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Why Investors Care About the Fed (and Rate Hikes)

June 14, 2017
Investing, Investing Strategy, Investments
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There’s a standing appointment on many investors’ calendars eight Wednesdays a year. That’s when the Federal Open Market Committee releases a statement about its two-day meetings that fall every six weeks or so. In Wall Street talk, “it’s FOMC time.”

On Wednesday, Federal Reserve policymakers voted to raise interest rates by 25 basis points, to a range of 1% to 1.25%, only the fourth increase since the financial crisis. Even though this move was widely anticipated, after the meeting many investors continued to scan headlines for clues to the Fed’s next steps or potential surprises.

Investors monitor Fed moves to place bets on the pace of the nation’s economic growth. If there’s a way to make money, you can be sure investors will jump on it. Even some people who are new to stock trading will try their hand, as well.

While this may seem excessive, investors have actually eased up on their obsession with all things Fed now that policymakers have begun raising interest rates again. But the market will always care about the central bank and its decisions about interest rates.

The Fed’s role in the economy

The central banking system was established in the Federal Reserve Act of 1913. Congress has amended this act in the 100-plus years since, including one important amendment in 1977 that gave the central bank the mandate “to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” The first two goals are often referred to as the Fed’s dual mandate.

Plenty of investors second-guess the central bank’s every move, questioning the pace of rate increases or examining whether the language in the Fed’s statements is hawkish (worried about inflation) or dovish (worried about jobs), says Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management. What’s more, investors look to the Fed to confirm, or refute, their views on the pace of economic growth. The symbolism of a rate hike — signaling the Fed’s confidence in the economic outlook — also is important, Jacobsen says.

Market interest in the Fed reached a fever pitch in the wake of the financial crisis that began in 2007. That’s because central bankers deployed new tools — including a stimulus program of buying securities to add liquidity to the markets — that were intended to promote economic growth and stave off an even worse recession.

The unconventional nature of the Fed’s response helped stimulate the economy and the stock market, but also had investors hanging on its every word. That’s changed somewhat — the most-recent rate hikes were all but guaranteed after Federal Reserve Board Chair Janet Yellen signaled three increases were coming this year — but investors are wary of surprises, especially from the central bank.

For example, in mid-2013, then-Fed Chair Ben Bernanke said the central bank would begin winding down its monthly stimulus of buying bond assets, a program that made riskier assets like stocks more attractive to investors. The market’s response, called the “taper tantrum,” saw the Standard & Poor’s 500 index tumble almost 5% in four days. Months later, the Fed began to slow asset purchases.

As the economy stabilized, investors then tried to predict when the Fed’s first rate hike might come, and that also created market turmoil, says Walter Todd, chief investment officer of Greenwood Capital.

“For so long coming out of the financial crisis, the Fed was the only game in town in terms of trying to help the economy recover,” he says.

The Fed is doing what it promised and the U.S. economy appears to be on solid footing, but the central bank’s role will once again come into focus when conditions worsen, Todd says.

Meanwhile, the market may soon grow antsy about another issue: When the central bank will begin shrinking its nearly $4.5 trillion balance sheet. As a result of the stimulus programs that purchased securities from 2009 to 2014, the Fed is one of the biggest holders of U.S. debt. How and at what pace the central bank sells these assets could unsettle the market.

The Fed affects everyone

The Fed has a direct impact on your life, including the currency you use, the rate of inflation, employment rates and interest rates. The federal funds rate — which is what the central bank raises or lowers — affects the availability of credit in the broader market. If the Fed is hiking rates, your local bank may have more of an incentive to make loans to consumers after it increases its prime rate, which in turn affects your cost to borrow money and how much you’ll make on deposits, says Wells Fargo’s Jacobsen.

“The Fed helps influence the price and availability of loans,” Jacobsen says. “If you’re thinking of buying a car or a home, what the Fed does or doesn’t do is going to influence how much you pay and whether you’re going to get that loan.”

Nothing lasts forever

Another reason investors keep an eye on the Fed is because its members regularly change. The Federal Open Market Committee has 12 voting members, some of whom serve terms ranging from one to 14 years. Investors keep track of which members are doves or hawks. Generally speaking, hawks favor higher interest rates to keep inflation in check, while doves prefer to keep interest rates low to stimulate the economy.

Changes are especially evident in the chair, where some, like Alan Greenspan and Paul Volcker, have displayed distinctive approaches or style.  Greenspan ushered in a more transparent era during his 18-year tenure by talking about the Fed’s action and policies more so than his predecessors, while Volcker was adamant about fighting inflation as interest rates soared as high as 20% while he was chair.

The chair serves a four-year term, and Yellen’s ends Feb. 3. Whether she’ll stay on longer will depend on President Donald Trump, who is reportedly considering two candidates for current vacancies and one could replace Yellen.

Anna-Louise Jackson is a staff writer at NerdWallet, a personal finance website. Email: [email protected]. Twitter: @aljax7.