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Fed watch • Credit creation, cause & effect • May 18, 2022
(1) The Federal Reserve buys and sells securities and (2) sets interest rates to influence: (3) borrowing costs, (4) lending activity, (5) inflation and employment; (6) with varying effects.

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TLDR: Last week, the Fed added $1.4bn net to its Treasury security holdings and $19.4bn net to its MBS holdings. The total amount of Reserve Bank credit increased by $14.8bn net. Note that additions at this stage are likely caused by previous purchases settling. Settlement can take up to 180 days.
  • The 10-year Treasury yield dropped by 3bp to 2.88%.
  • The 30-year fixed-rate mortgage fell by 5bp to 5.25%.
  • The market expects the federal funds rate to hit 275-300bp by year-end.
  • I have added an inflation-adjusted US house price index. I will update this monthly as the Bureau of Labor Statistics (BLS) updates its consumer price index (CPI) data and the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index comes out. This is current as of February. The expansion data is in section 5 and the chart is in section 6.

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1/ The Federal Reserve buys and sells securities
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sources: Federal Reserve Bank of St. Louis, Board of Governors of the Federal Reserve System

2/ And sets interest rates
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source: Federal Reserve Bank of St. Louis

3/ To influence: borrowing costs
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source: Federal Reserve Bank of St. Louis

4/ Lending activity
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source: Federal Reserve Bank of St. Louis

5/ Inflation and employment
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sources: Federal Reserve Bank of St. Louis, US Bureau of Labor Statistics, S&P Dow Jones Indices

6/ With varying effects

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'*'money multiplier is calculated as M2÷monetary base. The pre-GFC average (1958-2007) was 8.9. sources: Federal Reserve Bank of St. Louis, Valuabl

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'*'calculated as the change in S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index adjusted for the change in CPI for all urban consumers. sources: US Bureau of Labor Statistics, S&P Dow Jones Indices, Robert Shiller.

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ELI5: Why is this gobbledygook relevant?
The Federal Reserve creates money and uses it to buy bonds. They do this to push interest rates down and to put more money into the economy. Low rates mean people can borrow more, spend more, and afford higher prices. More spending and higher prices mean people feel rich, and businesses hire new employees.

But, if prices rise too quickly or people borrow too much, the Fed does the opposite. It sells the bonds it has and then destroys the money it receives. These sales push interest rates up and take money out of the economy. Higher rates mean people can't borrow or spend as much and need to pay lower prices. It makes people feel poorer than before, stops them from being able to spend as much, and makes businesses trim employment.

In addition to this, the Fed borrows and lends to banks. If a bank doesn't have enough money for a day or two, it can borrow from the Fed. If it has too much, it can lend to the Fed. A group of people who work for the Fed, the Federal Open Market Committee (FOMC), decide the interest rate that the Fed will pay for, or demand of, these short-term loans.

The Fed does these because they believe in two objectives: first, that a low and stable inflation rate is good for the economy, and second, that minimising unemployment is desirable.

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