Chris explains the Federal Reserve and how it impacts the entire US economy. Eric asks questions to simplify what Chris is saying, because sometimes the massive dollar amounts get blurred together. In short, there could be good news on the horizon because the Federal Reserve is shrinking its balance sheet and reducing the amount of money in circulation.
00:00 - Intro
00:50 - Revisiting Chris's 2021 prediction about bonds and inflation
02:34 - What is the Federal Reserve?
04:21 - What has happened to the US economy since COVID?
06:20 - The monetary base
07:12 - Three ways the Government can throw money around
09:02 - Interest rates and inflation
10:35 - The Fed has grown massively
12:03 - How the Fed buys and sells debt
13:41 - Quantitative easing and tightening
15:05 - What value does the Fed provide to the world?
17:30 - Summary. Thanks for listening!
Chris is a novelist author of financial thrillers.
A PRINCE AMONG MEN
13. The Federal Reserve and its Power over the Economy
[00:00:00] Eric Knight: Welcome back everybody. It has been a long time since Chris and I have done an episode, but we've been busy. Life just happens and I've been in the middle of a move, and I'm just glad that we are both available. Chris is also a very busy man. He now has a substack that he sends out weekly, I believe. Is it weekly, Chris, that you're writing this Positive Space?
[00:00:21] Chris Coffman: There's been some weekly ones and then there's one every two weeks and we'll just see it. Some of them are really intense and I need an extra week to get it done.
[00:00:28] Eric Knight: Well, let's not be too shy. You published another book.
[00:00:31] Chris Coffman: You mean, a Prince Among Men?
[00:00:33] Eric Knight: What other book did you publish? The amount of times it's, yes.
[00:00:36] Chris Coffman: Haha, yes there has only been one, you're right.
[00:00:38] Eric Knight: It's called A Prince Among Men. You can get it on Amazon. I'm knee-deep in it already. It is a fascinating story and it's a novel. Just like Crisis Deluxe, which was your first book. This is about the financial system.
Revisiting Chris's 2021 prediction about bonds and inflation
[00:00:50] Eric Knight: And today we are going to talk in episode 13 of this Recovering Investment Banker podcast about a question that I've had watching all the ups and downs in the economy in the last, I don't know, two, three years.
[00:01:03] We talked back in October of 2021. I believe that was episode seven or eight about what inflation was. And you made a call back then about bonds. And I want to revisit what you said back then. Why don't you tell the audience what your prediction was back in October of 2021, about buying bonds?
[00:01:24] Chris Coffman: Well, Eric, it was a question that, as you said, came up a lot in just managing your life and your very busy job as an executive in your company and so forth. And so we decided to dive in there. And at the time a lot of information in the New York Times and other very prominent publications was saying that inflation is transitory. It's based upon supply chain issues related to COVID, it's just going to work its way through the system. It's no problem with it. It's all fine.
[00:01:49] That was clearly not the case because of things that we talked about, like the money supply and so forth. So it wasn't really all that hard, ultimately. We talked about a New York Times article advising its readers to buy bonds. That would've been a very expensive mistake.
[00:02:02] But I think we've got some good news for our listeners, Eric. So we can bring 2023 in hopefully with a bit of an upbeat forecast, and help people in their busy, complicated, stressful lives knowing that maybe there's some good news that might be emerging.
[00:02:19] Eric Knight: The focus of this episode is we want to talk about the Federal Reserve. What is the Federal Reserve? Why does it exist? What was it supposed to do? And what does it actually do? What does its impact over the economy? So that is the focus of episode 13. And Chris, take it away.
What is the Federal Reserve?
[00:02:34] Chris Coffman: So The Federal Reserve, of course, is the Central Bank of the United States. It was started at the beginning of the 20th century. It's mandate was always to keep the currency strong, to keep prices stable, and assist the economy in its natural growth.
[00:02:50] Eric Knight: You said the beginning of the 20th century? I thought it was way older than that.
[00:02:53] Chris Coffman: Well, no, 1913 I think the Federal Reserve Act.
[00:02:56] Eric Knight: Wow.
[00:02:56] Chris Coffman: Just before World War I. But we have had central banks before. It's a long history and Andy Jackson killed one and there was the first National Bank in the United States, Alexander Hamilton. There's been lots of different fights, but the one we've got now is a little over a hundred years old. And has basically made lots of big mistakes that everyone knows about and agrees with. So it's not a perfect institution, but it is a very, very powerful institution. It's kind of this huge bully, kind of patrolling the markets and the economy.
[00:03:26] It's sad to say that it's helpful to know what the Federal Reserve is doing because average Americans shouldn't have to be able to anticipate what the central bank's going to do.
[00:03:34] But if you don't have any understanding, you could make a big mistake in your own personal life, in your own investment decisions. So it's a good time to talk about it. You've asked questions before about what is quantitative easing, what is quantitative tightening? What's an open market operation?
[00:03:48] I think hopefully we can talk today in a way that helps our listeners have a very clear, practical understanding of Federal Reserve, how it affects the markets, and how it affects our own decisions about buying and selling houses and the likelihood of getting fired from our jobs or getting pay raises and, you know, whether we can afford to send our kids to college in 10 years and so forth. Because that's ultimately the kind of decisions that the Federal Reserve has enormous influence over.
[00:04:12] Eric Knight: So it was originally created to keep this currency stable?
[00:04:16] Chris Coffman: Yes. And therefore prices stable.
[00:04:19] Eric Knight: All right. Well get started. Let's go.
What has happened to the US Economy since COVID?
[00:04:21] Chris Coffman: The Federal Reserve, of course, issues currency. It's the so-called printing press. The Federal Reserve also buys and sells government debt. So for example, in 2019, the federal debt, not including what the Federal Reserve itself holds because it does hold federal debt is an asset, the federal debt held by the public was 17 trillion.
[00:04:43] And then the COVID thing happens, you know, everyone starts to realize what's going on in February, March of 2020. By the end of 2021, the federal debt has gone up to 22.3 trillion.
[00:04:56] Eric Knight: So it's grown by 5 trillion in year and a half.
[00:04:59] Chris Coffman: Good call. Exactly. In 18 months. It went up by 5 trillion dollars.
[00:05:02] Eric Knight: Oh my gosh.
[00:05:03] Chris Coffman: Yeah. Yeah. That's pretty dramatic.
[00:05:05] Eric Knight: A lot of people don't realize how big a trillion is. If you were to count to a trillion, one number per second: 1, 2, 3, 4. It would take over 32,000 years to get to a trillion.
[00:05:19] Chris Coffman: Yeah, it's a lot of money. The important comparable is what's the debt compared to US GDP? In other words, the value of all the goods and services produced in the United States economy. And US GDP right now is about 21.3 trillion.
[00:05:33] Eric Knight: GDP stands for gross domestic product. For those listeners who have never heard that term.
[00:05:39] Chris Coffman: Yeah, a proxy for the size of the US economy. So basically in 18 months, we ran a cumulative debt that exceeded the size of the US economy. Not a good idea. And as you say, that was a 5 trillion increase.
[00:05:52] Eric Knight: Has that ever been done in US history before?
[00:05:54] Chris Coffman: No. I think World War 2, I can't remember where it was in relation to GDP at the time, but anyway. What we're focusing on is how much purchasing power is getting dumped into the US economy? Remember, businesses are closed, people aren't working, they're working from home at best. There's a lot of fear out there. People are not producing a lot of stuff. But the fed is pumping all this fire power to purchase things into the US economy. 5 trillion of debt is one thing.
The monetary base
[00:06:20] Chris Coffman: Another thing though is the monetary base. Now the monetary base, without getting into it too much, is mostly what you think of intuitively. It's those Federal Reserve notes in your wallet you were talking about, Eric. Also includes savings accounts and, certificates of deposit. All that money adds up to the purchasing power of Americans.
[00:06:38] Eric Knight: So the monetary base is all of our money as American citizens, not government entities, not companies, but people.
[00:06:45] Chris Coffman: Exactly.
[00:06:46] Eric Knight: Okay.
[00:06:47] Chris Coffman: So that's where the Fed directly gets involved. That's the famous printing press, basically. So the monetary base again, right before COVID, was 3.4 trillion dollars. Uh, 18 months later it was 6.4 trillion dollars. So, A 3 trillion dollar difference. Now that's on top of the 5 trillion in borrowing.
Three ways the government can throw money around
[00:07:12] Chris Coffman: There's three ways the government can throw Americans money around. One is by taking our taxes. One is by borrowing the money that we're going to have to repay for our children or grandchildren. And then the third way is by simply printing money. And all those things happened as a result of COVID.
[00:07:28] But, and this might be a little complex, but I'm just going to put this out here because it's an important way to understand the Federal Reserve. The government borrowed 5 trillion dollars. The Federal Reserve pumped out the printing press of 3 trillion dollars. But the Federal Reserve also acted to slightly slow down the American economy, and it did that by buying some of those treasury bills. So of the $5 trillion that the government issued, the feds actually bought 3 trillion of them.
[00:08:07] Eric Knight: Interesting. So they bought debt from the federal government.
[00:08:11] Chris Coffman: Correct.
[00:08:11] Eric Knight: And treasury bills are the same as bonds basically.
[00:08:14] Chris Coffman: Yeah. I won't go into it, but there's treasury bills and bonds and so forth. Yeah, exactly right Eric, it's all the same thing.
[00:08:18] Eric Knight: Same concept. Generally speaking, it's like they bought three of that five trillion.
[00:08:24] Chris Coffman: Right.
[00:08:25] Eric Knight: Okay.
[00:08:25] Chris Coffman: That's exactly right. So that actually gets deducted from the 8 trillion that got put into the economy.
[00:08:31] Eric Knight: So it was three plus five to put you to the eight and then subtract three. So you're back at five?
[00:08:36] Chris Coffman: Correct.
[00:08:37] Eric Knight: Okay. Understood.
[00:08:39] Chris Coffman: What the Feds did was they printed $3 trillion and they sent people checks. Then they borrowed 2 trillion more, and they sent people checks. So they put 5 trillion on 15 into the economy. That's a 30% increase. And of course, that's going to create very significant inflation, probably around 30% cumulative across different asset classes. That's basically what did happen.
Interest rates and inflation
[00:09:02] Chris Coffman: So Here's the thing. When you increase the debt and when you print money, simply raising interest rates cannot lower inflation unless you start to pull that purchasing power back out of the economy.
[00:09:18] Eric Knight: Okay, hold on. I make sure I'm tracking here. Yeah. Mm-hmm. They raised interest rates a lot. I know this because I'm in the process of buying a home.
[00:09:25] Chris Coffman: Right.
[00:09:26] Eric Knight: That was designed to make borrowing more expensive so that less people borrowed to slow things down, right?
[00:09:33] Chris Coffman: Exactly. Yep.
[00:09:34] Eric Knight: But you're saying that alone cannot stop or slow inflation?
[00:09:38] Chris Coffman: Interest rates alone will slow down economic activity and hurt people, but they're not going to by themselves cure inflation. They can't. Because the cause of inflation is too much money chasing the same number of goods and services. So we have to look at the other ways that the Federal Reserve operates in order to understand whether or not they're going to be able to tame inflation.
[00:10:01] And what we now have is what's called an inverted yield curve, which means that short term interest rates are higher than longer term interest rates.
[00:10:09] Eric Knight: Meaning you'll make more money on short-term than long-term bonds.
[00:10:13] Chris Coffman: Yes. But you can't keep rolling them over and re borrowing at the higher rates because the market thinks rates are going to go down. Historically that means a huge recession. But that may not be the case this time. We might have good news for our listeners. But it's all related to the fact that raising interest rates alone will not tame inflation.
The Federal Reserve has grown massively
[00:10:35] Chris Coffman: So let's just look at some of these numbers. When last week closed on Friday, the total assets of the Federal Reserve of the United States were 8.5 trillion dollars. That's a third of the size of the economy. Now, just to give you a comparison, right before the global financial crisis, the size of the US balance sheet was 856 billion.
[00:11:03] Eric Knight: So less than 1 trillion.
[00:11:05] Chris Coffman: Correct.
[00:11:06] Eric Knight: And now it's 8 trillion?
[00:11:07] Chris Coffman: Eight and a half trillion.
[00:11:09] Eric Knight: Oh my gosh.
[00:11:11] Chris Coffman: Yeah. The GDP of the United States in 2007, was about 13-14 trillion. So the size of the Federal Reserve Bank was less than a trillion in an economy that was 13 or 14 trillion. Now the size of the Federal Reserve Bank is 8.5 trillion compared to a GDP of 21 trillion. This isn't the 900 pound gorilla anymore. This is Godzilla.
[00:11:41] This is why it's so important for people to have some kind of understanding about what the Federal Reserve is doing. We shouldn't have to, we should have a very stable situation and stable prices and no budget deficit and low taxes. But that's not our world. So people need to understand that the Federal Reserve was always powerful. But it's now Godzilla. It's enormous. It's huge.
How the Fed buys and sells debt
[00:12:03] Chris Coffman: So what's going on with Godzilla? And this is where hopefully, actually we want to have some good news here. What was the size of the Federal Reserve Bank the end of April, 2022? Right before they started raising their interest rates? And the answer is $8.9 trillion.
[00:12:22] Eric Knight: Wow.
[00:12:23] Chris Coffman: Yeah, but remember two days ago it was 8.5 trillion dollars. So it's actually come down about 500 billion dollars. Their balance sheet is declined by 5%, which means that they're sucking that much purchasing power out of the economy. So that's actually good news.
[00:12:38] Eric Knight: So hold on. So they're sucking purchasing power out of the economy. How are they doing that? What are they doing?
[00:12:44] Chris Coffman: They're decreasing the size of their balance sheet.
[00:12:46] Eric Knight: Meaning they're destroying cash?
[00:12:48] Chris Coffman: They're reducing their assets and they're reducing their liabilities.
[00:12:51] Eric Knight: So let's talk about that. How is the Federal Reserve going to do that? How are they going to contract the purchasing power and take money out of the economy?
[00:13:00] Chris Coffman: One thing that they can do is start to sell treasury bonds. Maybe this should have gone much earlier in the conversation. When the government wants to expand purchasing power in the economy, it borrows. So it sells securities out in the market. Those securities are bought by financial institutions.
[00:13:21] Eric Knight: Those securities being bonds or T-bills or something exactly like that?
[00:13:24] Chris Coffman: Exactly. Okay. They're, they're bought by financial institutions. The Federal Reserve Bank, a completely different entity, then buys those bonds from the financial institutions, which means the financial institutions, instead of having bonds, they've got all that cash.
Quantitative Easing and Quantitative Tightening
[00:13:41] Eric Knight: Got it. So it's just a shell game at a huge, huge, like unprecedented level of trillions and trillions of dollars.
[00:13:51] Chris Coffman: Yeah. That's actually what quantitative easing and the open market operations are. That's what it is.
[00:13:56] Eric Knight: Quantitative easing. Define that in a sentence. What does that mean?
[00:13:59] Chris Coffman: Quantitative easing is increasing the money supply.
[00:14:03] Eric Knight: So quantitative tightening would be the opposite. That would mean decreasing the money supply. So shredding cash, figuratively speaking, taking it out of the economy.
[00:14:12] Chris Coffman: Figuratively speaking. just cancel it out. Just cancel it out.
[00:14:15] Eric Knight: Why doesn't the Fed just buy these T-bills directly from the government? Why does it have to go through financial institutions?
[00:14:21] Chris Coffman: Because then nothing would happen.
[00:14:22] Eric Knight: Ah, so it's injecting it into the economy.
[00:14:26] Chris Coffman: Precisely. In fact, that's actually the word that economists use. That's exactly right, Eric. There it's injecting the cash into the economy. And of course, as we all know, they also sent $5 trillion worth of checks directly to people. But meanwhile, they were growing the money supply through quantitative easing and open market operations. And what they're doing now is they're starting to reverse that. That's why the balance sheet of the Federal Reserve got so big.
[00:14:51] Because remember, it had grown a lot between the global financial crisis when it was less than 1 trillion to 4 trillion before COVID because we had an era of, frankly, too much money. And we had, we didn't have a very good federal reserve with under Bernanke.
What value does the Federal Reserve provide to the world?
[00:15:05] Eric Knight: A more abstract question, what does the federal reserve actually produce for the world? Like what is its value? Why does it exist? I mean, you say to stabilize a currency, but if they're not doing that, they're just manipulating the markets. Could we do without them?
[00:15:21] Chris Coffman: Well, some very wealthy, very powerful people have gotten wealthy and powerful because of understanding how the fed works. So that's just not going to happen. Andy Jackson could do it in about 1837, but it's not...
[00:15:35] Eric Knight: Theoretically?
[00:15:36] Chris Coffman: Yeah, theoretically. Sure. Money is probably most closely related to credit rather than to gold and silver. So for example, if you had bought a car from me, you gave me a note. I, Eric Knight promise to pay Chris Coffman in six months time, $20,000. And you took the car off to North Carolina. In the old days, the way this happened, the way trade worked was I would have this note and I would go into Regalsville or Hellertown or Bethlehem, and I'd go this very well known citizen, Eric Knight, who we all know is a senator from North Carolina and a very wealthy landowner.
[00:16:14] He's given me this note. This is actually his signature promising to pay me $20,000. So why don't you take this instead of cash and let me buy an old truck. Some guy might discount it to make a little bit of money. He'd say, okay, I'll give you a truck for $19,000. Chris. With this note in six months I'll collect it from Eric Knight and I'll make an extra thousand dollars. That's actually how it worked. And so by giving a credit note that was trustworthy, because it's Eric Knight, prominent citizen, I can actually use that for purchasing power. Because people know who you are up here in Bethlehem and they know that you're this prominent senator from North Carolina and that you will pay.
[00:16:57] So they give me the truck now and they know that you're going to pay $20,000 in six months, they're going to make an extra thousand dollars in cash.
[00:17:04] Eric Knight: And meanwhile, the money has not actually transacted yet.
[00:17:08] Chris Coffman: Correct.
[00:17:08] Eric Knight: It's just a promise.
[00:17:09] Chris Coffman: Correct. But that's probably the deep nature of money. It's probably not really related to pieces of gold or silver. Hmm. So that's when you're asking an abstract question. That's probably the answer. And that's how the Federal Reserve, that's how the banking system, that's how it all works.
[00:17:30] Eric Knight: So, let me see if I can summarize all this. The Federal Reserve was originally created or the, let's say the central. There have been multiple variations of it, but it was originally created to standardize the currency. And then in 1913 or so, the Federal Reserve Act, as we know it today, was designed to stabilize the currency and print the currency. And what they do is they basically buy and sell government debt, but they inject it through financial institutions.
[00:18:01] So the government, in order to increase its spending power, because they are infinitely spending more and more, they either have to tax, they have to borrow or they have to print. If they are borrowing, they put out bonds or T-bills or something and financial institutions then buy those debt notes from the government and then the Fed comes and buys those from the financial institutions for cash. And that is what injects cash into the financial institutions, ergo, the economy. Do I have that right?
[00:18:30] Chris Coffman: You do.
[00:18:31] Eric Knight: If you were in charge of the entire economy, obviously this position doesn't exist, but even the president can't do it. So you're in charge of the government and the Federal Reserve. And Chris Coffman, the Recovering Investment Banker can correct the US economy and perhaps the global economy. What would you do? How would you work the Fed and the government together to fix our drastically... I mean, we're basically heading off a cliff, debt wise, how do we fix it? What would you do?
[00:19:00] Chris Coffman: Well, I think actually that the Federal Reserve is, is now taking the right course. They are shrinking their balance sheet. They are projected to decrease the money supply by over 12% the next three months. They have raised interest rates. I think those are all exactly what need to happen. We, we will never get back the inflation that's happened. In other words, the US dollar is now permanently less valuable than it was at the beginning of 2020.
[00:19:31] But if we were to do that, we would cause it a very severe recession contraction, which would be very painful to people.
[00:19:37] And as it's already happening there's all these firings in Silicon Valley and it looks like it's now starting to go beyond the tech industry. So you don't want to be any more aggressive, I think, than the Federal Reserve already has been. And that four or five percent fed funds rate is actually pretty reasonable.
[00:19:55] Eric Knight: Well, Chris, thank you so much for this. This has been episode 13 of the Recovering Investment Banker. I don't know what we're going to talk about in the next one. I appreciate all of you listeners, and thank you for your feedback that we get. And Chris, congratulations on your second book. It's awesome that you've published a second one. And if you get a chance to get A Prince Among Men, you can get it online on Amazon, we would appreciate it. Thank you so much. Anything else, Chris?
[00:20:20] Chris Coffman: All good, Eric.
[00:20:22] Eric Knight: All right. Take care everyone.