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How to analyze the Federal Reserve's monetary policy?
Do you remember the unprecedented rate hikes in 2022? The Fed raised interest rates seven times by 425 basis points that year, a historically fast move.
Why did the Fed increase interest rates? How does the monetary policy influence the economy and your investment? In today's lesson, we will explore the Federal Reserve's monetary policy and help you gain a deeper understanding of its composition, function and impact on the major assets. Let's get started!
Federal Reserve: What It Is
Federal Reserve: How It Works
Monetary Policy: How to Achieve Its Goals
Interest Rates: How to Forecast Their Changes
Monetary Policy: How It Impacts Major Assets
Takeaways
To understand the role of the Federal Reserve, we should first learn about what it is.
The Federal Reserve System is the central bank of the United States. There are three key entities in the Federal Reserve System: the Board of Governors, the 12 Federal Reserve Banks, and the Federal Open Market Committee (FOMC).
The Board of Governors, an agency of the federal government that reports to and is directly accountable to Congress, provides general guidance for the System and oversees the 12 Reserve Banks. Officers of the Board are all appointed by the President and confirmed by the Senate. The chairman of the Board of Governors is the head of the Federal Reserve and the active executive officer of the Board of Governors of the Federal Reserve System.
The 12 regional reserve banks are located throughout the country. You may have seen news with titles such as "Atlanta Fed President on the Debt Ceiling and Inflation." These spokespersons are from the Regional Reserve Banks, which help monitor the regional economies and report to the Board.
The members from these two entities make up the Federal Open Market Committee (FOMC). The FOMC holds eight regular meetings per year, but sometimes more in case of emergencies. For example, during COVID-19, five meetings were held in March 2020 alone.
Track FOMC meetings on moomoo calander.
At these meetings, the Committee determines the direction of monetary policy by managing open market operations. It also assesses the risks to its long-run goals of price stability and sustainable economic growth.
Therefore, interest rate hikes are decided during FOMC meetings. This is why the FOMC is considered the most influential part of the Fed.
After discussing the components of the Fed, let's turn to its goals.
The Fed adjusts monetary policy according to its examination of the current economic and financial conditions.
The Federal Reserve performs five key functions:
Conducting monetary policy;
Help maintain the stability of the financial system;
Supervising and regulating financial institutions;
Fostering payment and settlement system safety and efficiency;
Promoting consumer protection and community development.
The first function is probably the most crucial for the market and investors. The Fed has two primary mandates when conducting monetary policy: achieve maximum employment and price stability.
For example, why did the Fed start the new interest rate hike cycle in 2022? To try to curb inflation and stabilize prices. But this plan of action also tends to influence the job market because it is challenging to achieve a balance between full employment and price stability. There are inevitably trade-offs between different goals.
Generally, the Fed puts the brakes on the economy before it overheats and provides stimulus when it slumps, which helps reduce market volatility and achieve more stable economic operation. This is the primary goal of the Fed.
Considering from the perspective of "quantity" and "price," the Fed attempts to stabilize the economy by controlling the money supply and interest rates. How is this achieved? Normally, the Fed uses three tools to conduct monetary policy:
The first critical tool is open market operations (OMO).
The Fed buys or sells government securities in the open market to increase or decrease the total money supply, which can also affect the federal funds rate.
Here is an example. Suppose the Fed purchases securities from a commercial bank. The transaction involves the Fed obtaining securities from the bank and the bank receiving payment from the Fed. The bank then circulates the money by loaning it to consumers, creating a transmission from the Fed to the bank and finally to the real economy, which achieves the goal of increasing the overall money supply.
Conversely, if the Fed sells securities in the open market, it means that liquidity is withdrawn to reduce the overall money supply of the economy.
How does buying or selling securities impact interest rates? First, it is important to understand the relationship between prices and interest rates: when prices rise, interest rates typically fall, and vice versa. Therefore, if the Fed purchases a lot of securities, their prices will generally increase, usually making interest rates drop. On the other hand, if the Fed sells bonds, it will likely drive down bond prices and raise interest rates.
Here is a classic case for better understanding. From late 2008 through October 2014, the Federal Reserve significantly expanded its holdings of long-term securities through open-market purchases to exert downward pressure on long-term interest rates, thereby supporting economic activity and job creation by making financial conditions more accommodative.
The second tool is the discount rate.
The discount rate is the interest rate at which the Fed lends money to banks. As a creditor, the Fed can influence a bank's decision to borrow money by changing the discount rate.
What are the potential impacts on the economy? The lower the interest rate, the cheaper the borrowing, and the less profits from savings, stimulating consumption and encouraging individuals and corporations to borrow money. The increased credit will boost the overall money supply in the economy, leading to a more active economy.
Some of you may notice the common side effect of lowering interest rates: inflation.
One of the proofs is the record high US Consumer Price Index numbers in 2022. At that time, The Fed engaged in balance sheet expansion, popularly known as quantitative easing (QE), to respond to COVID-19.
The third tool is the reserve requirements.
Reserves are the amount of cash that banks must hold to protect themselves against deposit runs. The Fed has the power to adjust a bank's reserves and influence the amount of bank loans by changing the reserve requirements. For example, if a bank's deposit reserve ratio is relatively low, it does not need to keep as much cash. The bank can lend more money to consumers, adding to the overall money supply in the economy.
During COVID-19, the Fed lowered the reserve requirement ratio to 0% as a part of its massive stimulus program.
The Fed often employs multiple tools simultaneously. Let's use QE as an example.
QE is a large-scale asset purchase program implemented by the Fed, which directly affects the size and composition of the Fed's balance sheet. Its purpose is to provide additional stimulus by lowering long-term interest rates and increasing the liquidity of the financial market.
Regarding the specific implementation, the Fed first lowers the target interest rate to near-zero levels. Then it injects reserves into the banking system to purchase a large amount of US Treasury and mortgage-backed securities (MBS) in the open market. As a result of these purchases, the Fed's balance sheet has more than doubled from about $4 trillion before the pandemic outbreak to nearly $9 trillion in early 2022.
When the economy expands, we must prepare for the possibility of it overheating. To try to prevent an overheated economy and inflation, the Fed raised interest rates and reduced its assets, leading to unprecedented interest rate hikes.
When do such intense rate hikes usually end?
As mentioned, the Fed aims to achieve maximum employment and price stability. There are standards to decide whether the goal has been achieved.
The Fed sets the target of reducing inflation to 2% to stabilize prices. Regarding maximum employment, the Fed pays attention to various indicators such as nonfarm payrolls, unemployment rates, job openings, etc.
If the Fed achieves the 2% inflation rate or sees signals of a sluggish job market, it will probably stop raising interest rates.
It is tricky for investors to predict the Federal Reserve's rate hikes or cuts. However, some handy tools can help us gauge the Fed's intentions.
The first one is the dot plot, which looks like this:
If this is your first time seeing this chart, you may have trouble interpreting it.
Let's start with some background information. At the last FOMC meeting of each quarter, the Fed releases its economic projections (SEP), including a dot plot showing the expectations of the 12 Federal Open Market Committee members for future changes in the federal funds rate. The voting is done anonymously, and each dot represents the expectations of one Fed official.
Taking the year 2023 as an example, the median on the dot plot is between 5.5%-5.75%, indicating that the federal funds rate target is likely to fluctuate within this range over the year.
The dot plot may be an effective tool to help forecast interest rate changes, but it is not as reliable as you think. Why?
This is because it is mainly used to indicate the attitudes of the Fed toward current monetary policy rather than the potential changes in the federal funds rate.
In addition to the dot plot, there is a more commonly used tool, the CME FedWatch tool.
With the help of CME FedWatch, we can observe real-time target rate fluctuations. It forecasts potential changes in Fed rate and monetary policy, as implied by Fed Funds futures pricing data.
Therefore, it is also not an indicator that can forecast rate hikes or cuts with 100% accuracy. We use it primarily to gauge market attitudes.
To summarize this section, investors can use two tools to monitor potential interest rate changes. However, we should always remember that monetary policy changes frequently, so we should be flexible and adapt our strategy to the current situation.
Lastly, and considered most important to investors, how might the Fed's actions influence the major assets?
The Fed's monetary policy impacts some major asset classes such as stocks, bonds, cash, real estate, commodities, and currencies.
Let's take the stock market as an example. Do you remember the discount rate we mentioned above?
The Fed can influence how much money the banks borrow by changing the discount rate. When a tight monetary policy is implemented, high-interest rates will limit corporations' risk appetite and increase the cost of borrowing for publicly traded companies, likely affecting stock returns.
Conversely, low-interest rates will make savings less attractive when the Fed loosens monetary policy. Investors are more willing to allocate funds to high-yield investments such as buying stock. This is why we typically witness strong rebounds in the stock market when there is a loose monetary policy.
Some investors may ask: should we avoid investing in stocks during a rate hike?
Not necessarily. Many factors affect stock prices, and monetary policy is only one of them.
This brings us to the last new concept in today's lesson, expectation management. How does the Fed manage interest rate expectations? Before implementing monetary policy, the Fed discloses "rumors" to the market and lets it "digest" negative news. When the Fed formally releases public statements about the economy, the market is generally more prepared for specific changes and thus may not overreact.
We've walked through a lot of information about the Fed's monetary policy. Let's take some time to review what we've presented today.
The Federal Reserve is the central bank of the United States and can decide open market operations and the federal funds rate. Therefore, it is very important to learn about the Fed's monetary policy.
After this lesson, we now should better understand why the Fed implements monetary policy, how it is implemented, and how these policies work in the economy.
From an investment perspective, monetary policy and economic cycles are closely connected.
An expansionary monetary policy can create opportunities for profits, while a tight monetary policy calls for us to avoid investment risks. Therefore, understanding monetary policy can be extremely useful when evaluating investment opportunities.
Check out the macro analysis in the "Advanced" section to learn more about the job market trends. Update yourself with the latest employment data and market trends to make more informed investment decisions!