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How FOMC Monetary Policy Tools Affect the Market

by Jan 9, 2019Bishop's Corner0 comments

We’re seeing a nice rally in the Dow since the bottom just after Christmas.  Nearly straight up since then!

That said, the market will be shifting its attention to Ralph, Charles, Eric, Tom, James, Richard, and Jerome.

No, these are not members of a hot new boy band, instead, they are some members of the Federal Open Market Committee (FOMC), rockstars in the eyes of the market.

And over the next two days, traders and fund managers will all be paying attention to what these individuals have to say about the state of the economy.

You see, while technicals matter do matter in this market. The power of their words can act as a catalyst. After all, this rally from Friday has been driven by the Fed Chairman, Jerome Powell. During an interview, he said that the Fed will remain patient, regarding raising interest rates further.

That one word, patient, is all traders needed to hear.

While making his comments on live T.V., you could see the stock market starting to turn greener… and greener. The Dow finished up more than 700 points that day and has remained strong since.

Thanks to Jerome’s comments, I was able to put together back-to-back +100% winning trades.

You see, putting the charts and patterns together is just one part of the puzzle. Heck, if it was just that, I could hire a programmer and automate my strategy. However, computers can only do a few things faster, and thinking is not one of them.

That said, I told my Weekly Money Multiplier clients that there would be no more rate hikes in 2019. It’s one of the seven trends I see in 2019. Here is what I wrote:

5. No more rate hikes in 2019. The market is pricing in about a 90% chance that the Fed will NOT hike rates for the foreseeable future. This is a signal that they are worried about the delicate nature of our economy right now. I think they are right to keep a lid on rates, in fact, I really disagree with how much they raised rates to begin with. They may need to backpedal on that sooner than they hoped for. That is a bullish sign for bond prices.

That said, understanding how the Fed moves and the way they operate can lead you to profits. It has for me, and I want to show you too.

Now, you’re probably wondering, “What’s the Fed, and why monetary policy is so important?”


The FOMC (FED) Could Move the Markets…

 

 

Well, the Fed – also known as the central bank – could move the market…

For example, when the Federal Open Market Committee (FOMC) minutes are released at 2:00 PM ET, the SPDR S&P 500 ETF (SPY) could have some sharp moves…

That said, the Fed is not only important to traders but also institutions and banks.

You see, the Federal Reserve Bank controls three tools that dictate monetary policy:

  • Discount Rate (also known as the overnight interest rate)
  • Reserve Requirements
  • Open Market Operations

Before we delve into these topics, there are a few things you need to know about the Federal Open Market Committee (FOMC).

The FOMC consists of 12 members who vote and decide on monetary policy. These members include:

  • Seven members of the Board of Governors
  • Federal Reserve Bank of New York President
  • Four Reserve Bank Presidents (These members serve one-year terms on a rotating basis)

There are also non-voting members who attend FOMC meetings, analyze the economy and monetary policy options. However, they don’t have a final say as to what the FOMC would actually do when it takes action.

Now, the Federal Open Market Committee holds 8 regularly scheduled meetings per year. If you want to stay up to Fed events, you can check out the Fed’s calendar here.

That in mind, let’s take a look at some of the monetary policy tools.

FOMC Monetary Policy Tools – Discount Rate

Over the past decade or so – following the global financial crisis – policymakers have been focused on the overnight interest rate.

You’ve probably heard the talking heads say, “The Fed raised rates by 25 basis points.”

But what does that actually mean?

Well, 100 basis points (bps) is equivalent to 1%, so if they raised rates by 25 basis points, it means they raised the discount rate by 0.25%.

Now, the discount rate is the overnight interest rate charged to banks and depository institutions (financial institutions legally allowed to accept cash deposits from consumers) on loans received from their respective regional Fed Reserve Bank.

When the FOMC raises rates, it makes it more expensive for financial institutions to borrow funds. That in mind, they would have less cash to lend out to consumers. It doesn’t matter if these banks don’t borrow money from the Federal Reserve Bank…they’ll soon realize the institutions they may be borrowing from have raised their interest rates to be in line with the change in policy.

Why would the FOMC want to raise rates?

One of the main reasons is to curb inflation. Now, inflation is simply an increase in the prices of goods and services, coupled with a decrease in the purchasing power of money. You’ve probably heard of this before…but overinflation is bad for the economy. When there’s high inflation, a buck won’t get you a soda anymore, it might cost two bucks in a rising inflationary environment.

That in mind, when inflation is high, the FOMC may look to raise rates. In turn, this would slow economic growth, which is a good thing sometimes. On the other hand, when inflation is slow, the Fed may look to cut rates to stimulate the economy.

Moving on, the Fed also uses reserve requirements as a monetary policy tool.

Reserve Requirements

Depository institutions are required to have a specific amount of funds in reserve against specified deposit liabilities. This is known as the reserve requirement.

Now, the Fed’s Board of Governors has the sole power over reserve requirements. We won’t get into all the details about reserve requirements.

Just know that the Fed places reserve requirements so that banks don’t go out lending all their capital, potentially leading to another financial crisis. Basically, the FOMC imposes thresholds on reserve requirements. For example, if the FOMC imposed a reserve requirement of 20%, that means if the bank has $100M in deposits, it could only lend out $20M, or $100M * 0.20.

Last, but not least, the FOMC engages in open market operations as another form of federal policy tool.

Open Market Operations

If you didn’t already know, the central bank buys and sells securities in the open market. This is one of the key tools of monetary policy.

Now, the FOMC lets the public know about its objectives for open market operations.

For example, prior to the global financial crisis, the Fed used open market operations to adjust the supply of reserve balances. In turn, this allowed the Federal Reserve to keep interest rates around the FOMC’s target federal funds rate.

Why is this important to monetary policy and the markets?

Well, if the FOMC wants to increase the money supply in the U.S., it would purchase securities. On the other hand, if the Fed wants to decrease the money supply, it would sell securities.

You probably know what that means for the market…

If the Fed is buying securities, there is more available capital for lending purposes. In turn, this would lower the rates on the loans, which could drive the market higher.

Look, there are very few groups that can move stocks as much as the Fed can. As a shrewd trader, take the time to study their moves, it could lead to extra $$$ in your trading account.  

To YOUR Success,


Jeff Bishop

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