The Federal Reserve’s interest rate policy has been an economic focal point over the past 4 years, as it’s been the main tool used to attempt to combat post-COVID inflation. Though interest rate policy occupies the limelight, there are a number of tools in the Fed’s arsenal that can be used in different ways to achieve different outcomes.
As the nation’s central bank, Fed actions and policies certainly have a sizable impact on stock and especially bond markets. The outcomes the Fed is trying to achieve are often misunderstood and knowledge of what actions they are taking is crucial to being an informed investor. We’ll take a look at the Fed’s goals, the tools they use, and their impact on markets as a whole.
The Dual Mandate
Any Federal Reserve decision must be viewed through the lens of its “Dual Mandate”: to promote maximum employment and stable prices. Maximum employment refers to a healthy job market where unemployment is low, and most people who want to work are able to find jobs.
Stable prices means keeping inflation in check, with low volatility at a level that promotes long-term growth in the economy.
The Fed’s challenge lies in carefully using policy tools to strike a balance between these objectives, fostering economic growth and job creation while keeping inflation under control. That sounds easy on paper, but is exceedingly complex in an intertwined, international economy.
What’s in the Toolbox?
The main tool used by the Fed to deal with inflation over the last two years has been the discount rate, which is the rate it charges banks for short term loans. The discount rate affects borrowing rates across the board for everyone from governments to people looking for a mortgage.
A lower discount rate encourages borrowing, driving spending and consumption from businesses and consumers and promoting economic growth. A higher discount rate makes loans more expensive, discouraging borrowing and investment and potentially slowing economic growth while helping reduce inflation.
Open Market Operations are another option that can be employed by the Fed and involve buying or selling securities (bonds) in the open market. This method was primarily used to combat the recession of 2009. Simply put, if the Fed chooses to buy securities, this should lower interest rates, increase the money supply and promote growth. Conversely, if the Fed sells securities, interest rates should increase, the money supply should decrease, and economic growth and inflation should subside., while selling securities raises interest rates, decreases the money supply and potentially hinders economic growth.
Reserve Requirements are the third main tool that can be employed by the Fed to influence inflation. This is a requirement on the minimum amount of cash reserves banks must hold against deposits. Reserve requirements have been unchanged since the beginning of the pandemic and have far less of an impact on overall economic matters than either open market operations or interest rates.
Economic Impacts
Interest rates, specifically, can be thought of as dials that the Fed adjusts to control the costs of borrowing and impact economic activity to help achieve their Dual Mandate goals.
When businesses and consumers cut back activity during economic downturns, the Fed lowers rates to stimulate growth. This is exactly what happened during the peak of the COVID pandemic, when widespread economic uncertainty led to a rapid decrease in activity with serious potential impacts on the worldwide economy. The Fed’s significant response of lowering rates to near-zero levels helped stave off a potentially serious and sustained recession.
Just as lowering rates provides a stimulant for the economy, raising rates helps to “cool down” an overheating economy. Increasing borrowing costs to slow down economic activity from businesses and consumers can help to slow down inflation; additionally, higher interest rates on deposit and savings accounts encourage more savings and less spending from consumers, helping to dampen overall economic activity.
Why Does this Matter to Investors?
As the nation’s central bank, Fed policies have a significant impact on both stock and bond markets. Through monetary policy, Fed actions ripple through financial markets, affecting companies' business activity, investor sentiment, and the attractiveness of various investments. Expansionary policies that stimulate growth also tend to see increased business activity, which can positively impact their stock prices. Additionally, Federal Reserve interest rates directly influence the rates offered on bonds, making them more or less desirable investments depending on the returns investors seek.
Federal Reserve policies can have an impact in the short term on markets and are prominently discussed in the media. This makes it difficult to ignore the constant noise suggesting short-term, emotionally driven decisions.
That’s why financial planning is so important. Having a financial plan enables an investor to tune out distractions and make informed, rational decisions about their long-term financial picture.
We’re always glad to discuss how a financial plan might help you develop a personalized path towards meeting your unique goals and circumstances.
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