Anatomy of a Dollar

Inflation, deflation, quantitative easing, interest rates, the fed... for most people it is all just a mystery. Every day we hear things about the dollar, but it is not often that we take the time to learn about what it all means.

Here I want to go into a simplified version of what all these terms mean and what they mean to the stock market and the American economy.

The Federal Reserve

I am sure you have heard of the Federal Reserve (or the Fed), but didn't know what exactly it is or what it does. The Federal Reserve is what we call a central bank. Now this central bank is technically separate from Congress and is intended to act on its own devices when it comes to making decisions.

Although the chairman and vice chairman are appointed by the President and confirmed by the Senate. The central bank acts as a bank for all the other banks... I know that was a bit confusing, but essentially it is a place where the banks that we use go to borrow money and perform other financial transactions.

Since all the banks use the Fed then it in turn regulates how banks operate. Think of this regulation as terms on the loans it gives to the banks. For example, when taking a loan from the Fed the bank must keep a certain amount of this money in reserves as cash rather than lending it all out. Along with that, it acts as the bank of the US government. So with a lot of arrows pointing to the Fed you can see how they can have a large effect on the global economy as a whole.

The Federal Reserve has two main mandates: keep unemployment low and keep the price of the dollar stable (low inflation).

This is done by using one of their three levers: Regulating money supply (printing money, destroying money, buying treasury bonds and other assets), setting interest rates, and regulating how much banks need to have in reserves.

Setting interest rates is a way they can regulate how much borrowing is done in the economy. In a bit, we will talk more about some of the feds historic actions, but for now just know that they have a lot of swing when it comes to the banking industry.

Inflation vs. Deflation And Why It Matters

So what is this inflation and why do we work so hard to control it? Well first let's talk about what inflation and deflation is.

Inflation and deflation are two sides to the same coin. Inflation is generally the increase of prices on goods and services or you can think of it as that a dollar cannot buy as many products or goods as it used to.

Conversely deflation is when prices of goods and services become cheaper over time. That is your dollars can now buy more products and services over time. Now at the surface we would think that things going down in price over time (deflation) would be a good thing and things going up in price over time would be a bad thing. Actually, it is the exact opposite. Let's run through it.

Let's say you own a furniture store. Being a business owner you want customers to come buy your furniture sooner rather than later as this is more money in your pocket to either invest back into your business or do a number of other things. Now let's consider a period of inflation.

In a period of inflation the costs of your furniture go up slightly (2-3%) per year. At a consumer level your customers are incentivized to buy furniture now rather than later because later on it will be more expensive.

To expand this a little let's consider that your customers not only have the opportunity to buy your furniture, but they also have the ability to buy the exact same quality furniture from Europe.

Since they live in the US and are paid in US dollar then they would theoretically have to convert their money to euros in order to buy this furniture. With inflation the value of the dollar is constantly eroded over time. If the dollar is less valuable relative to the euro then it is likely that you will opt to buy American rather than European as it is cheaper.

That means that a low level of inflation is good for US businesses. Since we live in a capitalistic society, we are employed by businesses which means if they do well we get better bonuses and better job security. This is good for the US economy. So even though our money sitting in our bank account is constantly being eroded over time, inflation is overall a good thing for the US economy, American industries, and American commodities.

Now let's consider the same situation but with deflation. With deflation the furniture that you sell is actually getting cheaper over time. Therefore consumers will be incentivized to buy later rather than sooner as the furniture is getting cheaper. This is bad news for you, as you will begin to see a drop in sales.

If this continues too much then you will have to start firing employees and closing down stores. Conversely, now that the dollar is getting stronger, things from Europe are starting to get cheaper relative to the dollar. This means people become more incentivized to buy foreign rather than American.

Overall this causes a contraction in all businesses as our economy is dependent on consumer spending. So even though the value of money in our bank accounts is getting more valuable people are losing their jobs and are holding off on making purchases. This causes the US to drop into a recession. So you can see why the Fed exerts so much energy to keep us in a inflationary period.

The Fed and The Great Recession

So now we must ask the most important question of all: why should we care? This is often very complicated and difficult to understand as in this case, but we will walk through it.

Let's flash back to 2008. The real estate bubble bursts on dramatic proportions. Not only is the stock market tumbling but also people are losing their homes and jobs and the investment banking industry is on the brink of complete failure. 

The economy is dropping into a deep recession and everyone is looking to the Fed, as usual, to pull us out of it. So the Fed begins to ratchet down interest rates over time until they eventually hit .25% in 2009, the lowest they have been in a very long time.

This means that banks can now borrow money from the government at near zero interest rates and then can in turn lend this out to consumers to buy houses and cars. This is one of the main ways that the Fed tries to stimulate the economy.

The other way is by essentially printing money. That brings us to how our currency system works.

With the emergence of the civilized world we moved away from a barter and trade system to a currency system. This means instead of saying "hey I need some milk and I have some grains so I will trade you grains for milk" we instead say "I need milk so I will sell some grains and buy milk". But who anoints this so called "currency" with value and how much value does it have?

Historically it was governments who took this job and up until the 1970s this was usually done by backing the currency with a precious metal such as gold or silver at a fixed rate. That is to say that every dollar there was in circulation there was a certain amount of gold sitting at a place like Fort Knox.

In the 1970s the world left the gold standard and instead went to what we call a Fiat Currency System. That is to say that currencies are no longer backed by anything physical. Rather they are backed by the faith that the government will make good on their debts. With this came the establishment of the US dollar as the world reserve currency.

This gave tremendous power to the Fed as they now are in control of the currency in which all other currencies are pinned to. So instead of the other central banks across the globe putting gold on their balance sheets to back the currency, they now put US dollars usually in the form of US treasury bonds on their balance sheet.

Now the Fed essentially has the power to print US dollars out of thin air and use them to bolster the global economy. This is like going to Best Buy and buying a TV by taking out a piece of paper and writing "$1,000" on it. If it seems absurd then that is probably because it is. 

Starting after 2008 not only did the Fed and other global banks across the world cut interest rates to near zero percent but the Fed also began printing money. A LOT of it. About 3 trillion dollars or so of it.

This is called Quantitative Easing or QE. But this "printing" is not exactly printing actual money (although they did do some of that). Rather it is buying assets with IOUs like I described above. They did this in the hopes that it would stimulate the US economy.

Now you will see many articles written with authors who are cultivating the fear associated with the mystery of how the Fed works and will use this money printing fact to scare people into reading their site and usually buying gold or something like that. Don't let them fool you. The act of printing money alone is not telling the whole story.

Let's again consider an example. Let's use a company like Amazon who is selling gift cards. Now when Amazon sells a gift card they are essentially creating cash flow out of nowhere. They didn't actually sell you anything other than the opportunity to buy something from them at a later date. Now as long as Amazon continues to offer products to sell then they can sell all the gift cards they want.

If for some reason Amazon suddenly begins to go out of business and doesn't have products to sell then that is when the amount of money used to purchase gift cards becomes a large problem.

The same is true with the economy in a way. As long as there is products and services being sold in the US then the printing of money is not necessarily a problem. If for some reason things begin to become restricted and there is a lack of products to meet demand is when the money supply becomes an issue which is where the Feds ability to destroy money comes in.

How This Effects The Dollar and The Market 

So in summary what has happened since 2008 is that the Fed has dropped it's interest rates to about as low as it can and has been "printing" a ton of money in an attempt to bolster the US economy after the great recession. Now you can't eat cake forever so at some point the Fed wants to let the market stand on it's own and prosper without holding it's hand.

This past December we saw the first of this action. The Fed raised its interest rates very slightly signaling that it will further do so in 2016. This is essentially a test as to whether the economy is back on its feet yet.

So far we have seen a strengthening of the dollar which is a very deflationary action. From my explanation above you see that this can be a bad thing for US-based global businesses. Indeed that is what we are beginning to see. Corporate profits are beginning to sink and the euro is now worth .92 dollars at the time of writing this, the lowest it has been in quite some time. 

The billion dollar question is what will it do next? Will the Fed begin another quantitative easing program? Will the dollar keep strengthening? Will the market keep falling? The real answer is no one really knows.

As of right now it is important for everyone to not make any rash decisions. There will be people screaming on both extremes for both hyperinflation and rapid deflation. Don't let them scare you. Hopefully, this article gives you are better understanding of how it works so that you may be able to keep your wits about you when ignorant people begin following their fear.

The Young Analytical Mind

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