The Federal Reserve’s Role: Maintaining Stability and Acting as Lender of Last Resort

The Federal Reserve has long held two primary objectives: maintaining full employment and ensuring stable price levels. But there’s a lesser-known role the Fed plays, acting as the economy’s “lender of last resort.”

This responsibility positions the Fed to step in and prevent financial catastrophes, whether during the subprime mortgage crisis or addressing liquidity imbalances due to pandemic-related shutdowns.

However, years of extensive bond-buying have expanded the Fed’s balance sheet to a staggering $8 trillion, raising questions about the impact on the prices of goods and services. With inflation concerns widely discussed in financial news, understanding inflation—the general increase in price levels across the economy—is essential.

Two primary tools track these changes in prices: the Consumer Price Index (CPI) and the Personal Consumption Expenditure Price Index (PCE).

Inflation Measurement: CPI vs. P

The Consumer Price Index (CPI) is widely reported as a measure of price changes over time, specifically tracking what urban consumers pay for a standardized basket of goods and services. Another index, the Personal Consumption Expenditure (PCE) Price Index, measures prices consumers pay but with different weighting and a broader scope, capturing shifts in consumer spending habits.

The Fed primarily uses the PCE when setting monetary policy to support its stable price mandate. This mandate currently targets an annualized 2% increase in price levels—essentially aiming to keep price trends near this 2% mark.

Responding to Inflation: Temporary or Persistent?

When prices exceed this trendline, the Fed has options: it can adjust the Fed Funds target rate or use carefully chosen language to influence inflation expectations.

For example, you may have heard Federal Reserve Chairman Jay Powell mention “transitory” inflation. This term suggests a temporary increase in prices, though defining “temporary” remains complex.

For instance, supply chain disruptions may cause short-term price spikes, but “transitory” lacks a precise timeframe. The Fed’s use of this term may be a strategic attempt to temper consumer expectations around inflation.

Though we can’t predict whether prices will remain above the 2% target, current data shows the CPI up 5.3% over the past 12 months, with PCE tracking at 4%, both above trend for now. However, these figures could fluctuate.

Strategies for Managing Inflation in Financial Planning

As financial professionals, we rely on available data and adhere to a disciplined process. This includes diversifying with non-correlated assets like broad-based commodities, gold, silver, and even digital assets like Bitcoin and Ethereum.

In financial planning, we take a conservative stance by factoring in potential cost-of-living increases, which helps ensure our clients’ portfolios are resilient. We are committed to a data-driven, logical approach when discussing inflation with our clients, aiming to address the impacts thoughtfully and proactively.

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