Big news is about to hit the stock market, and you don’t want to be caught off guard when it happens. The Federal Open Market Committee (FOMC) is meeting this week to discuss monetary policy and interest rates, and there’s a good chance stocks will react strongly to new information coming out of this meeting. Make sure your investment portfolio is set up to handle one of the biggest events in the financial calendar.
Why the FOMC Matters
The stock market has been heavily influenced by interest rates over the past two years, and the Federal Reserve is driving interest rate changes.
Interest rates are often associated with relatively low-risk assets, such as treasury bills and high-quality corporate bonds. When interest rates are high, investors can earn decent rates of return without taking too much risk. However, periods of particularly low interest rates force investors to look elsewhere for better returns.
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This exact process has been happening over the past few months. Low rates tend to increase demand for stocks, especially high growth stocks with more speculative valuations. It was important fuel for the COVID-19 bull market.
The Fed controls interest rates by buying and selling securities (usually Treasury bills) on the open market. When the central bank buys bonds, it increases demand for those securities and injects liquidity into the economy. This lowers interest rates and stimulates economic growth, so it is considered expansionary monetary policy.
An expansionary policy also tends to raise inflation by stimulating the demand for goods, services and labour. The Fed sells securities and reduces the money supply if it wants to raise rates.
The FOMC is the arm of the central bank that implements these strategies. The committee meets every two months to discuss these actions, and the meetings are followed by a data release and press conference. There’s an FOMC meeting this week, giving investors a rare glimpse into one of the greatest economic forces as it changes.
If any of the information from this week’s FOMC meeting differs from expectations, chances are the market will change again. The market was shaky and the CBOE Volatility Index has been high, so any surprises from the Fed are likely to lead to a sharp rise or fall.
What to expect
There is no way of knowing exactly what the Fed will do, so all forecasts are speculation and guesswork. Still, we can make educated guesses and prepare for a range of outcomes.
The Fed’s primary responsibility is to balance inflation and economic growth. Not everyone agrees with modern monetary policy, but there is plenty of evidence to suggest that the activities of central banks can reduce the severity of recessions or limit irresponsible economic expansion. The idea is that a steadily growing and more predictable economy is better for everyone in the long run.
The basic principle is to cut interest rates when unemployment is high and raise rates when inflation is too high. February’s jobs report shattered expectations, with nearly 300,000 more jobs than expected. Unemployment fell to a low of 3.8%, and there was also a significant improvement among those underemployed for economic reasons. We are approaching pre-pandemic employment levels, which were very high.
Meanwhile, the latest inflation data points to the biggest consumer price increases in decades. Food and energy prices soared due to supply shocks, adding to an environment of already high inflation.
Since the last FOMC meeting in January, inflation has been higher than expected, while unemployment has been better than expected. This would indicate that the Fed will maintain or accelerate its rate hike schedule.
Some people believe that the Fed’s reluctance to take action drove the stock market down. It’s naïve to think that the Fed doesn’t consider equity investors at all, but monetary authorities have already taken action that resulted in a sell-off of stocks. Inflation is a threat to economic stability right now if left unchecked, and the economy as a whole looks strong enough to absorb higher rates. Therefore, the monetary policy response seems quite predictable.
Don’t be surprised if the market reacts negatively as the Fed takes a more aggressive stance against inflation. Prepare mentally and emotionally for volatility so you don’t panic over bad news. Make sure your investment portfolio has the right balance of growth and volatility to achieve optimal results, whether the economic news is good or bad.
Remember: this is all just a temporary interruption to the long-term growth of the economy and the stock market. You have to work your way through this short-term stuff, but don’t get too carried away.
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Ryan Downie has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.