Who is the ‘Fed’ and what do they do?!

Fed Reserve CartoonDear Mr. Market:

“Who and what is the Fed”?  “What do they do” and “How do I understand what they are really saying and how it will impact me!?”  These are questions that we often hear from investors.  The Federal Reserve frequently dominates economic headlines and although its actions impact us all, very few of us truly understand what “the Fed” is or what it does.

We all hear terms like: “Don’t bet against the Fed”, “Dovish or hawkish sentiment” “Quantitative Easing” and “When will the Fed begin to taper”?  These are just the tip of the iceberg as the press and media attempt to interpret anything and everything released by members of the Fed.  Let’s take a moment and look at the basics of what the Fed is.

The Federal Reserve System (the “Fed”) is essentially the central banking system of the United States.  Through the Federal Reserve Act of 1913 it was created in response to financial uncertainties in the early 1900’s.  Over the last century the responsibilities and roles of the Federal Reserve System have evolved to address the changes in our economy.

In the Federal Reserve Act the U.S. Congress designated three key objectives for the monetary policy that the Fed manages: (1) maximize employment (2) keep prices stable and (3) manage long-term interest rates.  Over the years the responsibilities have expanded and today they are expected to manage the nation’s monetary policy, regulate the banking industry and monitor the overall stability of our financial system.

The structure of the Federal Reserve System consists of many individuals located throughout the country.  The key components are: The Federal Reserve Board, the Federal Open Market Committee (FOMC), 12 regional Federal Reserve Banks located in major cities throughout the country, numerous privately owned banks and several advisory councils.  By having representation from the private and public sectors it was designed to serve the interests of the general public and the banking/financial industry.

Janet Yellen is currently positioned to become the next Chairman of the Federal Reserve Board after the Senate Banking Committee recently confirmed her nomination.  Many news sources have stated that this promotion will make her the most powerful woman in the entire world!  As we close out 2013 there are many questions on where our economy is headed and what actions the Fed will take to either support or limit that movement.  That being said, let’s try and make sense of “Fed Speak” and translate some of this stuff into plain English!

The press loves to break down every tiny detail when the Fed Chairman speaks.  At one point the media would look at former Fed Chairman Alan Greenspan’s briefcase and attempt to estimate its thickness.  If it was thin it was assumed there would be no change in policy but if it was thick there was a chance that change was inevitable as he had material to back his stance.  This “Briefcase Indicator” is just an example of how closely the Fed is watched.  Below are some common words/phrases that are often associated with the Fed:

Inflation 

Definition: The rate at which the general level of prices for goods and services is rising, and subsequently, purchase power is falling.

Example: If inflation is 3% then bottle of water that costs $1 today will cost $1.03 in a year.

Deflation

Definition: A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression.

Example: Japan experienced a deflationary environment for nearly 20 years starting in the 90’s.

Beige Book

Definition: The Beige Book is more formally called the Summary of Commentary on Current Economic Conditions and is a report published by the Federal Reserve Board eight times a year.

Quantitative Easing

Definition: A monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

Example:  In an effort to promote economic growth the Fed will buy government bonds to lower short-term interest rates and increase overall money supply.

Tapering

Definition: When the Fed cuts back on the purchasing of government securities and slows the supply of money into the overall economic system.

Example:  The Fed is currently purchasing $85 billion per month of government securities and much of the future of the market hinders on how and when the Fed will slow down these purchases.

Dovish

Definition:  An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that inflation and its negative effects will have a minimal impact on society. This term is derived from the docile and placid nature of the bird of the same name.

Example: Statements that suggest that inflation will have a minimal impact are called “dovish”.

Hawkish

Definition: A policymaker or advisor who is predominantly concerned with interest rates as they relate to fiscal policy. A hawk generally favors relatively high interest rates in order to keep inflation in check.

Example: Less concerned with economic growth than they are with recessionary pressure brought by high inflation rates.

The media is always creating new terms when it comes to the Fed.  While not everyone agrees with what the actions of the Fed there is very little we can do to impact it.  Investors need to take this information and decide how it will impact their portfolio and what they need to do….

What should I do now? 

This leaves us with the final question that we are often faced with– what  should I do with my portfolio now?  While there are many answers to this question we like to take a step back and ask the most important question – What is your plan?  There will always be headlines and events that will impact the markets but ultimately every investor needs to have a plan that they can count on.  Let’s put this in other terms – if you were going on a long road trip would you stop and make a decision at every street intersection to decide if you should turn or continue straight ahead?  The answer here is quite obvious – NO, you would have a plan on how you were getting to your final destination and not get sidetracked at every intersection or obstacle that you encountered.  Investing should be no different!  Rather than get bogged down by the news of the day from around the globe or what the Fed is doing, stay focused on your plan.  We are reminded of a popular saying, “People don’t plan to fail, they fail to plan!”

There will always be debate on the actions that the Fed is taking!  Don’t allow yourself to be overwhelmed with headlines but take control over what you can truly control. It’s no secret that the government has basically been a printing press and that the stock market has been pushed to all-time highs because of it. It also shouldn’t come as a surprise that one day the “music will stop” and this country (and stock market) will have a huge hangover.  If you’re worried about things like inflation or what will happen once the Fed starts tapering, you likely don’t have a solid financial plan or strategy in place. That peace of mind is available but it begins with you having either the education or the guidance to filter out what is noise from what is news.  Contact us to help you put things in place!

(888) MY-GUIDE or (888) 474-8433

info@myportoflioguide.com

3 thoughts on “Who is the ‘Fed’ and what do they do?!

  1. Pingback: Currency Markets: Not the Roller-coaster you think it is! | Dear Mr. Market:

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