The Fed is Prepping for Liquidity Problems

Michael LebowitzAdvisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

In 2019, the Fed cut interest rates and restarted QE despite a healthy economy. Today, inflation is higher than the Fed's target, economic growth is above historical trends, and financial markets are complacent and exuberant. Yet, the Fed is talking about cutting rates and reducing QT. The only rationale for it in such an environment is a concern with liquidity problems, as the declining balances in the Fed's reverse-repurchase program (RRP) suggest.

Before discussing RRP and what it foretells, it's worth appreciating that a good understanding of the Fed's policy tools is vital for investors.

Why the Fed is so important for investors

Twenty to 30 years ago, very few investors needed to understand the Fed's monetary plumbing. The Fed was undoubtedly important, but its actions were not nearly as closely followed or impactful as they are now. Investor success, whether in real estate, stocks, bonds, or other financial assets, now hinges on understanding the Fed's inner workings.

Total debt is growing much faster than the economy's collective income. To facilitate such a divergence and to avoid liquidity problems, the Fed has increasingly employed lower interest rates and balance sheet machinations (QE). Numerous bank and investor bailouts have also helped.

As the country becomes more leveraged, the Fed's importance will increase.