As inflation accelerates in the United States, the Federal Reserve is faced with a difficult decision: raise interest rates and risk crashing the markets, or keep interest rates low and risk hyperinflation. The Fed seems to be leaning towards the former rather than the latter, and recent comments by its top officials suggest it’s ready to do much more than just raise rates.
Today I’m going to give you a bit of background about the Federal Reserve and tell you exactly what its top officials have been saying and how this could make or break the crypto market. But before we examine the money printer, I need to hit you with the Jet-Bot bitcoin copy trading platform. With 3 days of trial access, this software allows you to automatically replicate the best traders.
What Is The Federal Reserve?
Now let’s see what the Fed has been up to and whether it could cause the markets to blow up. If you’re unfamiliar with the Federal Reserve, here’s what you need to know. The Federal Reserve, aka the Fed, is the central bank of the United States of America. The Fed was founded in 1913 and, though it’s often considered to be part of the US government, it’s technically a corporation that is owned by regular commercial banks via the 12 regional Fed banks that make up the federal reserve system. Although the Fed is privately owned, it is governed by the seven members of the Federal Reserve Board who are nominated by the U.S. president and confirmed by U.S. politicians.
The Federal Reserve Board is tasked with making sure the Fed adheres to the two directives that were given to it by U.S. politicians in the 1970s, and those are to ensure “maximum employment” and “price stability.”
The Fed achieves this dual mandate primarily by raising or lowering interest rates. When the Fed raises interest rates, it becomes more expensive to borrow money. The resulting slowdown in the supply of new money reduces inflation, but it also runs the risk of increasing unemployment since economic activity slows down when interest rates are high. When the Fed lowers interest rates, it becomes cheaper to borrow money. The resulting increase in the supply of new money tends to decrease unemployment since economic activity increases when interest rates are low, but it also runs the risk of causing inflation.
However, it’s not enough to know what effects interest rates have on the economy. We must go one step further, and that is to understand two of the main ways the Fed actually changes interest rates.
How are Interest Rates Changed?
The first way the Fed changes interest rates is by raising or lowering them. The federal funds rate is basically the interest rate for short-term lending and borrowing between commercial banks, and this interest rate is eventually passed on to the customers of those banks. To use a simple example, if the Fed raises the federal funds rate to, say, 5%, you’re likely to pay slightly more than that to borrow from a US bank, possibly as much as 6% or even 7%. The extra percentage you pay is how the commercial banks make their money.
As such, when the Fed talks about raising interest rates, what it’s essentially talking about is raising the federal funds rate, which is what you see in the image below, and chances are this is an image you’ve seen before.
Now, the second way the Fed changes interest rates is through “open-market operations,” which is basically when the Fed buys or sells U.S. government debt on the open market. Note that U.S. government debt is called different things depending on when the debt is supposed to be repaid.
The long-term types of government debt are called treasury bonds. Medium-term types of government debt are called treasury bills, and short-term types of government debt are called treasury notes. For context, long term means 20 years or more, medium term means between two and ten years, and short term is less than two years.
US government debt is important because it is used as the risk-free rate in the economy, i.e., the base rates that can be charged for similar terms of debt in the economy. So, to use a simple example again, if the interest rate on 30-year treasury bonds is, say, 5%, then on a 30-year mortgage you’ll be paying the base rate of 5% plus an individual credit spread. If you don’t default on your mortgage, then this spread is profit for the bank.
The interest rates on the different types of U.S. government debt depend on supply and demand. When demand for a particular type of government debt is high, the interest rate on that debt is low. When demand for a particular type of government debt is low, the interest rate on that debt is high.
As such, when the Fed talks about tapering, aka reducing its balance sheet, what it’s essentially talking about is selling the government debt it owns, which will increase interest rates for those types of government debt in the absence of sufficient demand from other buyers.
The Fed’s Recent Interest Rates
Now that you understand two of the main ways the Fed changes interest rates, we can take a closer look at what the Fed is planning on both fronts. But first a bit of background.
When the pandemic began in early 2020, the Fed lowered the federal funds rate to zero and started buying up trillions of dollars of assets, mostly government debt and mortgage-backed securities, which is basically housing debt. To be exact, the Fed started buying up $80 billion of government debt and $40 billion of mortgage-backed securities every month. This buying pressure lowered medium and long-term interest rates for borrowing for the reasons I mentioned just a few moments ago. As I also mentioned earlier, low interest rates make borrowing very cheap, and zero interest rates, well, that technically makes borrowing free.
This created a huge incentive for individuals and institutions to borrow and spend. This economic activity caused the economy to overcome the shortest recession in history, at least in theory. At first, all this borrowing and spending didn’t cause too much inflation, and that’s simply because it takes time for all this new money to make its way through the economy, typically about a year. Low and behold, almost exactly one year later, inflation started to increase according to the official CPI statistic, which almost certainly undercounts inflation.
Anyhow, at first, the Fed didn’t flinch, and though federal reserve chairman Jerome Powell claims that this was because the fed believed most of the inflation was coming from supply chain issues that would be resolved. Many analysts believe that this had more to do with Jerome’s pending re-nomination.
The short story there is that the current ruling party in the United States wants the fed to continue its easy monetary policy, whereas the opposition wants the fed to raise interest rates. Given that Jerome’s nomination and appointment depended on the former, he stayed away from interest rate rhetoric, but low and behold, right after Jerome was re-nominated by U.S. president Joe Biden last November, he started talking about how the fed must raise interest rates to tame inflation, which had started hitting record highs by that point.
Not surprisingly, the markets have been slowly crashing ever since. Today Jerome’s rhetoric has tilted towards the other extreme, and this is primarily for political reasons. The Fed is under extreme pressure from both sides of the aisle to tame inflation ahead of the upcoming midterm elections in the United States, because inflation is obviously very unpopular with voters. Speaking of which, it appears that U.S. politicians are starting to become acutely aware of just how much the average voter cares about crypto because they’ve been saying surprisingly pro-crypto things during recent hearings related to crypto.
The Fed’s Interest Rate Roadmap
Anyhow, with official inflation approaching double digits in the United States, the Fed has changed the interest rate roadmap its officials had detailed a few months ago. At first, Fed officials suggested that they would begin raising the federal funds rate by 0.25% every two months or so, and institutions predicted that the Fed would keep raising the federal funds rate until it reached a level between 2.5% and 3%.
The first 0.25% increase took place in mid-march, and this actually caused markets to rally, including the crypto market. This is simply because the interest rate increase was in line with what investors had priced in, and it’s actually quite common for the markets to rally on what should be bad news so long as the outcome is certain. What investors did not account for was the possibility that the Fed would gradually raise the federal funds rate from 0.25% to 0.5% at a time, as chairman Jerome Powell hinted late last month. Might have guessed, this is roughly when the crypto market started to trade sideways for days on end.
As the crypto charts suggest, some very unexpected news came from the Fed in the first week of April, specifically from Federal Reserve board member Lael Brainard. You see, Fed officials initially suggested that they would begin slowly selling off the assets on the Fed’s balance sheet later this year or early next year, which, you’ll recall, will result in an increase in medium-to long-term interest rates. However, earlier this month, Lael revealed that the Fed is now looking to sell off the assets on its balance sheet as early as next month and at a much faster rate than investors had priced them in. This is more significant than you think because Lael has often been labeled a dove, meaning that she’s historically been in favor of keeping interest rates very low. The fact that this hawkish, high interest rate rhetoric, was coming from her sent shock waves through the market.
The very next day, the Fed released the minutes or summary of its March meeting, and it revealed more details about the Fed’s new roadmap, especially regarding its balance sheet reduction.
The Fed is now looking to reduce its balance sheet at a rate of up to $95 billion per month. This is almost the same amount of money the Fed was adding to its balance sheet at the start of the pandemic, which means it’s practically a complete 1/80 from its monetary policy.
Naturally, this translated into a crash across asset markets, but it also caused the interest rates on long-term government debt to spike. This is simply because bond investors preemptively priced in the incoming cell pressure from the Fed, which will, of course, raise interest rates on these types of debt. This kind of front-running behavior is common in crypto too.
How Much Will The Fed Do?
So what happens next? For the time being, it looks like the Fed is still intending to increase the federal funds rate between 2.5% and 3%. If we assume the same two-month timeline that Jerome gave for the Fed’s interest rate hikes earlier this year, the Fed will hit that 2.5% target in less than a year, specifically in January 2023. Take note that this is for short-term interest rates only.
With over $5 trillion in government bonds on its balance sheet, the 60 billion per month sell-off of these specific assets detailed in the March meeting minutes means that medium and long-term interest rates will rise by another half percentage point over the next year or so.
The question investors are currently asking is how much the Fed can realistically raise interest rates before something in the economy breaks, and two indicators offer some clues.
First, there’s the yield curve, which is basically the annual interest rate of the different types of government debt put on a chart.
Under normal economic conditions, the longer-term types of government debt will offer higher interest rates, and this is to compensate for the opportunity cost that comes with lending money to the government for such a long period of time. Basic economics, so to speak.
When something in the economy isn’t quite right, the yield curve will invert. This is when the short-term types of government debt offer higher interest rates than long-term government debt, which is the opposite of the basic economics I just detailed.
An inversion of the yield curve has therefore been a historical sign of an upcoming recession, but it’s obviously not the only indicator to pay attention to and hasn’t always been all that predictive. Even so, the current state of the yield curve is important in this context because it basically tells you how much the Fed can raise short-term interest rates before investors start to get nervous.
The short-term interest rate that most investors reference is the two-year treasury note, and the long-term interest rate that most investors reference is the 10-year treasury date. Right now, the two-year and the 10-year are neck and neck as far as interest rates go, so the Fed can’t raise interest rates at the moment according to this interpretation.
The caveat is that when the fed starts to sell some of the longer-term government debt it’s holding next month, this will likely cause the 10-year rate to rise high enough to give wiggle room for more short-term interest rate hikes.
However, if it’s true that this cell pressure will only open a 0.5% gap, it still doesn’t leave much wiggle room for the Fed on the short-term side, even if additional investor speculation drives long-term interest rates slightly higher.
It’s the same story with the second thing to consider, and that’s the fed’s effective funds rate graph we looked at earlier. As you can see, short-term interest rates have been on the decline for decades. This is simply because individuals and institutions have taken on so much debt during low interest rate conditions that the economy literally starts to fall apart at lower and lower interest rate hikes.
If you extrapolate this downtrend, you end up with an interest rate of around 1.5% for this cycle, assuming. If the Fed sticks to its current schedule, we could hit 1.5% as soon as September this year. It depends on how well the heavily indebted economy is coping with these higher interest rates. The Fed will have to make some serious decisions about whether it wants to continue its rate hiking cycle.
What Does It Mean For Crypto?
And now for the big question: what does all this mean for the crypto market? In short, it’s not good, but it all depends on inflation, because that’s ultimately why the Fed is raising interest rates.
One important interest rate indicator that investors are waiting for is peak inflation, which is basically the point at which the relentless inflation we’ve seen starts to reverse course. This is because if inflation starts to ease, the Fed will be less likely to increase interest rates as aggressively, if at all.
Some analysts are speculating that the record inflation figure for March was peak inflation, but we won’t know this for sure until a few more inflation figures come in over the next few months. We also won’t know the exact details of the Fed’s new interest rate roadmap until its press conference in early May, which means we’re likely to see lots of volatility until that time. Beyond that point, it’s really anyone’s guess. But if the Fed manages to stick to what’s known of its current roadmap, then the crypto market could continue to take a beating until early next year and will likely enter a bear market as a result.
For those who say we’re in a bear market already, well, I beg to differ because we’ve consistently seen higher lows over the last year for most cryptocurrencies and a long-term downtrend of lower lows hasn’t set in, at least not yet.
Now, I know this sounds terrible, but it may be for the best that crypto enters a bear market because the alternative is much worse, and the Fed appears to be aware of this as well. If the Fed reduces interest rates in response to a market crash while inflation is still running rampant, this could lead to hyperinflation not just in the United States but around the world, and some would say this hyper-inflation has already begun in some places.
Now you might think that this would present the perfect opportunity for the world to adopt cryptocurrency, but it’s much more likely that governments around the world will take this as the perfect opportunity to introduce their own dystopian central bank digital currencies.
[This article is a transcription of a video made by Coin Bureau]
Original video: https://youtu.be/DPE5D7X3N7U ]