Fed, Monetary Policy, and the Stock Market

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The Federal Reserve Act of 1913 birthed the central bank for the United States. From that moment, the Federal Reserve (Fed) was entrusted with the responsibility of establishing the nation’s monetary policy. In 1977, the act was amended to include two primary objectives: maintaining the goals of growth, employment, price stability, and consumption. But how influential is the Fed in reality?

What is Monetary Policy?

The term “monetary policy” refers to measures taken by the Central Bank to intervene in the money supply, affect the cost of credit, and thereby help the national economy achieve its objectives.

Monetary policy is considered “expansionary” if the central bank increases the money supply or lowers interest rates. For example, since November 2008, the Fed has increased the money supply by purchasing a large amount of securities to stimulate economic growth after the 2007-2008 financial crisis.

Conversely, monetary policy is considered “contractionary” when the central bank decreases the money supply or raises interest rates.

In a publication released by the Fed titled “Federal Reserve System – Objectives and Functions,” it is noted that: “In the short run, there will be conflicts between the two main objectives: price stability and promoting production growth, employment. Policymakers will face a daunting challenge and must choose between focusing on price stability or production growth, employment. Monetary policy will then be classified based on the central bank’s objectives: when the central bank wants to promote economic growth and employment, they will choose expansionary policy; When the central bank believes the economy is stable and does not need intervention, they will choose a neutral policy; Finally, when the central bank wants to stabilize prices (curb inflation), they will choose a contractionary policy.”

Three Key Monetary Policy Tools of the Fed

The Fed cannot directly intervene in inflation or impact economic output and employment. But they can use indirect tools to intervene in the economy, including:

• Open market operations
• Discount rate changes
• Required reserve ratios

With these three tools, the Fed intervenes in the reserve supply of commercial banks, thereby changing the basic interest rate (the rate at which commercial banks lend to each other to ensure the reserve requirement set by the Federal Reserve).

When the basic interest rate (Fed funds rate) is adjusted, it triggers a series of events affecting short-term interest rates, exchange rates, long-term interest rates, cash and credit, and ultimately a series of changes in the economy including employment growth, output, and prices of goods and services.

The Importance of Monetary Policy for the Stock Market

Monetary policy affects production and employment growth in the short term and is used to regulate the economy. For example, when demand decreases and an economic recession occurs, the Fed will lower interest rates to stimulate the economy in the short term, bringing it back to the long-term trajectory established earlier. But in the long run, the above objectives depend heavily on the effective use of capital, labor productivity, and the risk tolerance of businesses.

Fed monetary policy is difficult to maintain perfectly and satisfy all sectors of the economy; its impact can be a favorable wind that propels businesses forward faster, but sometimes it inadvertently becomes a headwind, requiring businesses to navigate carefully to reach their destination.

An investment strategy is considered effective when it steers the ship towards its goal in both favorable and adverse conditions, and it is often implemented through the principle of “Don’t fight the Fed.” When the Fed loosens monetary policy, focus should be on investing in economically sensitive sectors such as industrial, financial, and technology. Conversely, if the Fed tightens monetary policy, investments should be made in less sensitive sectors such as healthcare and essentials.

The Impact of the Fed on the Stock Market

Several studies have been conducted to determine whether investors can profit by monitoring changes in the Fed’s monetary policy. Two of these studies concluded that by using a simple principle to identify the monetary policy that the Fed uses, investors can profit from the stock market.

These studies concluded that:

• Expansionary monetary phases often witness stock market growth and profitability (stocks bring higher profits with lower than average risks). Conversely, contractionary monetary policy tends to coincide with sluggish stock market phases (stocks often have lower profits and higher than average risks).
• Small-cap companies are more sensitive to monetary policy than large corporations.
• Cyclical stock groups are more sensitive to changes in monetary policy than defensive stock groups.

The Fed’s monetary policy has a significant impact on global markets. However, there are also many dissenting opinions about whether investors can profit by monitoring the Fed’s monetary policy, as exemplified by Benson Durham, author of a series of articles titled “Monetary Policy and Equity Returns” published in the Financial Analyst Journal.

He believes that “studies assuming that monetary policy affects stock prices, but stock prices do not affect monetary policy, need to be carefully considered. Although central banks do not target specific asset values, stock prices contain expectations about economic cycles and future monetary policy. This coincidence can lead to erroneous conclusions if minimum average statistical methods are used.”

Conclusion

Monetary policy can influence the stock market. However, an investment strategy tied to monetary policy is not necessarily effective in every tightening and loosening cycle. Investors should be cautious and consider other factors such as bond interest rates, economic forecasts, and the fundamental factors of stocks they are considering before making investment decisions.