10 Reasons Why Investors Need To Pay Attention to the Fed

The Fed (formally known as the Federal Reserve System) is the central bank of the US, and it largely controls monetary policy. The Fed regulates commercial banks and is responsible for conducting monetary policy to achieve its dual goals of full or maximum employment and stable prices, meaning low inflation. Investors need to pay attention to the Fed.

However, the Fed’s independence appears to be under investigation. Recently, there have been growing questions from the Trump administration about whether the President can have a more prominent role in monitoring the Fed. The President influences the Federal Reserve primarily by nominating Fed Governors and the Chair, who require Senate confirmation, but typically cannot control monetary policy. Since the beginning of his term, President Trump has put pressure on the Chairman, Jerome Powell, to lower rates faster.

Through its monetary policy, the Fed influences money, credit, interest rates, and the US economy overall.  The Federal Open Market Committee (FOMC) is made up of the seven members of the Board of Governors of the Fed, including Chair Powell, plus the Presidents of the five Federal Reserve District banks (including the New York Fed). The NY Fed is always on the FOMC, but the other four rotate every couple of years.

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, and 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 create uncertainty in our financial markets through poor communication, as Chair Jerome Powell once did when the FOMC prematurely raised rates in late 2018 amid a stable, not rising, economy. The financial markets do not handle uncertainty well. Stocks react swiftly in either direction when they perceive the Fed may be too slow to adjust rates.

 Understanding The Fed’s Independent Role

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

Individual FOMC members schedule speaking engagements and are closely watched. Formally, the FOMC meets about eight times a year to determine monetary policy in accordance with its dual mandate from Congress. They have targets for these goals, pointing to longer-term normal unemployment rates of 3.5-3.75% and an inflation rate of 2.7%, a bit higher than its target. They assess our economy by examining a broad range of economic and inflation indicators, economic forecasts, and financial markets.

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

 

Sample 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, such as the S&P 500, from every sector that 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 cycle expansions or contractions.

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.

The current administration, led by President Trump, has often pushed for lower interest rates and, more recently, is pushing the DOJ to open a criminal investigation of Powell. The probe appears to raise questions about the central bank’s independence. Powell has been expected to remain Fed Chair until this May.

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

It is easy to criticize the Fed for having missed or 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 over 60% at one point). Housing prices fell about 20% over a 15-month period.

Stock performance and housing prices provide the Fed insight into the “wealth effect” of household net worth.  Losses in household net worth affect 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 matter significantly to our economy.

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

When our economy worsens and unemployment rises, 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.

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

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

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

Post-pandemic, strong economic growth has fueled higher inflation, peaking at over 9% in 2022. The Fed has acted to tighten or constrain growth and is often referred to as “tight or “restrictive monetary policy”.  Otherwise, left unchecked, this economic expansion could lead to tighter credit and potentially higher inflation, which is still above its target in 2026.

Higher inflation reduces your purchasing power.  Wages will not keep pace with inflation. Purchasing power is the amount of goods and services your income can buy, but necessities 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 goods or face higher interest rates when they borrow. Businesses cannot necessarily pass these higher costs on to consumers, 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 that households have more incentive to save money at higher-yielding bank accounts. With raging inflation in the early 1980s, banks were literally paying double-digit interest rates to their customers.

7) The Fed has other tools it can use to push the economy in the direction of its 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 commercial banks’ balance sheets in exchange for money, providing liquidity to the public. But during the Great Recession, the Fed was more aggressive in its purchases.

They adopted quantitative easing (QE), a large-scale asset purchase program. They essentially bought predetermined amounts of government bonds and other financial assets, including mortgage-backed securities. This is 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)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 the US government’s banker. As the largest borrower in our economy, the US Treasury raises capital through weekly auctions of Treasury securities.

The large budget deficit, on its own, puts upward pressure on interest rates, so the Fed closely monitors it.

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

They will lend money to our commercial banks at the discount rate (set above the fed funds rate) during liquidity crises. Both the Fed and the US Treasury worked feverishly as Bear Stearns collapsed in April 2007. Their hedge funds were exposed for holding high-risk subprime mortgage securities. JPMorgan Chase bought Bear Stearns at a price well below its previous value.

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

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

Other central banks look to the Fed and to its actions. The Fed, in turn, also closely monitors the actions of the central banks of major economies, as well as 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 benefit our economy, as US exporters fare better against global competitors. The Fed also looks at actions taken by global central banks and their currencies.

It pays to be at least aware of what the Fed does and says, given its potential impact on 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 up January 27-28, the first meeting in 2026. Take a look at the markets in the days leading up to the meeting, during the meeting, and especially at 2:00 pm, when Chair Jerome Powell announces the FOMC decision. When the Fed speaks, investors pay attention! When President Trump speaks about the Fed, the market can be impacted as well.