You might have heard that the Federal Reserve Bank (“Fed”) chose to keep their benchmark rate at the previous 2.25-2.5% benchmark level on Wednesday. Big deal. What does this mean, and how can it affect your portfolio? That’s something you might be interested in. Let’s dive in.
The Fed was established by Congress over a century ago in 1913. Prior to its establishment, the U.S. economy had frequent episodes of panic, credit scarcity and bank failures. Due to this, it was decided that a secure centralized system was needed to reduce the frequency and severity of these episodes. The Fed’s role in our economy has expanded significantly since and their goals have become more clearly outlined.
The Fed’s monetary goals (also known as the dual mandate) are as follows:
Low and stable inflation at the rate of 2% per year
Maximum employment; a fixed employment level is not specified, however, because the maximum level is determined largely by non-monetary factors (such as structure/dynamics of labor market)
To achieve their goals, the Fed has multiple levers that it can pull on. Some ways in which it can influence low and stable inflation, and employment are:
Raise/Lower Fed Funds Rate: This is the interest rate that banks charge other banks for lending them money from their reserve balances required by the Fed. This is closely correlated with the return on short-term treasury yield curve. An increase in fed funds (short-term) tends to flatten the curve because the yield curve reflects nominal interest rates. It also affects consumers in various ways. For instance, if the Fed raises interest rates, banks will, in turn, charge more to lend money to consumers to account for this increase. This affects everything from your annual percentage rates on credit cards to interest charged on mortgages.
Increase/Decrease Banks Required Reserve Ratio: Minimum amount of money that banks, credit unions, and savings and loan associations must keep on hand to cover depositors' withdrawals and other obligations. Currently, the ratio sits at 10% for banks that have more than $122.3 million in deposits. So, for every $10 banks have in deposits, they must keep $1 in reserves, pretty simple. If the Fed decides to increase the required reserve ratio, it leaves less capital for banks to lend out, often causing them to increase interest rates they charge on loans.
Open Market Operations: Purchasing/Selling of treasury notes or mortgage-backed securities. This is still a relatively new function of the Fed. It was introduced in 2008 to help stimulate the economy. Economists disagree on the ultimate effects of the program, but the Fed’s balance sheet expanded tremendously over the period (as you can see from the chart below. When the Fed purchases mortgage-backed securities and treasury bills, it increases the price of government securities and effectively reduces interest rates. This can reduce borrowing costs for companies and consumers.
Why it Matters to Your Portfolio
The Fed’s monetary policy effect stocks in a multitude of ways. When interest rates rise, companies face increased borrowing costs and may have to turn to other markets to secure funding. This is known as contractionary monetary policy. This can cause new stock issuances or firms being forced to entice bondholders with higher yield (junk) bonds to raise additional capital. If neither of these options suffice, some companies might forego or postpone projects they otherwise would’ve pursued, reducing investment into the overall economy. Due to the easier monetary policy that existed after the recent financial crisis, more public companies were able to accumulate debt at a lower cost than before. Since the Fed began increasing interest rates in 2015, the cost of that debt has increased as well, which is why a clean balance sheet and ample cash reserves are becoming more important for savvy investors.
Conversely, if interest rates are reduced, companies can lower their cost of capital when securing funding for projects. This generally increases investment in the overall economy as more companies capitalize on lower discount rates for projects. This can drive security prices up and is considered expansionary monetary policy. This can also have a tangential beneficial effect on dividend-paying stocks, as retirees and other income investors seek out yield that hasn’t been depressed in the equity market.
So always keep an eye on the Fed’s policy minutes from their monthly meetings and Jerome Powell’s comments on how the Fed is viewing the rate path and economy moving forward. The Fed’s policy can, and will, influence your portfolio, so it is important to understand some of the implications.
