The term monetary policy refers to the actions taken by a central bank to influence the price of credit 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:

  • Promote maximum sustainable output and employment
  • Stabilize prices

Read on to find out how these two goals affect the way the economy works.

What is Monetary Policy?
Monetary policy can be described as a change in something that the central bank can control, such as the money supply. Policy is considered to be "expansionary" if it increases the money supply or decreases the interest rate. For example, the Fed boosted the money supply to spur economic growth following the financial crisis of 2007-08 by buying large amounts of financial assets beginning in November 2008 under a program called quantitative easing. Policy is said to be "contractionary" if it reduces the money supply or raises the interest rate.

Another way of describing monetary policy is by its 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" of stabilizing prices and promoting output and employment. "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 it is intending to reduce inflation.

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 by using the following three tools of monetary policy:

  • Open market operations
  • The discount rate
  • Reserve requirements

Using these three tools, the Federal Reserve influences the supply and demand for reserve balances of commercial banks at the central bank, and in this way alters 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 the system's requirements. The Federal Open Market Committee (FOMC) sets a target for the federal funds rate, but the market determines the actual rate itself. The Fed uses the above three tools to ensure that the actual funds rate follows its target.

For example, an open market purchase increases the reserve supply, causing the federal funds rate to fall. A higher discount rate - the interest rate that an eligible depository institution is charged to borrow short-term funds directly from the central bank - will discourage banks from borrowing from the central bank, decreasing the reserve supply and causing the federal funds rate to rise. Lower reserve requirements decrease the demand for reserves and can cause the federal funds rate to fall. A change in the federal funds rate, according to the Federal Reserve, "triggers 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."

In addition, the Federal Reserve can use "moral suasion" by pressuring certain market participants to act in a particular manner. Or the Fed can use "open mouth operations," where it states the 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 current monetary actions.

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 on capital efficiency, labor productivity, savings and risk tolerance. For example, when demand weakens and there's a recession, the Fed can temporarily stimulate the economy and help push it back toward its long-run output level by lowering interest rates. The Fed will have some difficulty managing monetary policy perfectly, but the monetary forces it puts into play can either add wind to the sails of business or create a headwind that it must fight against.

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, the strategy is to invest in economically sensitive sectors such as industrials, financials and technology. When Fed policy is contractionary, the strategy is to decrease equity exposure and invest in economically less-sensitive sectors such as consumer staples and health care.

As always, there are risks with any investment strategy. A few concerns when following a strategy based on monetary policy include:

  • The fact that this strategy has proven profitable in the past doesn't mean it will continue to be effective going forward.
  • Professional managers are typically prohibited from deviating too far from their stated investment objective. So they can't move a substantial proportion of the portfolio into money market instruments when the Fed tightens.
  • The investment results reflect the average performance over long time periods. The strategy does not provide superior returns every period. The degree to which managers feel they are graded on short-term performance will probably affect their willingness to deviate from their stated investment objective even when it is possible.

Empirical Evidence
A few studies have been done to determine if investors can earn higher profits by watching changes in Federal Reserve monetary policy. The following two studies have concluded that by using a simple rule to determine the monetary policy stance, investors can outperform the U.S. stock market. Written by Gerald Jensen, Robert Johnson and Jeffrey Mercer, the monograph "The Role of Monetary Policy in Investment Management" (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:

  • Periods of expansive monetary policy are associated with strong stock performance (higher-than-average returns and lower-than-average risk), whereas periods of restrictive monetary policy generally coincide with weak stock performance (lower-than-average returns and higher-than-average risk).
  • Small-cap companies are more sensitive than large-cap companies to changes in monetary conditions.
  • Cyclical stocks have a much higher sensitivity to changes in monetary conditions than defensive stocks.
  • U.S. monetary policy has an important influence on global markets.

On the other side of the argument is Benson Durham, who published the following articles in the July/August 2003 and July/August 2005 editions of the "Financial Analyst Journal." The articles were titled "Monetary Policy and Stock Price Returns" and "More on Monetary Policy and Stock Price Returns," respectively. Benson concludes that investors cannot earn superior returns by Fed watching. The author points to the following reason for his conclusion:

  • Studies that assume monetary policy affects stock prices, but stock prices don't affect monetary policy, should be taken with a grain of salt if they use ordinary least squares analysis. Although central banks do not target asset prices explicitly, it can be argued that stock prices contain information about expectations regarding the course of the economy and monetary policy. The potential joint determination of stock prices and monetary policy means statistical techniques using standard ordinary least squares may lead to false conclusions.

Over the time periods studied, it seems monetary policy does matter to the stock market. However, as stated, an investment strategy tied to monetary policy does not necessarily work for every easing or tightening cycle. There are caveats. Investors should consider many other factors too, such as yield curve, before making their investment decisions.

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