The U.S. Federal Reserve, Monetary Policy and Your Investments
The U.S. Federal Reserve’s monetary policy can impact every asset class. Learn more about expansionary (or loose), and contractionary (or tight) policy and how that can affect investments.
The U.S. Federal Reserve is in charge of is U.S. monetary policy—the supply and rate of growth of money. The Fed’s monetary policy impacts equities, real estate, commodities, and currencies—pretty much anything you can invest in. Therefore, it’s probably a good idea for those investing in the U.S. market to have at least a basic understanding of the Fed and the current monetary-policy environment.
The Fed and Monetary Policy
In the case of U.S. monetary policy, the U.S. Congress has instructed the Fed to pursue three economic goals: promoting maximum employment, stable prices (keeping inflation in check) and moderating long-term interest rates.
The Fed has a range of tools that it uses to implement monetary policy. Ultimately, the Fed pursues the goals Congress gives it by managing short-term interest rates and affecting the availability and cost of credit across the U.S. economy.
Monetary policy is typically expansionary (loose), contractionary (tight), or neutral. If the U.S. economy starts growing too fast and inflation speeds up, the Fed might raise interest rates and take steps to reduce available credit to slow it down, which is a contractionary or tight environment. On the other hand, if the U.S. economy is growing too slowly, or not at all, the Fed might lower interest rates and take steps to increase available credit to jumpstart growth, which is an expansionary or loose environment.
Some investments tend to perform better in times of expansionary monetary policy, while others tend to perform better under contractionary monetary policy. That’s not to say investors should entirely base investment decisions on what the Fed is doing, but it is something to take into account when thinking about your portfolio.
Expansionary Monetary Policy Environment and Investments
This is how major asset classes typically perform when monetary policy is expansionary (loose):
- Equities typically outperform. As the Fed focuses on spurring economic growth, that can bode well for companies that are able to capitalize on a stronger economy. At the same time, low interest rates and low potential returns in other asset classes might make equities more attractive to investors, helping equities to increase in price.
- Cash doesn’t hold up too well. The Fed’s actions to lower interest rates carry over to deposits, resulting in lower returns in savings accounts, certificates of deposit (CDs) and money-market funds.
- Commodities can increase in value, but they frequently lag other asset classes like equities. Stronger economic growth can result in greater demand for certain commodities, like copper and steel that are heavily used in construction and manufacturing industries. “One thing to keep in mind is that not all commodities are going to perform similarly. Supply and demand dynamics have a large impact on prices, something we’ve seen with oil and natural gas over the past few years. Commodities get lumped together often, but there are huge differences between metals, energy, and agriculture,” JJ Kinahan, Chief Market Strategist at TD Ameritrade, pointed out.
- Real Estate prices typically rise, helped out by low interest rates on mortgages that might spur people to buy new homes or potentially buy a more expensive house than they otherwise would’ve been able to afford.
Contractionary Monetary Policy Environment and Investments
On a broad level, here’s how major asset classes tend to perform in times of contractionary (tight) monetary policy:
- Equities tend to underperform. Investors might be attracted to higher yields on other investments, reducing demand for riskier assets like equities. Higher interest rates can also make it more expensive to buy stocks on margin.
- Cash returns can improve during tight monetary policy environments. Rising interest rates can trickle through to savings accounts, CDs, and money-market funds, making it more attractive for consumers to save.
- Commodities tend to outperform other asset classes during times of contractionary monetary policy. Although, as the Fed lowers interest rates and reduces money supply to slow down the U.S. economy, the effects can result in diminished demand for some commodities, driving down the price. Higher interest rates can also make it less attractive for companies to stockpile commodities they use as raw materials. And the rate of inflation, which often increases during contractionary monetary policy, can help increase the attractiveness of real assets like commodities.
- Real Estate tends to underperform during periods of tight monetary policy. Higher interest rates on mortgages result in a higher cost of home ownership, leading to reduced housing demand, ultimately driving down prices.
Takeaways for Investors
The above is somewhat of a simplistic explanation and, in reality, the U.S. economy and markets are constantly shifting. Oftentimes, it can take years for trends to materialize, or for the effects of the Fed’s actions to trickle through the U.S. and global economy.
Different asset classes are going to perform differently under various environments. Having a diversified portfolio across asset classes can help manage risk and make sure you’re not too heavily weighted in one area.
Regardless of the environment, Kinahan recommends that you check in on your investments on a monthly, or at least quarterly basis to ensure they are aligned with your goals and needs, as well as your overall risk tolerance.