How the Fed Affects the Stock Market

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The Federal Reserve is one of the most misunderstood institutions in the US right now. Investors and everyday Americans have begun to resent and distrust the Fed while political parties vilify them as an enemy to economic growth. But the Fed is an independent entity beholden to no political party that serves an important role in the economy.

Operating as an economic regulatory agency, the Fed has several missions that it is charged with. To execute its role, it also has three tools at its disposal to keep the economy on track – not too much growth that inflation becomes a runaway effect, but not so low that stagflation occurs.

The role of the Federal Reserve

The stated purpose of the Federal Reserve is four-fold: to manage inflation, supervise the financial system, regulate the money supply to maintain financial stability, and act as a lender of the last resort to banking institutions.

It has three methods at its disposal to perform this function as the economic referee by way of the Federal Open Market Committee (FOMC). The most common method is by using open market operations in which the Fed may buy or sell treasuries to financial institutions. If the Fed wants more liquidity in the markets, it will buy treasuries and if it wants a tighter supply, it will sell treasuries. The Fed can also raise or lower the federal funds rate – the rate that it charges banks to borrow funds – as a way of combating inflation. And finally, the Fed sets the reserve requirements for banking institutions. This is the amount of money banks are required to hold in reserve to cover the amount in loans it has outstanding. Used the least, this Fed tool can heavily impact the money supply by freeing up more money or restricting it.

Because the Fed’s actions directly impact the stock market, investors keep a close watch on what the Fed has to say. Fed meetings are often dissected under a microscope and every word analyzed to determine what actions may lie ahead. Fed meetings are often given labels such as ‘hawkish” or “dovish,” and while most Fed officials attempt to avoid overt statements about the economy, investors have grown skilled at reading between the lines.

Final thoughts

What happens in Washington D.C. rarely has a significant long-term impact on the stock market, although it can cause temporary dips or surges. What the Fed does, however, can have a deep and meaningful effect on the market. Changes in the Fed funds rate directly impacts interest rates for everything else. Even the smallest hint of dovish or hawkish behavior from the Fed can be enough to trigger large swings in volatility. For investors, paying attention to Fed statements can let them know what direction the market may be headed in.