Investing

What the Federal Reserve is — and why investors care so much about it

Twenty/20

The Federal Reserve is the central bank for the U.S. And the Fed, as it's known, has played a starring role in much of the stock market's drama in recent years.

The Fed, which is tasked with helping to maintain a well-functioning economy, has three key goals: to maximize employment, to keep prices stable, and to moderate long-term interest rates. What central bankers do, or don't do, to fulfill that mandate can have a big impact on the markets.

Traders decide how much they're willing to pay for various assets, like stocks and bonds, based on the Fed's forecasts for economic growth, so they monitor what central bankers say about the economy to help inform their investing decisions. And even regular consumers benefit from understanding how the Fed influences the supply of money, for example, or the rates borrowers pay on loans.

Here's what you need to know about the Fed — and why investors track its every move.

Monetary policy: What the Fed does

Congress created the Federal Reserve in 1913 to serve as the central banking system for the U.S. In the past 100-plus years, the Fed's role has evolved along with the tools it uses.

The Fed is best known for setting short-term interest rates. It does so by raising or lowering its target for the federal funds rate, which is the rate banks charge other banks to lend money. That influences the rates you'll pay on debt like auto loans, mortgages, and credit cards — along with the amount of interest you'll earn on savings accounts.

When economic growth is strong, the Fed raises interest rates to keep inflation in check. Policymakers cut interest rates when economic growth is slowing in an effort to stimulate activity by making it cheaper for consumers and businesses to borrow money. The Fed cut rates in July for the first time since 2008, during the Great Recession.

The Fed uses a variety of tools — known as monetary to policy — to achieve its goal of maintaining a well-functioning economy. The three traditional policies are:

  1. Open market operations. Buying or selling U.S. government-backed securities. This is the primary tool the Fed uses to keep the federal funds rate within its target range.
  2. Reserve requirements. Setting requirements for what percentage of deposits commercial banks and other depository institutions must hold as reserves. This is a less frequently used tool to increase or decrease the supply of money in the economy, which influences interest rates.
  3. Discount window lending. Banks can borrow money from one of the 12 Federal Reserve banks, and the rate they're charged on these loans is called the discount rate. The Fed will use this tool to provide liquidity, or more assets, to the banking system during times of strain.

During the Great Recession of 2007-2009, policymakers unveiled nontraditional techniques to try to boost economic activity:

  • Forward guidance. In an effort to help the public understand next steps, policymakers began communicating how it intends to adjust monetary policy in the future.
  • Large-scale asset purchases. In 2008, the Fed began buying longer-term government securities in an effort to lower interest rates on long-term bonds.

The Fed could deploy these nontraditional tools again, if warranted, or develop new ones.

Why investors care so much about the Fed

The Fed's ability to raise and lower a key short-term interest rate is a big deal because its action, or inaction, reflects how policymakers believe the economy is faring.

In turn, traders closely watch any news coming from the Federal Open Market Committee (FOMC) — the group of policymakers tasked with making rate decisions. This committee is made up of 12 members, headed up by the Fed's current chair, Jerome Powell. It meets eight times a year to review economic and financial conditions and to make monetary policy decisions.

Investors track what comes out of the FOMC meetings, including statements, minutes, and press conferences, for clues to tell them how to price stocks and bonds. They're also watching because Fed news itself moves markets.

In December 2018, the central bank raised interest rates for the ninth time since the Great Recession and signaled it planned to continue doing so. But traders were betting on a slower pace of increases ahead, or even a rate cut — and the ensuing uncertainty was accompanied by a sell-off, as the S&P 500 tumbled nearly 8% in a four-day span.

A few weeks later, Fed Chair Powell told investors what they wanted to hear: Central bankers would be flexible with policy. That sparked a huge market rally that saw the benchmark index rise more than 6% in five days.

The Fed cut interest rates in July for the first time since the Great Recession, but prior to that meeting policymakers didn't signal that such a cut was a given — which also caused market uncertainty. Even now, investors and policymakers have different views on the extent of further rate cuts ahead.

When speculating about the Fed's next steps, investors often identify policymakers as one of two birds:

  • Doves. Generally speaking, doves prefer to keep interest rates as low as possible to stimulate economic growth. Investors will term statements from the Fed or speeches as "dovish" if it supports lower interest rates.
  • Hawks. By contrast, hawks favor higher interest rates to keep inflation in check. And language that investors deem "hawkish" supports raising interest rates.

While investors may be obsessed with the Fed's every move, because of the impact policymakers have on short-term interest rates, the rest of us are well-served understanding the reasoning behind these decisions.

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