The role of the Federal Reserve is to help the U.S. economy operate effectively.
The Fed has a lot of power to influence the economy, and this indirectly impacts how stocks move. While the stock market is not the economy, it can be seen as a reflection of how confident consumers are about the strength of the economy now and in the future.
Additionally, the stock market is a helpful indicator of economic change, well-being and growth. Investors should keep a close ear to news coming out of the U.S. central bank as a gauge to where the markets might be headed next.
If you're interested in the role the Fed plays in markets, read on for answers to these questions:
— What is the Federal Reserve?
— How do the markets respond to Fed actions?
— How do interest rates impact market sectors?
— How can investors respond to Fed actions?
[Sign up for stock news with our Invested newsletter.]
What Is the Federal Reserve?
Founded by Congress in 1913, the Federal Reserve, or the Fed, is the central bank of the United States. The Fed provides stability to the financial system, conducts U.S. monetary policy, supervises and regulates financial institutions and activities, and promotes consumer protection.
The Fed's dual mandate for monetary policy is to achieve price stability and maximum employment in the U.S. economy. To accomplish price stability, Fed policymakers set a target rate of inflation of 2%. The Federal Open Market Committee, the policymaking body of the Federal Reserve, makes decisions on interest rate policy by setting a target for the federal funds rate. This is the rate banks use when they lend to one another.
Investors should care about announcements that come from the Fed because its decisions influence financial markets and the broader economy.
One of the key items that comes out of the Fed is its Federal Open Market Committee minutes. The FOMC holds eight meetings throughout the year that discuss national monetary policy. While these meetings are closed to the public, FOMC meeting minutes are released and provide details of what was discussed in the meeting.
Investors who pay attention to these releases can glean what to expect from the markets looking ahead.
[Read: How to Build an Investment Portfolio.]
How the Market Responds to Fed Actions
Investors are forward-looking. They pay attention to the Fed to gauge expectations on what potential monetary policy actions it'll take and how that will drive financial markets.
At the height of the coronavirus pandemic, the Fed positioned monetary policy to boost economic activity by reducing interest rates, buying up bonds and getting cash in the hands of consumers to generate spending. This allowed for faster economic growth to help the economy move toward recovery.
The effects of this policy also resulted in more people investing their money in the markets. As a result, the stock market rallied, and valuations kept elevating.
Most recently, the Fed has acted to continue to boost the equity markets. Since the coronavirus pandemic began, it has expressed its goal to grow the economy.
Fast-forward to today: The economy has accelerated in growth, and the stock market has exploded. But Tony Molina, certified public accountant and senior product specialist at Wealthfront, notes that while there hasn't been a shift in monetary policy for a post-pandemic world, there are changes in investor expectations of what might come from the government in the near future.
[SEE: 7 Best Emerging-Market ETFs.]
While conditions in the equity markets appear to be good, "The challenge now is that actions of the Fed can't go on in perpetuity — they can't continue to do what they've been doing," says David Keller, chief market strategist at StockCharts.com.
In other words, as the economy continues to grow, the Fed will need to strike a balance between changing its accommodative monetary stance and not disrupting the growth in the markets and economy.
If the Fed were to start tapering its purchases, volatility could return to markets in a way Americans haven't seen since 2020, says Lyn Alden, founder of Lyn Alden Investment Strategy, an investment research service that provides market research for retail and institutional investors. As a result, "Investors that might be overleveraged might want to consider dialing that back, making sure that they're diversified enough in investments they understand and that have long-term compounding potential," Alden says.
When investors are paying attention to the news coming out of the Fed, Keller says, they should try to get a sense of how it's going to start to lighten up its dovish policy, or supportive monetary policy, and go toward hawkish policy, or less friendly economic policy decisions.
Ultimately, experts say, this fear of the unknown is causing more volatility and uncertainty in the stock market.
How Interest Rates Impact Market Sectors
Focusing on interest rates is a great way to understand how the stock market moves. Knowing the relationship between interest rates and sectors can help investors understand why certain stocks are performing better than others.
When interest rates are lower, like they are now, it's cheaper to borrow money. That makes for easier consumer spending and is a suitable environment for a company looking for cheap dollars to invest in expansion.
"The whole point of interest rates is supposed to encourage or constrain lending because that's a big source of (gross domestic product) growth and money supply growth," Alden says. "However, this current bout of inflation in money supply growth is mostly happening due to fiscal spending and not really happening due to bank lending."
Interest rates should start to go higher, Keller says. "The environment where rates are going up is a very different environment than (what) most of us have learned to invest in," he says.
For a lot of investors, it may be helpful to look back on previous cycles to see how rates were moving, what strategies started to work and how sectors responded.
[READ: How to Invest in Stocks for Beginners.]
How Investors Can Respond to Fed Actions
Don't get complacent when the market is going higher and your portfolio is performing well. "This is the time to be thinking about risk management and what a market downturn could look like," Keller says.
While there isn't a way to time the market during inflationary periods or predict any type of unfavorable economic event that could impact asset prices, investors can position themselves to withstand stock market vulnerabilities, Molina says.
"Don't find yourself trying to switch between sectors to avoid taking a big hit," Molina says.
Try to avoid moving around your funds to dodge downturns, Molina says. That's because investors may be able to do this successfully in the short term, but not in the long term.
"It can be exciting to pick individual stocks, but the smart thing to do is diversify," Molina says.
"Spread your money out by buying very cheap index funds that track the global markets, not just individual sectors, but overall international markets," Molina says.
You can start investing for the long term with low-cost index funds that cover the entire U.S. stock market, along with international exposure through a developed market exchanged-traded fund while adding an emerging market ETF. These are simple investment vehicles the average investors can easily access and build upon.
Investors who are concerned about volatility should remember that cash is a tempting position, but should also keep in mind that Americans are in a period when prices of goods and services are rising, and inflation is a reality.
"A lot of the prices that went up over the past year, and that are likely to continue going up this year, are not likely to come back down," Alden says. "Anyone holding cash and bonds last year, those cash and bonds buy fewer goods and services than they used to, and that's not going to reverse."
"Cash can still be useful as a volatility reducer, as a way to rebalance back to risk assets when they have a correction," Alden says. But in this current environment, your cash is yielding below the inflation rate, so it's actually losing value, she says.
"If you're properly diversified to the long term, you don't ever have to react," Molina says. It may feel contrary to what you should do, but he says, you have to remove your emotions that stem from uncertainty and fear.
The main thing to do is not assume that the market is going to go up forever, Keller says. "You have to make sure you have a strategy."