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#1 The Fed: what you need to know - A discussion with David Vaught Thumbnail

#1 The Fed: what you need to know - A discussion with David Vaught

Episode 1 - Emily & Amanda talk with David Vaught about the current state of the Federal Reserve. This economic discussion touches on how the Fed's action or inaction affects the markets, which actions we think the Fed may take in the near future and how those actions will affect our daily lives.

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Evidence of inflation at the grocery store. That's some pricey milk!

Emily Agosto (00:07):

Welcome to connecting the dollars, a personal finance podcast. I'm Emily Agosto, a CPA and financial advisor,

Amanda Vaught (00:14):

And I'm Amanda Vaught, an attorney and financial advisor. And we both work at propel financial advisors.

Emily Agosto (00:22):

Propel Financial Advisors is an investment management and financial planning company. We are fee only independent registered investment advisors and work with clients nationwide.

Amanda Vaught (00:33):

The purpose of our podcast is to explore personal finance topics, including budgeting, investing, behavioral, finance, current happenings in the markets and the news, and any other topics we think our listeners might find interesting or helpful. We also hope you get to know us along the way.

Emily Agosto (00:52):

Thanks for listening. Today's episode features a discussion about the Fed with our colleague David Vaught.

Amanda Vaught (01:05):

We wanted to cover the Fed to explain how what they do or don't do can have a large impact on the markets like the stock market or, you know, everyday markets like the grocery store and how that affects everyone. You know, I was just thinking last week we went to the grocery store and a gallon of milk was almost $10. And, you know, I'm like, wow, I can't believe milk's so expensive. And then if you, you know, you think about it, it's supply chain issues, COVID lockdowns affecting dairy farmers and just inflation and what the Fed is doing with the interest rates going to impact inflation. So that's just one example of how, you know, the Fed is this, you know, body out there you may or may not pay attention to, but what they're doing is affecting your day to day life.

Emily Agosto (01:54):

Yeah, that's a great point. So the Fed sets those interest rates and, and it not only affects consumer prices as Amanda is talking about, but, but also can increase wage rates and affect the value of the dollar. So for example, a lot of people have been receiving COLA increases to their salaries, which is great. And they've typically been a little higher than in recent years. So if someone receives about 5% wage increase, you also need to think how that affects your retirement and think about maybe you need to increase your retirement and buy 5% as well.

Amanda Vaught (02:30):

Yeah. And I, you know, I would say for regular people, maybe isn't necessary to pay attention to every little thing that the Fed does day to day, like some, financial type people do, but, just have general background and a better understanding of what they're doing and, and how their decisions they make can really impact the economy we think can help you make better financial decisions in the long term.

Emily Agosto (02:56):

We hope you enjoy the discussion.

Amanda Vaught (03:01):

We wanted David here today to talk more about the Fed or the Federal reserve as its full name. The Fed is in the news a lot, especially lately or at least in the financial news. And I think for a lot of non-financial people, they just sort of tune it out or they don't really appreciate the significance of, what's going on at the Fed. So we wanted David here to give some background on the Fed and just try to explain what's going on recently with the Fed in a way that just regular people, non-financial people, you know, I'm not trying to save financial people, aren't regular, but I'm just trying to say that, you know, it's a way that, you know, people who don't work in financial sector could understand and better understand how it could apply to them and their personal finances.

Emily Agosto (03:56):

Yep. So, David, what are your thoughts here? What is important for us to be looking at?

David Vaught (04:01):

Well, I think the Fed is in, in the news it's, it's really generally called, is this the central power on monetary policy, which has to do with how much money is in the system and how that makes the economy work better or worse, or how it fights inflation or stimulates unemployment. Those are its two main functions, but the two points that, I've been hearing some questions about are: What are these terms that we hear about the Fed? And so I thought I'd talk a little bit about "taper". You know, it's a, not a commonly used word about a lot of things. And "liftoff". But those are in the Fed news, taper refers to the Fed's, plan or anticipated plan to reduce the purchase of long term treasury securities. Mostly the Fed deals with short term interest rates most of the time, but starting back in the, in the, last recession back in 2008 and 2009, which affected the mortgage rates a lot and the whole mortgage market, a lot, the Fed started buying a longer term securities mortgage backed securities, which were all part of that recession and, , and longer term treasury securities this way to try to get interest rates down so that people could get back in the mortgage market.

David Vaught (05:20):

It had frozen up and it was in deep trouble in that last recession. So in the current recession, the pandemic recession, , the Fed began to expand its balance sheet and it included the purchase of these longer term securities. Again, trying to keep long-term interest rates down, not just short-term interest rates.

Amanda Vaught (05:39):

Can I just interrupt you there with a question really quick? Yeah. So if the Fed is in charge of the interest rates, why is the Fed buying these mortgage backed securities in an attempt to control interest rates? If they're the one who controls them. Could you just explain how that works a little bit?

David Vaught (05:59):

That's one of the techniques they use is to buy and sell, securities, especially, treasury securities, and more recently, these mortgage back securities, and, you know, by the effects of supply and demand actually can change the rate structure, but because the Fed has this authority to essentially what's commonly called print money, create money. It can it used that created money to do these things. So it's changing the overall amount of currency that's out there, the amount of money that's out there. And it did that in this recent recession by expanding its balance sheet way up into seven or 8 trillion back in the last recession, we were talking about two or 3 trillion on the Fed balance sheet. And we, we talked about that in our last webinar. People want to hear more about it, but tapering is important because at some point, the Fed often needs to undo these things.

David Vaught (07:01):

In other words, you can't print money forever and just kind of ignore its consequences. And as the concern about inflation is increased, the Fed has been signaling that it's going to let interest rates rise a little bit. As interest rates rise that tends to slow down the growth of the economy a little bit. It tends to slow inflation down a little bit. So one of the first steps they're going to take in that direction is what's called taper. Taper means they're just going to buy less of those securities. It doesn't mean they're going to sell all of them or dump them all on the market all at once. But over a period of a few months, instead of buying 50 billion dollars worth of these securities a month - just think about that amount of money. Somebody buying 50 billion worth of securities every month and keeping it up.

David Vaught (07:48):

That's what they've been doing to keep mortgage rates low and it's worked. Mortgage rates are very low. A lot of people have been refinancing their homes, buying new homes - that stimulates the economy when that happens. And so that's what they're doing, but as they taper, they're going to undo that a little bit. And a few years ago, there was another taper term that got used because the markets, the bond market reacted negatively when the Fed began to taper. That's called the taper tantrum that the markets had, like a two year old having a tantrum, the markets were kind of having a tantrum that the Fed was tapering. And so you would hear this in the news and you'd go, what is going on? These are not two year olds. This is Federal monetary policy, but they're using these fairly common terms, I think, to try to create some understanding. But when they do it, they often create misunderstanding.

Amanda Vaught (08:43):

Well, would you say the tantrum occurred in the stock market or the tantrum occurred in the economy?

David Vaught (08:50):

Originally in the bond market, which affected the stock market and which often affects the economy. So it was a little bit of all three. So when people begin to lose confidence in the way the growth numbers or the, economic improvements and unemployment begin to change, it changes their investment outlook. It changes their economic outlook. It may change as well how businesses decide to spend money or expand employment and so forth. So those are all related effects. If the Fed is trying to, if I may use a pretty blatant word, manipulate in ways that are helpful, sometimes you know, it backfires, it doesn't work as well as they hope. .

Amanda Vaught (09:33):

And when you say the Fed is buying these securities, where is that money coming from? Can you explain how that works? And if they start tapering, does that mean, where is that money going? If they're not spending it on the securities?

David Vaught (09:50):

The common phrase is printing money. If the Congress, spends money that it's not raising by taxes, very often they're spending borrowed money. And very often the group that's buying the bonds that are issued to borrow the money is the Fed itself, except they're doing that by creating money. Um, you know, the government can coin money and in print money, print currency, but the Fed often does it with what are called balance sheet operations. They simply manipulate their balance sheets and their requirements, for their member banks. You know, the banks in this country all belong to a regional, Federal reserve bank. You know, whether it's the Chicago Federal reserve bank or the New York Federal, or the St. Louis Federal reserve bank and through its operations at the New York Fed and these, these regional banks, they have impact on the banking system. When you, when you make more funds available to lend in the economy, you are essentially creating money. And that's what the Fed does.

Emily Agosto (10:55):

I have a question for both Amanda and David, based on what we've been seeing in the news a lot, I think a lot of people, or a lot of opinion columns have been coming out saying that they think the Fed strategy is a little too optimistic and this plan can potentially put us further into your recession in the coming years. If, for example, unemployment doesn't recover, or if inflation doesn't come down. So what are your thoughts on that?

David Vaught (11:21):

That's the danger of what often is called stagflation. We had that back in the seventies where you had stagnant a stagnant economy where unemployment, unemployment was getting worse or unemployment was not growing our businesses and in the economy were not growing. So that was the stagnant part. And at the same time you had inflation, which meant everything is costing more for more people, , which creates a lot of pain among consumers and businesses. As they try to adjust the prices they sell their products for in an inflationary environment where sales are not growing. So that's a very negative effect. If the Fed gets things wrong, that's one of the negative scenarios that some people are worried about. The Fed's not trying to do that.  Right, of course.  They like to guide inflation. They like to keep inflation down, but they also like to get unemployment down. And so very often those two operate at cross purposes. And so, you know, the major mess up is to get them both going in the wrong direction at the same time. That's what stagflation is.

Amanda Vaught (12:24):

Yeah. I think everybody who owns a home has appreciated the opportunity recently to refine, you know, the low rates long to term are going to help potentially drive the inflation or, um, have other negative effects in the economy. So it just seems like a fine line there that the Fed needs to hoe.

David Vaught (12:47):

It is, and it's, and it's complicated, which is why I think a lot of people are confused by it. But if the markets tend to follow the Fed. If the Fed with all of its PhD economists and all. It's in a relationship between the Fed governors appointed by the president and the Fed presidents that are selected by member banks out of the private sector, the Fed brings together some elements of government and some elements of the private sector to try to influence the economy in a positive way. And so that's not a simple process.

Amanda Vaught (13:25):

. And so I was thinking, how would this apply for the regular people we mentioned earlier who are trying to save money for retirement, or maybe they're approaching retirement or they're in retirement, what is this going to do to their investments, but also, should they be changing their behavior in light of the anticipated Fed action? I mean, at the end of the day, the interest rates are going to go up at some point. Hopefully. I don't think we're going to go to negative interest rates. I know some people think that's possible. But if interest rates are going to go up, eventually, that's probably going to make the stock market go down a little bit, or at least not grow as much, right. Which is going to impact the amount of your return that you get in your investment account. Or inflation is going to go up and you're going to need more money to live off of when you retire or if you're currently retired. So I would think for people still saving for retirement, what this means is that you need to save more money.

David Vaught (14:31):

That's often always true, Amanda. And it gets more complicated because a lot of conservative investors or people that are in retirement are using bank accounts and bank CDs and bonds to actually create the cash flow they need in retirement. When the Fed, whose policy in the recession is to keep those interest rates low. Those people are suffering. Their income is not growing. Interest rates are low and they affect them. And in that same low rate bond market also affects the pension funds that are investing people's money.  They buy lots of bonds.

Amanda Vaught (15:09):

Anybody drawing social security is getting really good COLA increases now.

David Vaught (15:16):

As inflation goes up, they're going to get good COLA increases. That's correct. .

Amanda Vaught (15:20):

So I'm just saying there's always two sides to every coin. You know, it might hurt pension returns, but it's good for people drawing social security.

David Vaught (15:29):

That's right. Your comment about how it affects the stock market - that's also really important because the stock market is often driven by many factors, but two of them are earnings and then how you discount those earnings to arrive at a valuation. Right? So if interest rates are very low, that supports high price earnings ratios, and it supports high valuation into the stock market. And we've been seeing that in this low interest rate environment, that that's part of, or one of, the driving forces of the market going up. If interest rates go up, which we think they're going to do, and the Fed says it's going to do that, that puts pressure on those valuations in the stock market. And if they slow the economy too much, it also puts pressure on the earnings of those companies as well. So those effects are going to be very much apparent and they're one of the reasons we're seeing a choppy and volatile stock market today.

Emily Agosto (16:27):

Yes. So this is something that obviously us as investment advisors we're paying attention to, but the takeaway at the end of the day for the average investor might not be to really do anything drastic or is there something more specific, or what the bottom line for our clients would be.

David Vaught (16:49):

Well, you know, we say that all the time, diversification is usually your friend, to make sure that you're well represented in the market and participating in its positive moves. But also being a little bit protective if it moves in the other way, but staying the course in that is generally the best alternative doing that with really small adjustments in portfolios that either make them a little more aggressive or a little more conservative based on these conditions. One of the things that I talked about the other day that I wanted to mention in this podcast are these gloom and doom stories that just scare people significantly. You know a lot of them are out there. Often they're exaggerated or made up and fictional. Sometimes they're just sales pitches to convince people to scare people enough that they'll do something like the dollar is going to go way down.

David Vaught (17:46):

You better buy some gold. That's a sales pitch. That's often has some, not all, but some, negative, predictions built into it that I call "gloom and doom" predictions because they're often exaggerated. So I mentioned the other day, to some of our investors, a book that I recently read by Lawrence Lindsey. That's a "gloom and doom" book. It's called "Currency War." And it talks about what would happen in a novel. This is a novel; it's fiction. It's an interesting story, but because Lawrence Lindsey has been a Fed governor, he's not the typical gloom and doom person. Who's just spreading a bunch of scary stories to convince people to buy something or do something. He's been a Fed governor. He's been right in the heart of the system. And so when he writes about these potential negative effects, he writes about them with a lot more knowledge and a lot more reality than you sometimes see.

David Vaught (18:39):

So his story in that book is about what if the Chinese, the leading holder of US Treasury bonds, they have billions and billions of dollars worth of treasury bonds that they have purchased by the People's Bank of China and other entities in China. What if China decided we're tired of the dollar being the key currency of the world? Let's cause a little crisis in the dollar by selling all of our Treasury bonds all at once, all on the same day. We want to be paid for them right now. If the Fed, and the US economy, and the government are saying that their currency is strong and safe and Treasury bonds are safe, then we ought to be able to sell them all at once. It's kind of like a run on the bank, except a run on the Federal reserve system in the United States could have very disastrous consequences.

David Vaught (19:27):

So Lawrence Lindsey wrote a novel about that. I thought it was pretty good. So if you want to read a novel about how we could have a big currency war caused by the Chinese and what effect it might have on our economy, you know, if you want to stir up some of your own fears a little bit, I won't tell the end of the story. It ends positively, but I'll leave that to the readers that might want to think about that.

Amanda Vaught (19:50):

Don't tell me everybody switches to crypto in the end. .

David Vaught (19:54):

No, no, it's not about, it's not really about crypto. Although crypto is, is a challenge of a sort to regulated currencies, whether they be the Euro or the Chinese Yuan or the Japanese Yen or whatever. Those all operate in a regulatory system that keeps track of who's paying taxes and who's not paying taxes and who's borrowing money and who's not borrowing money. And to some extent, crypto is seeking to escape from that a little bit and essentially create a more free market in a, in a new form of currency. This book's not about that. But some of the people that are urging people to buy crypto are engaging in these "gloom and doom" stories to try to sell crypto too, just like they try to sell gold and some other things.

Emily Agosto (20:41):

We could probably do a whole entire episode on crypto. We probably should too.

David Vaught (20:45):

It's certainly in the news and it's a little more confusing, I think. I mean, the Fed is confusing because it's complex. Crypto is confusing because it has some complexities, but it's also very new and different.

Emily Agosto (20:59):

Yeah, definitely.

Amanda Vaught (20:59):

A difficult thing about crypto is that when you're trying to, you know, find information about it, a lot of the information sources are people who are trying to sell you crypto. You can't find a neutral source or, you can, but it's more difficult because it is really swamped with people trying to convince you to buy it.

Emily Agosto (21:00):

That's a really good point.

Amanda Vaught (21:22):

At the beginning, you mentioned two terms you wanted to go through. One was taper and other was...

David Vaught (21:28):


Amanda Vaught (21:30):

And I don't think you covered liftoff actually. Did I miss it?

David Vaught (21:33):

No, no, I didn't. Liftoff is kind of the second stage that the Fed is considering. And that would be the change in its short term interest rates. We've been talking about long term interest rates when we talk about taper, but mostly and traditionally the Fed controls the Fed funds rate, which is a short term interest rate. And it is expected that sometime in late 2022 or 2023, nobody knows exactly when; the Fed doesn't even know exactly when. What they say is they're going to do it whenever the indicators, the financial indicators say that it's the right time. And they'll decide when and what that is. So everybody wonders, when is the Fed going to do liftoff? And it's not a space shot. It has nothing to do with space or missiles or anything like that. It's when the Fed is going to start raising short term interest rates. So that's another term that you may hear out there. It's a little further away in terms of when it's going to happen. But that'll be a big change as well that the Fed will bring about.

Amanda Vaught (22:33):

A lot of what I see is that the Fed is expected to raise rates in 2022. But I have seen, I recently saw someone saying they could raise them in November, as in a month. So I think, you know, people in finance, they try to take out their crystal ball and predict these things. And it's a little bit of a fool's errand, but you can know that it's coming. We just don't know exactly when.

David Vaught (23:00):

Well, it's a lot of the people that are wanting to do it sooner are worried about inflation. And there are a lot of other people, both in the government and private economists who think this is more transitory. And it's been the Fed's position that the current bump up of inflation year-over-year, it's up over 5% now. That's, that's a pretty significant number, but if it's just transitory and it's coming back down, it's much less of a problem. Mm-hmm . But if it's not transitory, if the Fed has kind of lost control of inflation, that's a different thing. And that would cause liftoff to be much sooner.

Amanda Vaught (23:35):

I know, I think we're getting short on time, but I just wanted to get your thoughts on, Powell being up for reappointment. I know there's some talk that Biden might appoint someone new. Do you think if Biden appoints a new person, they'll continue with this general policy as Powell has, or you think they'll take a step in the other direction? Is there anything people should be looking for?

David Vaught (24:01):

The President can appoint who he wants and, but very often presidents like the stability of keeping the same Fed Chair, even though a lot of members of their party like Elizabeth Senator Elizabeth Warren has been very critical of chairman Powell. A lot of people in the financial community and the economic community have thought he's done better than expected, you know. And some people that were skeptical about him being a Trump appointee are kind of surprised that he hasn't been as bad as they expected. So it's hard to say what the President may do. It's up to him. I don't think he's going to, I don't think he's going to signal it much in advance that actually making his decision, but the term is near up. He could put in somebody new or he could keep chairman Powell in place.

David Vaught (24:50):

He has seven appointments on the board of governors as well. So if he wants to influence the board of governors of the Federal reserve system, you know, he can do that with those other appointments. There's been a lot of talk about the vice chair as well. The vice chair is by statute required to be much more involved in the regulation of banks. And so if there are abuses in the banking system or things that need to be regulated in the banking system, that vice chair is also a very important appointment that the president has.

Amanda Vaught (25:20):

And there's been several resignations recently over the ...I don't know, are they calling it insider trading or conflict of interest? ... Over the Fed members trading stocks out of their personal accounts?

David Vaught (25:36):

Well, there were some that were clearly violations of the Fed's rules, the Feds ethical rules. And then there were some that were borderline that caused people to question whether the rules need to be a little tougher. Those resignations were not from the board of governors. I'm referring back to our webinar where we talked about this hybrid structure. The board of governors is appointed by the President. The regional Fed presidents - that's where the scandal was - are elected by member banks. They come from the private sector, so they have to comply with the ethical requirements of the Federal reserve system. But their accountability runs a little different than people that can be removed or reappointed or replaced by the President.

Amanda Vaught (26:20):

I was just going to ask Emily if she had any other final thoughts or questions for David.

Emily Agosto (26:27):

I think that was a really great deep dive into what's going on in the news currently. And I wanted to make sure that we give you the information on the books that David mentioned. And so we will put those links in our show notes on connectingthedollars.com. We'll also share a link for the webinar that David mentioned that we did back in June, that gives a good kind of overview of the history of the Fed and its structure and historical interest rates. Thanks for joining us. Thanks for that economic discussion. I'm sure we'll have you back on again for a future episode.

David Vaught (27:06):

Thank you

Emily Agosto (27:12):

For all links and resources mentioned today. Head over to connectingthedollars.com. Thank you for listening.

Amanda Vaught (27:20):

This podcast is for informational and entertainment purposes only, and should not be relied upon as a basis for investment decisions. This podcast does not engage in rendering legal, financial, or other professional services.