Market Commentary: The money multiplier effect | The Fed gets serious about tightening policy

08 April 2022
Stephanie Leung
CIO Office

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Watch Freddy Lim, co-founder and CIO, Philipp Muedder, Head of Financial Planning, and Stephanie Leung, Group Deputy CIO, discuss the latest global events and their potential impact on the markets and on our investment portfolios.

In this episode:

  • What the US Federal Reserve discussed at its March meeting [1:10]
  • The money multiplier and what it means for the economy [2:20]
  • Why we shouldn’t overreact to the Fed’s tightening plan [9:00]


Philipp | 00:01

Hello and welcome everyone to another commentary from StashAway. With us today, our Chief Investment Officer, Freddy Lim. Hey Freddy, how are you doing?

Freddy | 00:10 

Hey Philipp! How are you? A big hi from Japan.

Philipp | 00:14

It's so good to see you being able to make your way over to your family so very excited and...

Freddy | 00:21

Absolutely! The reopening is happening in a lot of places in the world. And I hate to say this for people who are not here, it's cherry blossom time. It's beautiful.

Philipp | 00:32

I can imagine. I saw some pictures already across all the social channels. So yeah, it's looking beautiful. But hey, I'm envious of you because I think one of my last trips to Japan was actually with you a few years ago. But hey Freddy, lots of things are happening. Obviously, the big news this week - what everyone was waiting for was - the Fed minutes from the March FOMC meeting were released today as we record this on Wednesday, the 6th of April (US Time). So with that being said, maybe you can talk a little bit about what happened in the minutes and what kind of impact it had this week already on markets.

Freddy | 01:16 

Well, the minutes basically affirm the Fed's concern over inflation and their determination to keep it in control. As you know, their long-term target is, the natural equilibrium, is around 2 to 2.5 percentage points. Because of the new framework of using averages, maybe 3% is still comfortable. Today we're talking about a headline at 7.8% year-on-year and 6.4% in the core inflation. The PCE is a different number, but I'm just talking about the consumer trends here. It is a concern, even if you exclude the impact of fresh food and energy. So they probably felt compelled to do something about inflation right this very moment.

Philipp | 02:04

No, absolutely. And I think with that being said right, I think you wanted to also; we talked about a little bit before we went live is, we talked about it a lot of times probably a year or two ago; obviously during COVID, when it first started and markets were dropping, the Fed was stepping in, right? We talked a lot about the money multiplier - maybe you can refresh that a little bit for the listeners and see where does it stand right now and why is that an important indicator?

Freddy | 02:35 

Yeah. That's a very good point. The money multiplier works both ways. Suppose it's pre-crisis. It was 5.5 times. That means for every single dollar that the Fed has pumped into the banking system will over time, in a few months, grow towards $5.50. So, that's the money multiplier effect. That effect came from the fact that our banking system is a fractional one, if there's $100 in the banking system, the banks would only need to hold a certain fraction of it in reserve. As new money comes in, a fraction of it goes into reserve, a majority of it can be lent out again and the cycle multiplies money a couple of times. So that's a money multiplier. Now it works the other way too, when the Fed is withdrawing liquidity or selling the balance sheet in this case. So the so-called quantitative tightening is essentially reducing the holdings - the assets that the Fed has purchased over the years as part of their multi-year support to the economy. So they need to wind that down. Every dollar withdrawn through the money multiplier process results in a certain impact on the money supply and hence on the economy. And at the moment, the money multiplier, whether it is M1 which is more narrow or M2 which is broader, they are at an all-time low. So I mentioned 5.5 times just before COVID, it's gone down to 1.3 times in M1 and 1.11 times in M2. So what it means is quantitative tightening's impact is also a lot more muted than in the past. This is the right time to do so. But obviously the market has to digest this new piece of development.

Philipp | 04:19

No, absolutely. And that's why you're seeing in the first few days of this week, with the anticipation of the Fed, markets have started to go down a little bit after a couple of weeks of a refreshed up slope, right? Freddy, you talked a little bit about the money tightening and what the Fed is going to do, we talked about why they're doing it right - inflation is running amok a little bit. So a lot of times people argue or you hear a lot of people will probably have read this before is - oh, the Federal Reserve, if they don't get the Fed rate hikes correctly done, it usually ends up in a recession historically. There is a secondary part to this question and let's say, for example, they started hiking rates and then we're seeing equity markets drop by 10%, 15%, 20%, maybe even 30%. Who knows what's going to happen? Where is that threshold of equity market downside risk that the Fed has to actually step back in, right?

Freddy | 05:28 

Well, you know, they have a long history, the Fed. And in the past, a more primitive way of communicating and nowadays they're very experienced, let's put it this way. So it's a bit of a feedback loop between the Fed and the markets. If you see the amount of rate hikes priced into the market over the last year or till today, you can see it's quite artfully done, right? The Fed signalled that they needed to hike a little bit, the market priced it in and the market tells the Fed what they're expecting beyond the immediate, there's a whole market for different horizons going to the future. And then the Fed looks at that and says, well, OK, that's sort of reasonable. And they slowly guided the market there. So that's with the rate hike expectations, you see the market now comfortably pricing in 8% or 9% - 25 basis point hikes for this year. So that means the market is already bracing for some 50 basis point hikes. So that was very artfully done. And yet here we are, the market's a bit flattish, but it's not like a crash. It's very well done. Now, this is similar, in my opinion. It sounded a bit abrupt two days ago when Lael Brainard came out, being the dovish member, traditionally saying that sort of shocked everyone.

Philipp | 06:41 

Spooked it, yeah.

Freddy | 06:43

Yeah spooked. But the sort of numbers today, $95 billion USD, $1.14 trillion USD a year. The equity market is at least $48 trillion USD in the US. The money multiplier is 1.x times. So you're not withdrawing a lot in terms of liquidity out of the markets. So that's manageable at the moment, right? So I think the Fed is playing a game of signalling a little and testing the response of the market. If it's healthy enough, they will try to push it again, right. And ultimately, as long as there’s earnings potential or there's earnings momentum in the equity markets - rate hikes would not interfere with that, right? Like Warren Buffett famously coined the term synthetic bond, you can think about the stock market as a very long-dated bond. Every year, the cash flows, your earnings or expected earnings - if your earnings peaked and you have an interest rate hike, yes, a percent of interest rate hike can reduce the equity market by 15% to 16%, right? But as long as earnings momentum is there and that provides cushion from impact, and that's sort of what we see in the equity price action right now. Who knows what's going to happen tomorrow, but investors need to take this very long-term view going back many cycles and say, how has the Fed been doing this before? It's not like after every rate hike cycle comes a recession. In fact, the way it's done now is signalling, testing the response and then adjusting the expectations. That approach is a lot safer than in the past, in my personal opinion.

Philipp | 08:14

Yeah, and being open about it, right? The markets, you know, if they know about things, they usually price these things in and it's a lot less of a surprise, right? So I think that's very important. And then I want to ask you one other question that just came to my mind while we were talking about this. I think, you know, earnings have been OK this year still, right? I think you see a lot of companies taking the advantage, not advantage, but they have to because obviously raw materials have, you know, inflation has caught up, right? And they're passing it on to the consumer by raising prices. You see it across the board if you type in any company, they probably raised the prices over the last couple of months, right? Do you think the raise in prices versus the earnings not even reflecting it because companies will have to also raise pay, right? Because if inflation is 7% to 8% and employees are getting, you know, like their 1% to 3% normal, you know, merit increases, so to speak. It's not keeping up. And I think that's when the economy will start seeing it. If the end consumer can't buy things because they didn't get enough raise. Is there any relation, you think, between all of this or not really?

Freddy | 09:24

So this is a great dynamic, right? If I'm a company, I look at my costs, which includes a lot of wages. That increase in cost base; is my earnings potential growing faster? And right now, if you look at equity markets, the healthy thing is not the expansion of PE multiples, but expansion of earnings per share. So that is still very healthy. And at the moment they are sort of able to overcome and manage the situation of cost increases. But if the Fed does not do anything about it, in the year later and going more forward looking, those companies' quality of earnings will start coming down. So to move the market forward in a healthier manner, it's actually in the Fed's interest and the economy's interest that we do some sort of tightening now while we can while the money multiplier is low, right? So in a way, we shouldn't overreact to it. We should always stick to long-term plans, a portfolio should not be unidimensional to just the stock markets tracking it. It should be multi-asset, super diversified, not just by geography, but also by asset types, which is what we have been doing since the 3 reoptimisations we've done last year and this year. So those are very important.

Philipp | 10:33

That's super important because that's really you know, it really shows also in more volatile markets the benefit of it, right? So when it's all going up, then it's not so obvious for people. But it's times like this where you really want to protect the downside so you don't get hurt and you can stay in the market for the long term, right? I think that this is really, really important. So thanks again, Freddy for sharing all your thoughts here with us. And if you want to learn a little bit more about a couple of asset classes, we have a few cool events coming up. So for our Hong Kong and Singapore audience, we actually have an event with State Street and ourselves and it's called Gold versus Cryptocurrency. So if you want to learn more about using one or the other or both or a mix of them, you can ask all your questions during the webinar. That's on Tuesday, the 12th of April at 7pm local time. So if you have any questions, or want to sign up for this, check out our website or the links in the show notes below. And for our Malaysian audience, we have another couple of webinars. On the 13th of April, that's Wednesday, 6pm - it's called What is your Financial Plan B? So if you want to learn more about estate planning and having wills in place and protecting yourself and your family, it's a great event. I really recommend you guys join this. And another one is on the 20th of April. So the week after Wednesday - same time at 6pm, it's called An Inside Look into StashAway. So if you want to learn more about us, how we invest, how the app works, how we do all kinds of other things, please feel free to join, ask any questions you want, it's super interactive. Looking forward to having you there. Until then Freddy, I wish you a wonderful time and I'm sure we'll speak while you're still there. And I'm looking forward to that in a few weeks. OK. Thank you so much.

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