The 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.
As the markets waited for Jerome Powell to be sworn in to his role as Chair of the Federal Reserve, taking over from former Chair Janet Yellen on Feb. 5, 2018, many were wondering how he would approach running the Federal Reserve, and how that could ultimately impact different asset classes.
It’s natural to focus on the Fed Chair. After all, they are typically few and far between (see below), and, as the head of the nation’s central bank, they have a lot of influence on the U.S. economy.
DAYS SERVED BY PREVIOUS FED CHAIRS.
Fed Chair Powell is only the 10th Chair of the Board of Governors of the Federal Reserve since the Federal Reserve System was reorganized by the Banking Act of 1935. Data source: Federal Reserve.
But, beyond the Fed Chair, the overarching thing that is important that the 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, bonds, real estate, commodities, and currencies—pretty much anything you can invest in. Therefore, it’s probably a good idea for investors to have at least a basic understanding of the Fed and the monetary-policy environment we’re currently experiencing.
In the case of U.S. monetary policy, the three economic goals Congress has instructed the Fed to pursue are 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 is by managing short-term interest rates (sometimes longer-term interest rates like they did in the case of the Great Recession)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 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 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 you should entirely base your investment decisions on what the Fed is doing, but it is something to take into account when thinking about your portfolio.
The Fed has started to take action to raise interest rates and move away from expansionary monetary policy. Although, with interest rates still on the lower end of the spectrum, and the Fed is still in the early stages of selling securities it was buying after the financial crisis to push down long-term interest rates (a process known as quantitative easing), we’re coming to the end of the Fed’s “easy money” approach. This is how major asset classes typically perform when monetary policy is expansionary (loose):
The Fed has started to shift towards tighter monetary policy over the past several years and will likely continue to lean in that direction as long as economic data supports more restrictive monetary policy. Right now, according to Reuters, many market participants are expecting the Fed to hike interest rates three to four times this year. On a broad level, here’s how major asset classes tend to perform in times of contractionary (tight) monetary policy:
The above is somewhat of a simplistic explanation and, in reality, the 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.
TD Ameritrade clients can reach out to a financial consultant who can help guide you as you manage your portfolio. If you don’t have the time, or desire, to manage your own investments, another option is to look into investing solutions that offer managed portfolios to help you pursue your financial goals.
For more information on investment strategies to help weather rising interest rates, read this article on the Ticker Tape.
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