Jul 28, 2017 4 min read

This week the Federal Reserve Board’s Open Market Committee had a scheduled meeting at which it voted unanimously to leave interest rates unchanged.

The decision was what most of the stock market expected. The Fed has a mandate to try to maximize employment and control inflation. The committee expects inflation to be “somewhat” below 2 percent in the near term. It believes unemployment is within range of expected targets.

The committee has two main tools at their disposal. First, they set the short-term interest rates that they charge to banks. Every bank is required to maintain a certain amount of liquidity. When banks need more cash, they borrow short term from the Fed. When rates are higher, it reduces the amount of cash available in the economy. This reduces borrowing and slows down growth.

The Great Recession in 2008 was triggered by large scale fraud in the housing market. Many loans were given to borrowers who could never pay them back. Many of these loans had federal insurance guarantees and were packaged and sold to investors. As they defaulted, the stock market crashed and the economy went into recession. This required central banks to step in with stimulus to try to correct the situation.

Our Federal Reserve reduced interest rates to near zero, but the action still did not pull the country out of the recession. The Fed is not permitted to issue negative?interest rates like some other countries have done. In a negative interest rate market, you pay the government to store your money for you.

The other tool the Fed has is the ability to buy bonds. It accomplished that through quantitative easing. It had three rounds of QE where it purchased trillions of dollars of government bonds. Many were mortgage-backed securities because the Fed wanted to support the housing market.

Many people believe they did this by using the printing presses, but that wasn’t the case; it just issued itself more credit.

This increase in the balance sheet was the biggest in the bank’s 103-year history, leaving it with trillions of dollars more than normal.

Government bonds and the stock market are giant auctions. If there are more buyers than sellers, the prices will go up. If there are more sellers than buyers, the market will go down. Supply and demand is the most basic economic principle.

The Fed now has a giant balancing act. It is trying to normalize interest rates and reduce its balance sheet without disrupting?the economy. A mistake could cause inflation to spike or the stock market to crash. The Fed is in uncharted waters. It has never held rates so low for so long or had so many assets to liquidate.

Governments usually like to see inflation around 2 percent a year. This keeps the economy growing and motivates people to buy today while prices are lower. It also makes paying back government debt a little less expensive.

Another problem for the Fed to consider is that our economy has been growing slower than usual since the Great Recession. We also have a record amount of government debt. There are a lot of unknowns that could be disrupted.

While the Fed did not increase rates this week, it has indicated there will probably be one more interest rate increase this year. The Federal Reserve Board is also going to start liquidating its balance sheet to a more normal level. The plan is initially to liquidate around $10 billion a month and gradually increase to $60 billion a month, a process that is expected to begin in September.

Hopefully, the Fed gets it right or we could see some undesirable changes in the markets. Make sure that you plan for all outcomes.

Gary Boatman is a Monessen-based certified financial planner and author of “Your Financial Compass: Safe passage through the turbulent waters of taxes, income planning and market volatility.”

To submit columns on financial planning or investing, contact business editor Michael Bradwell at mbradwell@observer-reporter.com.