

As an investor, what you need to know now is to continue on with your investment strategy. The markets are extremely irrational now, and everything depends on whether we can deal with this crisis in a timely manner. To that end - stay safe, and stay home.

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