They may not have access to the armed forces but it is often argued that the chairman of the Federal Reserve has a level of global power and influence that rivals that of the U.S. president. While most investors know the name of the current Fed chief, Ben Bernanke, how his decision-making impacts your money is much more elusive. In this installment of Investing 101, we address how the Federal Reserve's policy-making decisions impact your investments in stocks, bonds, and commodities.
1. Fed Liquidity & Stocks
The role of the Fed is simple on paper. The entity exists to carry out a dual mandate to use monetary policy to promote maximum employment and stable prices (keep inflation in check). That's it. While many critics believe the 2008 financial crisis caused the Bernanke Fed to stray beyond their traditional mandate, the debate is best left to the scholars.
What you need to know is whether the Fed is lowering interest rates or adding money or taking other actions that support or nurture economic growth --generally referred to as an "easing cycle."
"When the Fed is adding liquidity into the system, it's good for stocks," says Doug Roberts, author of Follow the Fed to Investment Success. "If they're not injecting liquidity (which is called ''tightening") and there's a crisis where the economic system is contracting, it's bad for stocks."
But it's not as simple as higher rates versus lower rates.
"I think you have to really look at what the Fed is doing," says Roberts. "If you rely on what they're saying, it's sometimes confusing."
The Fed holds eight regularly scheduled meetings per year, and it seems each one captivates Wall Street's attention. Investors go to great lengths to detect any hints that the Fed might be changing its policy direction and economic outlook.
2. Interest Rates & Bond Yields
Like stocks, your bonds are also impacted by rising and falling interest rates or other actions of easing and tightening by the Fed. Simply put, if the Fed is easing, or cutting interest rates, the value of your bonds will typically go up. But, if rates go are going higher, the value of your bonds that pay a lower percentage rate, will go down.
At the same time, you must remember the second part of the Fed mandate --price stability/inflation. Be aware that a rate hike is the surest method known to slow inflation, but there's a catch.
"Bonds can do well when the rate of inflation is higher than short-term borrowing costs," Roberts says, but points out when that it occurs, it's typically a good time to own gold.
Outside of its interest rate policy which has kept rates near zero for the last three years, the Federal Reserve is currently deeply involved in the bond market by directly purchasing bonds. These unprecedented actions, done under the banner of quantitative easing (or "QE" for short), have had an enormous effect on the marketplace, no different than if an extremely wealthy investor were suddenly buying up houses, lumber or gold.
3) The Fed's Impact on Gold & Commodities
Speaking of gold, the precious metal's role as an investment that can protect you from inflation is just part of the reason that it is effected by the words and actions of the Federal Reserve. Because the dollar is directly linked to the rise and fall of rates, Roberts says ''depreciation of the currency" has as much, if not more, impact on commodity prices.
Therefore, falling rates and a falling dollar tend to increase the appeal and price of gold, oil and other commodities.
"These assets by nature, are volatile even in goods times, so you have to be prepared," Roberts cautions, reiterating the need to pay attention and be aware of how the Fed's easing and tightening impacts virtually all asset classes.
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