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How Does the Federal Reserve Affect Your Portfolio? The New Investor’s Guide to Monetary Policy

When the Federal Reserve (“the Fed”) speaks, Wall Street scrambles. Here’s a high-level guide to how the Fed influences monetary policy and what it means for your investments.

The Federal Reserve: A Beginner's Guide to Monetary PolicyWhy are financial reporters obsessed with the Federal Reserve? How can a bunch of stodgy old economists be so interesting?

Well, to be honest, they’re not all that interesting. It’s just that what they say and do can have broad influence on the financial markets. And for investors worldwide, that’s the difference between making and losing billions.

As a new investor, you don’t need to be fluent in monetary policy to understand how — and little bit of why — the Federal Reserve will impact your investing success.

The basics: What does the Federal Reserve do?

The Federal Reserve (“the Fed”) is the central bank of the United States. The Fed sets monetary policy which influences the economic direction of our nation. The Fed’s policies influence the stock market on a daily basis.

The Fed has three simple objectives:

  • To maximize American employment
  • To keep prices stable
  • To moderate interest rates

Simple enough. But what makes the Fed’s work so interesting (to econ nerds, at least), is that these goals are often contradictory. Changing polices to influence one factor can wreck havoc on the others. This sends mixed messages and, as a result, increases volatility in the stock market.

In order to accomplish its goals, the Fed uses three tools to steer the economy and direct its path:

  • Open-market operations
  • Reserve requirements
  • Setting the discount rate

These tools enable the Fed to control monetary supply and demand so that the economy grows at a stable pace and, as much as possible, avoid booms and busts.

All day long, Wall Street investors are trying to predict what the Fed will do next and, when they act, how those actions will impact the economic future of the U.S. and the world. This speculation, in part, fuels the constant up and down of stock prices.

Open-market operations (bond buying and selling)

Open-market operations are the primary tool used to influence the economy. The Federal Reserve buys and sells government bonds, or treasuries, on a daily basis to keep the overall supply of money stable and control interest rates.

When the economy is doing well, consumers feel richer and buy more. When everyone starts buying new cars, phones and other widgets, demand may outpace supply and manufacturers may raise prices. This is just one of many factors that may lead to inflation (an overall increase in what things cost). When inflation goes up, your dollar buys less. Although it’s assumed that some inflation is inevitable, the Fed seeks to minimize inflation as much as possible.

If inflation becomes a threat, the Fed will start selling bonds to banks. This action reduces the supply of money available and causes interest rates to rise, thus countering the negative effects of inflation.

If the economy is doing poorly, as we’ve seen for the past several years, the Fed will buy bonds which in turn, gives banks more liquidity. When the Fed buys bonds it frees banks up to lend more. Interest rates go down, and consumers and businesses borrow money so they can buy things or invest. This stimulates the economy.

So what does this mean for you?

Investors typically respond to the Fed’s actions by buying when the Fed buys bonds, and selling when it sells bonds.

I said “typically”. In reality, other factors come into play. Take a look at the activity by the Fed over the past several years through its bond buying program known as Quantitative Easing. This was a long-term period of bond buying designed to stimulate spending and reduce interest rates, which it eventually did.

Recently, the Fed announced it will taper off its bond-buying program. In theory, this should have caused increased selling activity in the stock market and signaled an end to the bull run.

This didn’t happen.

Instead, this action was taken as a positive sign that the Fed believes the economy is strong enough to support itself without government interference. Hence investors remained bullish and kept on buying.

It’s important not to take the Federal Reserve’s actions at face value, but to get a sense of the bigger picture to understand why it’s doing what it’s doing.

The other two tools the Fed uses — setting banking reserve requirements and the discount rate — aren’t as common and are viewed as a more heavy handed action.

Reserve requirements

Historically, the Fed changes banks’ reserve requirements (how much cash they have to reserve rather than lend out — think of it like your emergency fund) roughly once a year.

Changing reserve requirements has the same impact that open-market operations have. The Fed tries to stimulate the economy by lowering reserve requirements and curb spending by raising reserve requirements. Again, it comes back to how much money banks have available to lend. The more they lend, the faster the economy can grow.

Discount rate

The discount rate is the rate that the Fed charges banks to borrow from them directly as the lender of last resort. This rate affects overall interest rates, but doesn’t always match. Usually the actual interest rate will vary by some degree greater than the discount rate the Fed sets in place.

For the average investor, the actions of the Federal Reserve and the meaning behind them are complicated and hard to predict. Even professional money managers that attempt to guess what the Fed will do may shift portfolios around in anticipation of a movement and suddenly find themselves taking huge losses because they guessed wrong or miscalculated how Wall Street would take the news.

For the individual investor, nothing beats regular, disciplined investing and paying attention to your asset allocation. But knowing how the Federal Reserve can help you understand financial news and the theory behind the stock market’s rallies and retreats.

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About Daniel Cross

Daniel Cross has been in the industry as an investment writer and financial advisor since 2005. He holds the Chartered Financial Consultant designation (ChFC) as well as Series 7 and Series 66 licenses, and has embarked on the arduous journey of obtaining the coveted CFA designation. Daniel lives in Florida with his wife, daughter, and pet Tortoise ironically named Turbo.