Time to Read: 9 Minutes
If you follow the economy in the news – and sometimes even if you don’t – you may have heard terms like “the Federal Reserve”, “Chairman Powell”, “transitory”, and “tapering”. Reporting on these terms is often followed by prognostications on how the markets may or may not react to whatever these terms are applied to. It can be difficult to get a real understanding of how the Fed’s actions impact your day-to-day life and your investment portfolio. Read on for a brief introduction of what the Federal Reserve is, how it impacts the economy, and how you can position an investment portfolio to stay in step with the Fed.
What is the Federal Reserve?
The Federal Reserve, called “the Fed” for short, is the central bank of the United States. It is in charge of monetary policy and controls the money supply.
What are the goals of the Federal Reserve?
The Federal Reserve has 3 main objectives
1) maximum employment
2) stable prices
3) moderate long-term interest rates
The Federal Reserve is essentially tasked with the balancing the competing goals of maximizing economic growth while keeping inflation within a reasonable, and predictable range. As the central bank of the US, the Federal Reserve oversees and provides liquidity to banks to prevent them from failing.
How does the Federal Reserve control the money supply?
The Federal Reserve has three main levers it can pull to try to achieve its goals:
- Open Market Operations – This is the most widely utilized tool at the Federal Reserve’s disposal and is the process of buying and selling government securities. If the Fed wants to stimulate the economy, called quantitative easing or expansionary monetary policy, they will buy up government securities, injecting cash into the economy to spur economic growth and business development. Per the laws of supply and demand, this influx of cash makes US dollars more abundant which pushes down interest rates. Conversely, if the Fed fears the economy may be overheating and wants to reel it in before inflation becomes a problem they will sell government securities, called quantitative tightening or contractionary monetary policy, which shrinks the money supply and drives up interest rates.
- Discount Rate– The discount rate is the rate the Federal Reserve charges banks to borrow funds. Lowering the discount rate would be a form of expansionary monetary policy, and raising the discount rate would be contractionary. There are two other interest rates worth noting: the federal funds rate (bank to bank lending), and the prime rate (bank to large institution lending), both these rates are positively correlated to the discount rate.
- Bank Reserves– The third tool in the Fed’s toolbox is the reserve requirement, which is the amount of cash that banks are required to always have on hand. Lowering the reserve requirement would be a form of expansionary monetary policy since more money could be lent by banks and circulate throughout the economy. Raising the reserve requirement would be considered contractionary monetary policy as it would reduce the money supply.
What is the Role of the Chairman of the Federal Reserve?
Jerome Powell is the current chair of the Federal Reserve. He was sworn in on February 5th 2018, succeeding former chair Janet Yellen. He leads the Federal Reserve Board, which comprises the presidents of the 12 member districts, and also chairs the Federal Open Markets Committee (FOMC) which sets short-term interest rates.
A key element of the Chairman’s role is to explain what the Fed is doing, and why they are doing it. Since the Fed is setting monetary policy– which will have both current and future impacts – the Chairman must be very careful with his choice of words as he explains the Fed’s actions and hints at what may be to come since so many people tune in and make investment decisions based on what he does and does not say, BWM Financial included.
Is the Fed political?
No, the Federal Reserve is proudly politically independent. However, the Fed is required to regularly testify and report to Congress as a form of checks and balances. Presidents have tried pressuring the Federal Reserve to take certain measures in the past but the Fed does not act on these pressures.
That said, the actions of Congress can directly impact the Federal Reserve, and vice-versa. For example, if Congress refuses to raise the federal debt limit, the Fed may need to take swift measures to avoid defaulting on its US Treasury securities, which are regarded as the most stable investments in the world.
What did the Federal Reserve do to help the economy during Covid?
The Federal Reserve took quick and unprecedented action in response to Covid 19. On March 15, 2020 the Fed cut short-term interest rates to near zero and started buying up government securities . Beginning in June 2020, the Fed has purchased $80 billion of US Treasuries and $40 billion of mortgage-backed-securities each month. Together these actions injected liquidity into the economic system by lowering the cost of money, making business development and mortgage borrowing much cheaper.
Inflation has increased. Is the Fed concerned?
The Fed’s position is that inflation is transitory, meaning that it is the result of the ongoing economic recovery and that it will resolve to more normal levels in the short term. In other words, inflation is not systemic but is a reaction to the current environment, which is changing and improving. Chairman Powell points to the re-opening of the economy after Covid and supply chain issues as the primary causes for the rise in inflation, and because these disturbances are highly conditional, they will work themselves out over time without the Fed needing to step in.
What is “tapering”?
Tapering is when the Federal Reserve slows its rate of asset purchases. In order to be considered a taper the Fed must have already enacted a stimulus program, like the one in place right now, that it then starts phasing out. Jerome Powell has suggested the Federal Reserve may start tapering towards the end of 2021.
It is hard not to question if the Fed truly wants to begin tapering, or if it simply needs to. Tapering suggests that the economy has stabilized and no longer needs the extra boost from the Federal Reserve. For many, it may be difficult to imagine that the economy has recovered with Covid still rampant and the unemployment rate above 5%. However, it is also clear that the Fed’s aforementioned spending is unsustainable and needs to be dialed-back, regardless of the state of the economy. Only time will tell which factor is the actual driving force. Whatever the case may be, it is inevitable that the Fed will start some form of tapering soon. Historically tapers have been met with sharp rises in bond yields and declines in equity prices, called a “taper tantrum”. This very well may happen again, but as we money managers know well, past performance is no guarantee of future results, and many analysts are convinced that this time may be different.
What are some investment strategies with regards to the Federal Reserve?
Forecasting the Federal Reserve’s moves, like when it may start to taper, is nearly impossible to get right, but important nonetheless since the Fed and financial markets are deeply intertwined. One phrase we like to use when talking about investment management is, “what central banks do matters”. The Federal Reserve has vast powers. For example, the Fed’s swift response to Covid 19 was incredibly effective in stabilizing markets even as over 30 million Americans filed initial unemployment claims in March and April of 2020. However, these powers can be too successful, causing the economy to overshoot the target. The Fed has fallen victim to excessive contractionary policy several times, raising interest rates too far and too fast and causing recessions.
Betting against the Fed would be like betting against the house at Vegas. Instead we recommend making investment decisions in accordance with the central bank of the United States. At BWM Financial we rely on research to gauge what the Fed might be doing. We bring these indicators together and factor in the weight of the evidence when making portfolio moves to align our investments with our Federal Reserve projections. For example, the Federal Reserve’s decision to hastily buy up government securities after the Covid market decline was one of the reasons we chose to go overweight equities in our investment portfolios in April 2020. If you are interested in learning more about our investment approach and other tactical investment moves we have made in the past you can subscribe to our market commentary or reach out to one of our advisors.
How does the Federal Reserve affect me?
You should not notice anything if the Federal Reserve does its job well, but if the Fed misses its targets, you may experience changes in your day-to-day life and you will most certainly hear about it in the news. For example, if the Fed fails to keep prices stable, the costs of goods and services may rise unexpectedly, eroding your purchasing power. Inflation makes headlines, but we think that it is interest rates that may become more problematic looking forward.
The Federal Reserve sets short-term interest rates, which represents the cost of money. Short-term interest rates have a trickle-down effect to long-term interest rates and the broader market as a whole. Interest rates have been at near-decade lows ever since the Federal Reserve cut rates back in March, but Chairman Powell has hinted at raising interest rates as early as 2023 to combat rising inflation. The timing of interest rate hikes may be unknown, but we have a good understanding of how these changes may impact everyday investors.
When interest rates are low…
When interest rates are low, money is cheap, which favors borrowers and hurts lenders. For example, more people have been able to afford homes with mortgage rates hovering below 3% in 2020 and 2021, which is a likely contributor to the recent spike in home prices. Existing homeowners have also been taking advantage of declining interest rates and have been refinancing their mortgages to lock in lower rates. Businesses also welcome low interest rates because it lowers the cost of borrowing money to finance their business operations. This allows them to borrow more money cheaply that they can use to finance new projects, boost company profits, and improve earnings which often increases the value of the company’s underlying stock.
On the flip side, low interest rates are less favorable for lenders who are not well compensated for giving their money out to others. Individual investors lend money to banks every day in the form of high-yield savings accounts and Certificates of Deposits (CDs) which pay very little in a low interest rate environment.
When interest rates rise…
When interest rates rise money becomes more expensive which tends to hurt borrowers and has mixed effects on lenders. Mortgage rates will increase making the cost of buying a house more expensive which may drive down demand for new houses and thus the price of homes. Also, when interest rates rise businesses must pay more to borrow the same amount of money as before the hike in rates, in order to maintain the same level of business operations. With more money earmarked for borrowing costs, there is less money leftover for companies to put towards new growth and development projects which often drives down earnings and the price of the underlying stock.
Rising interest rates can be particularly harmful to growth stocks, which are companies that pay little to no dividends, often make low profits today, but are predicted to grow over time. When one invests in growth stocks, they expect the company to be profitable and start paying dividends sometime far in the future. As many investors know, a dollar received a decade from now is less valuable than a dollar received today, whether that be in the form of profits or dividend payments. When interest rates are low, company profits and dividends 10 years from now are worth less but mostly maintain their value. However, when interest rates are high, those same profits and dividends 10 years down the line become much less valuable. This affect is particularly pronounced on growth-oriented companies whose investors may be banking on future returns far off into the future, and the stock prices of those companies may decline as a result.
The impact rising interest rates have on lenders varies depending on the timing of the underlying loans and investments. If you are lending out new money, like buying new CDs or contributing to a high-yield savings account, the rate of return on these investments will go up making them more profitable. However, if you are an existing lender with outstanding loans, these investments become less valuable when interest rates rise. For example, a common form of lending is buying bonds – you are giving the government, or perhaps a municipality or company, money today for periodic payments and a return a principal in the future. Say you lent money to the government for a Treasury bond last year when interest rates were low but since then interest rates have risen, the value of your old bond will have declined since new issues of that bond now pay higher yields due to higher interest rates.
The Federal Reserve’s actions affect nearly all areas of financial markets and it is necessary to have a system in place for making investments that will align with the Fed’s objectives and the moves the Fed makes to achieve them. At BWM we think it is critical to have an objective, unbiased, rules-based approach to these types of decisions. We start with making sure your investments are aligned with your financial plan, income needs, risk tolerance, and tax situation. We use third-party, agnostic research to make tactical investment moves within our portfolios according to our three rules of investing: 1) Don’t fight the Fed. 2) Don’t fight the trend. 3) Beware of the crowd at extremes. This article covers much of our first rule, don’t fight the Fed. If you would like to learn more about our other two rules of investing, or have any questions about our active portfolio management, please reach out to one of our advisors.