The September Federal Reserve Open Market Committee meeting starts today (Tuesday, September 20) and ends tomorrow, and expectations are that they will announce another 75 basis point increase in the federal funds rate. The Fed is working to reduce the rate of inflation, which was 8.3% at the end of August. In June our inflation rate was 9.1%, the highest in 40 years. I've talked before about what causes inflation but the key question now is how to reduce it and, more importantly, how to avoid an economic nosedive in the process.
The Fed is the most powerful financial institution in the world. The Fed chairman is appointed by the President and serves a four-year term. Each member of the Board of Governors, also appointed by the President, can serve up to a 14-year term. The length of these terms, coupled with the fact that the Fed tends to act on its own is supposed to ensure a level of independence. In practice, the Fed is subject to Congressional oversight and is supposed to work within the existing government's fiscal policy objectives.
Like all of our businesses, the Fed has a balance sheet of assets and liabilities. Its assets are US Treasury bonds and mortgage-backed securities. The Fed's liabilities are essentially all the US currency in circulation, and all deposits in commercial banks (the Fed can print money, which increases its liabilities, and then use that to buy US Treasury bonds, which increases its assets.) When the Fed wants to increase the money supply, it can buy $1 billion in Treasury bonds and deposit $1 billion into the reserves of banks. Those reserves can then be lent to consumers and businesses.
Money supply is a major cause of our current inflation (along with supply chain, Ukraine, etc.). When there is an increasing supply of money against a fixed level of production, prices rise and money is worth less. Back in June I predicted the Fed would raise interest rates over time. I think we are approaching the end of those increases, as we are starting to experience destruction of demand in some sectors. Take energy for example: over the last few weeks consumption of gasoline declined almost 12% from the same periods in 2021 and 2020 even though gas prices have dropped since July. Housing activity has been hurt by mortgage rates approaching 7%.
As credit card rates climb, consumers buy fewer big-ticket items (appliances, cars, etc.) Home prices drop to offset increases in mortgage rates. To make matters worse, due to economic issues in other parts of the world, our dollar is up against every major currency, making your goods more expensive to sell abroad. Less consumption means less production, particularly if inventories are shrinking. When production slows, job growth slows. People who have been sitting out of the "labor participation" pool for a year may get a rude awakening trying to dive back in.
Why should you care about this? You need to incorporate inflation assumptions in your business planning for the rest of this year and 2023. This includes assumptions for sales of your goods or services, your cost of sales, your workforce and your balance sheet. The Fed has raised interest rates to decrease the money supply, make each dollar in circulation worth more and make credit more expensive. The risk is that our economy stalls due to lack of demand and productive output. The Fed can't fix the supply side of our economy, so it focuses on demand.
Implications for business: Start with customer demand and revenue forecast. Know your differentiating capabilities so that you're not stuck with being the low-cost provider. Keep an eye on your order backlog, inventories and gross margin. For service providers, focus on helping your clients get lean and preserve their cash flow. For everyone, expect to see a tighter job market which could lead to an increase in the quality of your workforce. Manage financing and trade credit wisely. If your long-term demand forecast is not encouraging, use this period of time to get fit for growth once we rebound, as we surely will.