What Does the Fed Do and How Does it Impact the Stock Market?

If you are a new investor, you may be aware that the actions of the Federal Reserve Bank, commonly known as the Fed, have an influence on stocks. For a few days every month these days, it seems like the market goes on hold as traders and investors await the end of the Fed’s monthly meeting and the announcement and press conference that follows. That is primarily because the Fed sets interest rates, but it isn’t quite that simple. And with the central bank seeming to take a more active role than ever before in controlling the economy, it is important to understand exactly what the Fed is and how it impacts the stock market.

What is the Fed?

Let’s start by clearing up a couple of common misconceptions. The Fed is not “the government,” nor is it just a single entity. The official name of the institution is “The Federal Reserve System,” and it is made up of twelve regional reserve banks. The board of each of those consists of nine members, with six elected by the local banks that are the members of the region’s reserve bank, and three then appointed by the board. While the Federal Reserve System was set up to serve the public, the local reserve banks themselves are for profit companies. The member banks are the shareholders of each Federal Reserve bank. As such, they receive a share of the profits in the form of dividends, but do not have voting rights.

The belief that “the Fed” is a singular, political body comes from the fact that the twelve regional banks are overseen by a national board of directors. Those directors are political appointees, nominated by the President and confirmed by the Senate. They serve fourteen year terms. The chair of the Federal Reserve, the role currently held by Jay Powell, and the vice-chair are also presidential appointees. The nominees must come from existing board members, and they serve only four years in the role. They can be reappointed after that time, as Jay Powell, a Trump appointee was by Joe Biden.   

What Does the FOMC do?

For investors, the most important committee of the many on which Fed board members serve is the Federal Open Market Committee (FOMC), which is made up of the seven appointed Fed board members, the New York Fed President and four of the other regional Fed presidents. It is the group that sets monetary policy. That is mainly done by changes to interest rates, but it also controls liquidity in the financial system, meaning how much available cash banks and other financial entities have.

Interest Rates

The Fed does not set the interest rate on mortgages or other loans directly, but it does influence them. It is the main short-term lenders to banks, who are required to maintain a certain level of liquidity. The money it lends is called “Federal Funds” and it sets the interest rate on the money that is borrowed from them. That then works its way through the system, because if banks have to pay more to borrow money, they charge more to lend it too.

Liquidity

The Fed controls the amount of liquidity in the financial system by the amount of assets it buys and sells. It can buy assets, ranging from short-term paper to longer-term bonds, from banks. That replaces those assets on the banks’ books with cash that, in theory, the banks will then go out and lend, creating economic growth. That is basically what the Fed did with the quantitative easing (QE) that was used to stabilize the economy after both the financial crisis in 2008 and the shock of the pandemic shutdown in 2020.

On the other hand, if it wants to slow the economy by controlling inflation, it can do that in reverse, selling assets to take cash out of the system.

How Does the Fed Impact the Stock Market?

When the Fed either pushes interest rates higher or reduces liquidity in another way, it slows the economy. When interest rates rise, it discourages borrowing and makes it more expensive, which slows consumer spending and negatively impacts the growth of companies. Reducing liquidity just means less cash in the system for investment, either for investments that prompt growth, or for investing in assets like stocks. So in general terms and under normal circumstances, higher interest rates and/or reduced liquidity mean that stock prices will fall, with the opposite effect when rates are cut or liquidity is increased.

However, the Fed typically signals its intentions ahead of time, and the stock market is always looking forward. So when Jay Powell or other FOMC members start to talk about ending a cycle of hikes or maybe even cutting rates back at some time in the future, the stock market will sometimes go up, even as rates are rising. That is what we saw in the first half of 2023.

What to Watch For

That forward-looking nature of markets makes it in some ways more important to be aware of what the Fed is saying than of what it is doing. Each time the FOMC meets, it issues a statement explaining any changes to policy, or the lack of changes. Those statements are what institutional traders and analysts watch most closely. Investors should do the same. You should always be aware of the direction in which the Fed is heading and what its stated intentions are rather than focusing on what it has already done. Past actions matter, because its impact is always delayed to some degree, but those actions would have been priced into stocks when it was first signaled. That is why stocks dropped so much in the second half of 2022 as the Fed made it clear it was going to continue to hike rates into the following year.

The Federal Reserve system is complicated, but if you are new to investing, it is important to have a basic understanding of what it does, why it does it, and how its actions impact the stock market. If you have got this far in this article, hopefully you now have that.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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