11 Reasons Why Investors Need To Understand The Fed

When the Fed speaks, investors listen…really closely.

The Fed (formally known as The Federal Reserve System) is the central bank of the US. The Fed regulates commercial banks and has the responsibility for conducting monetary policy to achieve its dual goals of achieving full or maximum employment and stable prices, that is low inflation.

Through its monetary policy, the Fed  influences money, credit, interest rates and  the US economy overall.  The Federal Open Market Committee (FOMC) is made of the seven Board of Governors of the Fed, including Chairman Jerome Powell, plus the Presidents of five fed district banks (include the New York Fed).

The Fed affects every aspect of our financial lives.

Those interested in personal finance and investing, in particular, should have a working knowledge of what the Fed does, particularly if you are interested in all aspects of money and investing.

The Fed influences our economy, our borrowing rates, our investments. They communicate with the public and add their voice of reason when our financial system is being threatened as it was during the Great Recession. They can also provide uncertainty to our financial markets through poor communications as Chair Jerome Powell when they raised rates in late 2018 amidst a stable, not rising, economy. The financial markets do not handle uncertainty well. Stocks react swiftly, declining at the end of last year,erasing strong gains.

 Powell Added Uncertainty About Future Rate Hikes Unnecessarily

Chair  Powell signalled  upcoming Fed action in last few months of 2018. Specifically, he suggested the FOMC  may be raising the fed funds rate a few times in 2019. The fed funds rate is the overnite borrowing rate between commercial banks and is the primary means by which the Fed adjusts their stance in monetary policy. While we can’t borrow at the fed funds rate, it directly influences other borrowing rates such as mortgage loans, car loans, prime rate, and affects securities such as treasuries and even stocks.

The S&P 500  responded negatively to the comments, dropping “as much as 8%”  in October-December 2018. Investors were concerned about potentially higher interest rates as well as trade policy initiatives, slowing global growth and partial government shutdown. Powell later backtracked from his earlier comments at the December 2018 meeting.

The latest Fed minutes from  late January 2019’s meeting indicated that the Fed has taken on “wait and see” attitude which has provided comfort to investors. But it was a reminder that the Fed has certain power over the money supply and credit in our country.

Understanding The Fed’s Role

1) FOMC’s regular meetings are scheduled well in advance and made public.

Individual FOMC members schedule speaking engagements and are watched very closely. Formally, the FOMC meets about eight times a year to determine monetary policy according to its dual goal mandate provided by Congress. They have targets for these goals, pointing to  longer term normal rates of unemployment of 3.5-4% and inflation rate of 2%. They assess our economy through examination of a broad range of economic and inflation indicators, economic forecasts and consideration of financial markets.

2) The Fed looks at all kinds of economic and inflation indicators.

 

A sampling of indicators:

• Gross Domestic Product (GDP)
• unemployment rates
• industrial production
• wage growth
• retail sales
• consumer and business spending
• housing permits, starts, home prices
• confidence surveys
• S&P 500
•  wholesale price index and consumer price index

They will also look at the economy from different points of view, such as  demographics (eg. minority communities), or regionally(different parts of the country). They look at all of these indicators to better gauge where we are in the business cycle.

These indicators are either:

a) leading indicators from every sector which predict future economic activity;

b) coincident indicators which are in line with the economy and

c) lagging indicators which tend to rise or fall a few months after business cycles expansions or contractions.

S& P 500 stock prices are an example of a leading economic indicator and may forecast a downturn or strong growth.

3)The Fed needs to know about external variables that they don’t directly control but could be impactful to our economy.

The Fed  looks at important factors that could affect our economy, one way or another, such as trade talks between the US and China, overall trade policies, the government shutdown, tax reform, hurricanes, and the global economies

4)The Fed makes assessments and manages risk, including to the financial system.

It is easy to criticize the Fed at having missed or having been slow to manage the risks that were building in the months leading up to the Great Recession of 2008-2009.  Investors experienced  significant losses in the financial markets (S& P was down about 55%). Housing prices went down about 20% in a fifteen month period.

Stock performance and housing prices provide Fed insight into the “wealth effect” of household net worth.  Losses in household net worth affects whether to continue or constrain their spending in our economy. Household spending accounts for about 65%-70% of our economy. Our financial health and confidence matters significantly to our economy.

5)The Fed’s monetary policy offsets changes in our economy.

When our economy is worsening and unemployment is rising, the Fed will adopt a more “accommodative” or “stimulative” monetary policy. They will take action to gradually reduce fed funds rates as a first step. Lowering this benchmark rate will influence  consumer borrowing rates, which will decline in tandem.

Lowered rates for auto loans, mortgages and credit cards tend to lead to higher spending and borrowing. Ultimately, it should stimulate the economic growth.

The Fed has a number of tools in their arsenal and in times of severe recessions will use all of them. The lower interest rates also benefit stocks which in turn, generally appreciate. The lower interest rates sometimes encourage companies to use their capital for corporate buybacks, expansion and mergers & acquisitions, all positive for stocks.

6) Higher economic growth may lead to stronger inflation as signals to the Fed to tighten money supply. 

When we are experiencing strong economic growth, it could fuel higher than normal inflation. The Fed’s action would be to tighten or constrain growth and often be referred to as “tight or “restrictive monetary policy”.  Otherwise, left unchecked, this economic expansion could lead to tighter credit and potentially higher inflation well above the targeted 2%.

Higher inflation reduces your purchasing power.  Wages will not keep pace with the inflation rate. Purchasing power is the amount of goods and services your income will buy, but your necessaries such as groceries, rent, transportation, and clothing, will cost more.

How higher inflation affects business spending

High inflation also has a dampening effect on your investments as companies pay more for wholesale prices, or experience higher interest rates when they borrow. Businesses cannot necessarily pass these higher costs to the consumer, though they will try. They will postpone or cut their capital expenditures which may mean less future hiring.

One benefit of higher interest rates is there are more incentives for households to save money at the bank at higher yielding rates. With raging inflation in the early 1980s, banks were literally throwing out double digit savings rates at their banking customers.

7) The Fed has other tools it can use to push the economy into the direction of its stated goals.

The Great Recession was more severe than previous ones.  The Fed aggressively utilized its tools.  The Fed is always purchasing (adding liquidity to financial markets) or selling (tightening money supply) treasury securities from commercial banks.

For example, in a weakening economy, the Fed  purchases government securities from the balance sheets of the commercial banks in exchange for money to provide liquidity to the public. But during the Great Recession, the Fed was more aggressive in their purchases.

They adopted quantitative easing (QE) which are large scale asset measures. They essentially bought predetermined amounts of government bonds and other financial assets, including mortgage-backed securities. This in in contrast to buying conventional short-term bonds to keep fed funds at its target value.  powerfully put a lot of needed cash into the banks to stimulate more lending.

8) It took three phases of QE over four years to stimulate our economy.

As a result of QE1, QE2 and QE3, the Fed had a lot of those government securities accumulated in reserve  on their balance sheet and they have been working to reduce the amount. According to their latest minutes, the Fed reported that the peak amount of $2.8 trillion in October 2014 has declined by $1.2 trillion.

Investors had been concerned that further declines would act to “tighten” our economy, creating reduced credit even though we are experiencing low inflation. The Fed has indicated that reserves may soon approach efficient levels later in 2019.

9)The Fed works with the US Treasury, the latter being responsible for US fiscal policy.

The US Treasury also needs to raise capital to fund the US budget policy as part of its fiscal policy. They work interdependently, with the Fed serving as US government’s banker. As the largest borrower in our economy, the US Treasury raises capital through issuance of treasury securities through a weekly auction.

The large budget deficit on its own puts upward pressure on interest rates, so Fed looks at this budget deficit closely.

10)The Fed is also known as a bankers’s banker, or banker of last resort.

They will lend money at the discount rate (set above the fed funds rate) to our commercial banks in times of liquidity crisis. Both the Fed and US Treasury worked feverishly as Bear Stearns, collapsing in April 2007. Their hedge funds were exposed for holding high risk subprime mortgage securities securities. JP Morgan Chase bought Bear Stearns well the previous value.

After Bear’s dismantling, on September 15, 2008, Lehman Brothers collapsed, filing for Chapter 11 bankruptcy. This event nearly caused systemic risk to our entire financial system.

I highly recommend the book “Too Big To Fail” by Andrew Ross Sorkin. He chronicles the unimaginable circumstances of the Fed, the Treasury and Congress racing to save some of our oldest financial institutions. By the way, the movie is pretty good if film is better for you.

11)The Fed is the role model for central banks around the world.

Other central banks look to the Fed and the action they take. The Fed in turn also looks closely at the actions of the central banks of major economies, as well as taking into consideration international issues, such as trade policies, global growth and Brexit. The Fed looks at the US dollar and its relation to major global currencies. A weak dollar, on its own, tends to be beneficial to our economy as US exporters benefit against their global competitors. The Fed looks at action taken by global central banks and their currencies as well.

Want to become a  Fed watcher? It pays to be at least aware of what the Fed does and says given its potential impact to our economy and financial markets. Everything you may have wanted to know about the Fed and how it may affect your financial lives. The next important FOMC meeting is coming March 19-20. Take a look at the markets in the days before the meeting, during and especially at 2:00 pm when Chair Jerome Powell announces the FOMC decision. When the Fed speaks, investors pay attention!

Where were you when Lehman Brothers was collapsing? Do you recall the impact of the Fed on the financial markets at any time? We would love to hear from you!