MAKE A RECOMMENDATION FOR POLICY ACTION THAT SHOULD BE UNDERTAKEN AT THE NEXT FE
ID: 1178766 • Letter: M
Question
MAKE A RECOMMENDATION FOR POLICY ACTION THAT SHOULD BE UNDERTAKEN AT THE NEXT FEDERAL OPEN MARKET COMMITTEE MEETING.
1. BASED ON YOUR RESEARCH AND ANALYSIS, DETERMINE THE MONETARY POLICY ACTION YOU THINK SHOULD BE UNDERTAKEN.
2. DETAIL THE MONETARY POLICY RECOMMENDATION YOU MAKE AT THE NEXT FEDERAL OPEN MARKET COMMITTEE MEETING.
3. STATE A RATIONALE FOR YOUR POLICY RECOMMENDATION.
4. ANALYZE THE POTENTIAL EFFECTS OF YOUR MONETARY POLICY RECOMMDATION.
5. DESCRIBE HOW THE RECOMMENDED POLICY ACTION IS EXPECTED TO AFFECT THE ECONOMY, AND IN PARTICULAR, EACH OF THE IDENTIFIED.
Explanation / Answer
The term monetary policy refers to the actions undertaken by a central bank to influence the price of credit in order to promote national economic goals. In the U.S., the Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy. The Act was amended in 1977 to include the following two goals:
Read on to find out how these two goals affect the way the economy works.
What is Monetary Policy?
One way of describing monetary policy is by the change in something that the central bank can directly manipulate, such as money supply or a short-term interest rate known as the federal funds rate. The federal funds rate is the interest rate at which banks lend their excess reserve balances at the Federal Reserve to other banks that have reserves below what is required by the system. Policy is considered to be "expansionary" if it increases the size of the money supply or decreases the interest rate. On the other hand, it is said to be "contractionary" if it reduces the size of the money supply or raises the interest rate.
Another way of describing monetary policy is by the intended effects on the economy. According to Chapter 2 of the Federal Reserve's document, The Federal Reserve System: Purposes and Functions, "in the short run some tension can exist between the two goals" and "in such circumstances, those responsible for monetary policy face a dilemma and must decide whether to focus on defusing price pressures or on cushioning the loss of employment and output." Thus, monetary policy is described as "accommodative" if the central bank is looking to spur economic growth, "neutral" if the central bank is neither attempting to increase growth nor fight inflation, or "tight" if intended to reduce inflation." (For more, see How The Federal Reserve Was Formed and Formulating Monetary Policy.)
How Does the Federal Reserve Accomplish its Goals?
The Fed can't control inflation or influence output and employment directly. Instead, it affects them indirectly through the use of the following three tools of monetary policy:
Using these three tools, the Federal Reserve influences the supply and demand for reserve balances and in this way alters the federal funds rate.
In addition, the Federal Reserve can use "moral suasion" by pressuring certain market participants to act in a particular manner or through "open mouth operations" where the Fed states what goal it will be focusing on in hopes of getting the market to build these future monetary actions into expectations and thus increase the effectiveness of the current monetary actions.
Raising or lowering interest rates affects demand for goods and services. The Federal Reserve states that "changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output and prices of goods and services." (To learn how this works in more detail, see the Federal Reserve Bank of San Francisco'sAbout The Fed page.)
Why Does Monetary Policy Matter to the Stock Market?
Monetary policy influences output and employment in the short run and can be used to smooth out the business cycle, but in the long run output and employment are dependent upon capital efficiency, labor productivity, savings and risk tolerance. For example, when demand weakens and there's arecession, the Fed can temporarily stimulate the economy and help push it back toward its long-run level of output by lowering interest rates. The Fed will have some difficulty managing monetary policy perfectly but the monetary forces they put into play can either put wind in the sails of business or create a headwind that they must fight against. (For related reading, see How Does the Government Influence the Securities Market?)
An investment strategy designed to benefit from tailwinds and seek harbor in headwinds has been promoted as a method to achieve better than market returns. The mantra of this strategy is "don't fight the Fed." When Fed policy is expansionary, invest in economically sensitive sectors, such as industrials, financials and technology. When Fed policy is contractionary, decrease equity exposure and invest in economically less sensitive sectors, such as consumer staples and healthcare.
As always there are risks with any investment strategy. A few concerns when following a strategy based on monetary policy are:
Empirical Evidence
There have been a few studies done to determine if investors can earn abnormal profits by watching the change in Federal Reserve monetary policy changes. The following two studies have concluded that by using a simple rule to determine the monetary policy stance, investors can out perform theU.S. stock market. Written by Gerald Jensen, Robert Johnson and Jeffrey Mercer, their monograph "The Role of Monetary Policy in Investment Management" (Research Foundation of The Association for Investment Management and Research) was published in November 2000. The other article titled "Is Fed Policy Still Relevant to Investors?" was written by the above men along with Mitchell Conover and published in the Financial Analysts Journal (Volume 61) in 2005.
These studies conclude that:
On the other side of the argument is Benson Durham, who has published the following articles in the July/August 2003 and July/August 2005 editions of the Financial Analyst Journal. The articles were respectively titled "Monetary Policy and Stock Price Returns" and "More on Monetary Policy and Stock Price Returns". Benson concludes investors cannot earn superior returns by Fed watching. The author points to the following reasons for his conclusion:
Conclusion
Over the time periods studied, it seems monetary policy does matter to the stock market. As stated, the strategy does not work for every easing or tightening cycle. There are caveats, and the studies did not examine performance of the stock market during easing cycles conditioned on the slope of the yield curve and the valuation of the market. It appears that these two factors may influence the results. Easing cycles that begin with inverted yield curves and high valuations are likely to perform poorly.
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