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How the Fed Influences the Stock Market

Financial DistrictWhat moves the stock market? There is no easy answer to that question. Ultimately, many factors influence the stock market indices that are often referred to generally as the market.

At the most micro level, the price of individual stocks is influenced by company performance ─ or, more accurately, investors’ perception of future company performance. At the most macro level, the prices of stocks are influenced by the economy’s future performance.

From micro to macro, the key factor is this: investor perception. Whether investors are irrationally exuberant or irrationally despondent or anywhere in between, investor perception can and does move markets. One factor that strongly influences investors’ outlook of the future economic performance is the Federal Reserve.

The Fed: How It Works in the Economy

The Federal Reserve has a dual mandate: to pursue the economic goals of price stability and maximum employment. The Fed affects those goals through management of the nation’s supply of money and credit (in other words, by conducting monetary policy).

People sometimes talk about the Fed setting interest rates, which it does not actually do. The Fed sets a target for the federal funds rate, which is the rate banks charge each other for overnight loans and influences other interest rates. Typically, when the federal funds rate rises or falls, so do the prime rate, mortgage rates, auto loan rates, and other rates.

So how does the Fed help the economy reach its target fed funds rate it if doesn’t set the rate directly? Through what’s called open market operations, essentially buying or selling government securities. When the Fed wants to lower the fed funds rate, it engages in expansionary monetary policy. It buys government securities, which means that it’s sending more cash into the economy ─ specifically to banks. Banks want to loan that money, so they lower interest rates to entice more borrowers.

How Fed Actions Affect the Market

Since that financial crisis, the Fed had been engaged in a series of stimulus programs known as quantitative easing. The current program entails $85 billion in monthly bond purchases. As a result of these programs, interest rates have remained near historic lows.

But the Fed can’t keep interest rates low forever, because low interest rates put upward pressure on inflation. So the Fed’s job is a balancing act, trying to keep unemployment low and inflation at a target level of about 2%.

In recent months, as the economy has continued to slow signs of improvement and employment levels have continued to rise (even as the unemployment rate has not fallen dramatically), market watchers have all assumed that the Fed would soon announce it would scale back its economic stimulus programs.

The Fed did just that on June 19 when Fed Chairman Ben Bernanke announced after the Federal Open Market Committee meeting that the Fed intended to begin gradually reducing monthly bond buying this your, depending on continued economic strength. When the stock market reacted strongly, he later backtracked, indicating it would be some time before the Fed would reduce bond buying.

How Should You React?

As an investor, what does the Fed’s influence on markets mean for you? It’s not wise for individual investors to buy or sell investments based on what the Fed has said it might or might not do at some uncertain point in the future.

What individual investors should do is review investment portfolios annually. From changes in Fed policy to changes in asset value in different classes, an annual review of your portfolio ─  and tweaks to your investments to ensure that your portfolio remains in line with your financial strategy ─ is the right way to ensure that you are maximizing performance given market fluctuations that are out of your control. Please call if you’d like to discuss this in more detail.

Copyright © Integrated Concepts 2012. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.

Photo Credit: Dirk Knight via Compfight

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