As coronavirus outbreak has locked down many cities and states in the United States, unemployment is on a rise. According to the Department of Labor’s news release on March 26, 2020, the seasonally adjusted initial unemployment claims was 3,283,000, an increase of 3,001,000 from the previous week’s revised level. To counter the economic slowdown caused by the virus outbreak, the congress passed a $2 Trillion stimulus bill, which was signed into law by President Trump on Friday, March 27, 2020. In addition to this government stimulus package, the Federal Reserve has been buying all kinds of securities to inject liquidity into the economy.
Back during the 2007-08 financial crisis, the financial institutions were the ones that had to be rescued by the Fed. This time around, according to this press release, the Federal Reserve is not only buying treasury securities, but also buying large amounts of asset-backed securities (ABS) backed by student loans, auto loans, credit card loans, loans guaranteed by the Small Business Administration (SBA), and certain other assets. The Federal Reserve is also facilitating the flow of credit to municipalities by expanding the Commercial Paper Funding Facility. Additionally, the Federal Reserve expects to announce the establishment of a Main Street Business Lending Program to support lending to eligible small-and-medium sized businesses. What does all of this mean? It means that the Federal Reserve will do WHATEVER IT TAKES to ensure that there is monetary supply (liquidity) in every credit market of the economy.
The Federal Reserve is the central bank of the United States. Similar to other financial institutions, the Fed has its own balance sheet. The Federal Reserve works hand in hand with the Department of Treasury, the department that prints money. When the Federal Reserve buys treasury securities and ABS from other institutions, it is flooding the market with cash in return for those assets. Similar to how you pay cash for the strawberries that you bought at the grocery store, the Federal Reserve is paying cash for the various assets that it’s buying. The Fed plays a key role during times of uncertainty, such as now, when everyone is selling and there are no buyers on the other side. Asset prices drop tremendously when there are no buyer on the other end, since you are left with assets no one wants to buy. So, the Fed comes in and starts buying, and provides the much needed cash to all the sellers.
As the Treasury starts printing more money and the Federal Reserve increases the money supply in the economy, this depreciates the value of the currency. As the supply of US dollar increases, the price of it drops. Said differently, you are going to experience inflation. A dollar today is going to be worth less in the future. So, you’ll have to pay $5 for the $2 loaf of bread that you bought today.
Now you might be thinking that the Federal Reserve did Quantitative Easing (QE) after the great recession of 2007-08, but that did not cause a lot of inflation. So, how is this cash injection different this time around? Well, a lot of the cash that was injected after the great recession was locked up as reserves for the financial institutions. So, most of the cash was retained by the financial sector. This led to prices being fairly stable despite the fact that money was created out of thin air. However, I believe that it is different this time around as the Federal Reserve is injecting cash in every credit market out there.
I suspect that we are likely to see high inflation after we get past this coronavirus outbreak. Prices of goods are going to increase, wages are likely to increase, as the purchasing power of dollar drops. I do not expect the United States to have hyperinflation, since this would mean that the public has lost complete trust in the currency. Regardless, holding onto cash or bonds might not be the best investment strategy after this outbreak. While investing in stocks does provide a hedge against inflation, we do not know if that inflation could get out of control and lead to hyperinflation. In case of hyperinflation, according to Ray Dalio, the stock market is a mixed bag and isn’t the most ideal investment choice. In the next couple of months, I will slowly increase my exposure to commodities, such as crude oil and precious metals. Real assets i.e. commodities protect you from inflation and hyperinflation.
There is a possibility that we run into the great inflation of 1970s scenario, when the United States had high inflation and high unemployment. Paul Volcker, the Fed chair at the time, had to decide if he wanted to decrease inflation OR decrease unemployment (the Federal Reserve can not do both at the same time). He decided to curtail inflation by increasing the Federal Funds rate to near 20%, which is unfathomable given that the United States has been near zero interest rate for the past decade. Eventually, inflation was brought under control, and soon after, the unemployment decreased. However, it was a tough time for Volcker since he was criticized for pushing unemployment even higher. I do not know how Jay Powell, the current Fed chair, would respond to high inflation and high unemployment scenario post coronavirus outbreak. There is always a likelihood that the US economy may not recover from these supply/demand shocks as quickly as the government and the Federal Reserve anticipates. In that case, it is important for us, as investors, to have a balanced portfolio.
Hope you learned a little and found this blog post helpful. We talked about how there are trillions of dollars that are being pushed into the US Economy either by the government or by the Federal Reserve. We talks about how this money creation and injection could lead to high inflation. If things do not improve after the coronavirus outbreak, we could potentially see a scenario with high inflation and high unemployment. As always, you can sign up for our free mailing list here. You can sign up for our paid subscription services here. Like us on our Facebook page here. Thank you!
Superior North LLC’s content is for educational purposes only. The calculators, videos, recommendations, and general investment ideas are not to be actioned with real money. Vyom Joshi is not a professional money manager or a financial advisor. Contact a professional and certified financial advisor before making any financial decisions. Please review the Disclaimer and Terms and Conditions.