When the economy heats up or cools down, monetary policy is always a relevant force that comes into play. Controlled by a country’s central bank, which in the case of the US is the Federal Reserve (Fed), monetary policy influences everything from inflation and employment to the interest rate on your credit card or mortgage. Understanding how it works is essential for making more thoughtful, informed investing decisions for your portfolio.
At its core, monetary policy is just about managing the economy’s money supply and credit conditions through a few key tools. These tools which the Fed uses are the federal funds rate (the interest rate at which banks lend to each other overnight), open market operations (buying or selling government securities), and the administered rate (Post 2020 – interest the Fed offers on the reserves of commercial banks, acting as an incentive to or to not have more reserves). The last one has changed our monetary policy system to “Ample Reserves,” whereas before it was known as “Limited Reserves.”
When the Fed wants to stimulate the economy, it uses an expansionary policy. This usually means lowering the federal funds rate, incentivizing greater borrowing between banks. Since banks can borrow at lower rates, they can offer lower rates to consumers, which causes greater consumer spending, increases demand, and stimulates economic growth. They’ll also buy bonds as part of OMOs, since in doing so, they’ll have bonds while consumers will have money. And what do consumers do with money? Spend! And lastly, any change to the administered rate would be a decrease to attempt to provide less incentive for banks to keep money in reserves and instead loan it out.
*Side Note: I want to clarify a common misconception between the federal funds rate and the discount rate. The federal funds rate is the interest the Fed sets (the one you always hear about in the news these days) for commercial banks to borrow from each other. The discount rate is the interest rate at which commercial banks can borrow from the Fed. Since the Fed wants them to go to each other before coming to it, the discount rate is usually higher than the federal funds rate by about 1%. I understand this is counterintuitive, as the name of each contradicts its real purpose. Still, it is essential to know this distinction.
However, if the economy grows too fast, it can overheat, causing inflation to rise. That’s when contractionary policy kicks in. The Fed would take all the opposite routes compared to expansionary policy to cool things down. They increase the federal funds rate, sell bonds as part of OMOs, and increase the administered rate. In theory, this helps to reduce or slow inflation, but can also lead to a recession if not managed carefully.
For investors, these changes matter a lot. When interest rates are low, stocks often do well because borrowing is cheaper and corporate profits rise. Growth stocks, in particular, benefit. But when rates rise, bonds become more attractive due to higher yields, and stock valuations (especially for tech or high-growth companies) tend to fall.
Monetary policy does not operate in a vacuum, however. It works with fiscal policy (government spending and taxation) towards a common goal. However, as history has shown, from the 2008 financial crisis to the post-COVID inflation surge, the Fed’s decisions on interest rates can shift the entire market landscape. Take recent events as another example. Everyone on Wall Street listens whenever the Fed speaks on a potential rate cut/hike decision. It heavily influences consumer/investor sentiment, driving the stock market in different directions.
For investors looking to build long-term strategies, paying attention to monetary policy trends is just as important as reading earnings reports. Knowing when the Fed will likely make changes or implement policy actions can help you position your portfolio accordingly.
Sources
Investing IQ 
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