There is an old axiom on Wall Street: “Don’t fight the Fed.”
The Federal Reserve holds an enormous amount of power over the economy. While the President is usually blamed for a bad economy and praised for a good one, the fact is that the federal reserve actually has significantly more power over the state of the economy.
Despite the name, the Federal Reserve is not an institution of the Federal Government. The Federal Reserve is made up of a board of bank executives from around the country — the “Governors” — with one individual chosen as the Chairman. The Chairman is chosen by the President and confirmed by the Congress, but the post is meant to be non-political. The group meets periodically to discuss the state of the economy and any action that should be taken. The power of the Federal Reserve over the economy is so acute that the discussions held during the meetings are kept in secret with notes from the meeting only being released several months after they meet.
Often traders will move the stock market up or down before the Federal Reserve meets based on what they expect the group to decide. If the group’s decision surprises the market, the stock market will often move up or down several percentage points. The announcements made by the Federal Reserve are purposely made rather vague since they know the power of their words.
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The Federal Reserve controls the economy through two levers, the Discount Rate and the Fed Funds Rate. The discount rate (http://en.wikipedia.org/wiki/Discount_rate) is the amount that the Federal Reserve charges banks that borrow funds from it. Generally, it is frowned upon for banks to borrow from the Federal Reserve directly and they generally get a scolding when they do so. The exception is during the recent money crisis where borrowing from the discount window was encouraged since other sources of capital had dried up.
The Federal Funds Rate (http://en.wikipedia.org/wiki/Fed_Funds_Rate) is the rate at which banks loan each other for overnight periods. The Federal Reserve does not control the Fed Funds rate directly, but instead adds money to the economy or takes it away to affect the rate. This is done by selling notes, which has the effect of removing money from the economy, or buying notes, which injects money into the economy. Like anything else, the more money there is in the economy to lend, the lower the price for borrowing (therefore the lower the interest rate).
Because the bank’s costs of capital decrease when the rate at which they can obtain decreases, they also tend to lower the rates they charge. This trickles up into the economy (except, interestingly, credit card rates), such that most rates tend to fall. Because the rate savings accounts provide drops, bonds become more valuable, so their price tends to rise, dropping the amount of interest they provide. Likewise, because the return of common stocks becomes more valuable, stock prices also tend to rise.
This is the reason to not “fight the Fed.” When the Fed is lowering rates, it’s best not to be short, and when the Fed is raising rates, it’s best to prepare for a fall. Note that in the early ’90’s, the Federal Reserve lowered interest rates to bring the economy out of the early 90’s recession. The stock market took off first, followed by the economy. President Clinton was credited with the good economy that followed, but it was all touched off by the Federal Reserve.
In the late 90’s, when inflation was starting to pick up and internet stocks were trading at ridiculous prices, Fed Chief Alan Greenspan warned of what he called “irrational exuberance.” The Fed began raising rates to pick the ensuing bubble. A few months later, the bubble burst and the early 2000 recession occurred. President George Bush Junior was blamed for this recession, but the stock market had already started to fall before he took office because of the actions of the Federal Reserve. Finally, just before the latest recession, the Federal Reserve, concerned about housing prices, began to raise rates to dampen the economy. This caused the housing bubble to burst, leading to the current state.
The action of the Federal reserve typically takes half a year to have an effect. It takes time for companies to start borrowing and hiring after rates are lowered. Likewise, when the economy has a good head of steam it takes time for the wheels to grind to a halt. The Federal Reserve set rates at near zero in 2008 and had been waiting for the economy to pick up. It appears that there has finally started to be some growth, and the Feds are starting to slowly raise rates because they fear inflation picking up. As they do so, it is likely to slow the economy and may cause stocks and bonds to fall, at least temporarily.
It would not be wise to fight the Fed. If you have money invested that you need within a couple of years, it might be wise to take opportunities to sell. If you are invested long-term, however, it would probably be better to just stay put. You don’t know if the effects will be immediate or if there will be a great run-up through this New Years’ season as there often is. If President Trump is able to get a tax cut through, that will also add fuel to the fire and you might miss out on a great advance in stock prices before the Fed’s effect is finally felt. The effects of the Fed are temporary and matter little if you’re investing for 20 years. Missing a big move up in stocks because you’re sitting on the sidelines will.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.