The Federal Reserve Bank has several tools it uses to help with its congressional mandates on price stability and maximum employment. When the Fed changes course on monetary policy by tightening or loosening money supply, investors should understand how it could affect their investments.
The Fed can lower or raise the Federal Funds rate and it can affect interest rates across the spectrum (short- to long-term rates). The Fed Funds rate is simply the overnight rate banking institutions pay to borrow money needed for their reserve requirements.
This is just one tool the Fed uses but it encourages banks to lend more… and invest more freely when the rate is lowered.
Raising or lowering the Fed Funds rate has been effective in helping stabilize prices in an inflationary environment. Since we’ve been at a zero rate for the past six years, the effectiveness on deflation has been suspect.
For that reason, the Fed instituted quantitative easing (QE) which, in essence, was a creation of money supply fueled by buying U.S. Treasury bonds created out of thin air and the purchasing agency guaranteed mortgage-backed securities. Those asset purchases injected about $85 billion per month into the money supply in an effort to create inflation. QE finally ended in October of last year after nearly six years.
And so, the Fed’s target inflation rate has been 2% per year and after six years and trillions of dollars that were created on the Fed’s balance sheet, we still sit under the 2% target inflation rate.
The main beneficiary of the Fed’s easy money policy has been the stock markets, otherwise known as “risk” assets, to gain acceptable investment returns in this environment. When the Fed finally reverses course and starts to tighten the money supply, make sure your investments move to safer assets like cash.
Please, don’t fight the Fed!