How Monetary Policy Affects Investments

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Monetary Policy and Investments: An Overview

Monetary policy is a strategy by central banks to monitor the money circulating in an economy and achieve long-term economic growth. In the U.S., the Federal Reserve’s monetary policy goals promote maximum employment, stable prices, and moderate long-term interest rates. Monetary policy, and changes to it, can have a significant impact on an investor's portfolio and net worth.

Key Takeaways

• Central banks enact monetary policy to stabilize inflation and unemployment and grow the economy.
• Contractionary measures are used during periods of inflation, and expansionary policies are used during a recession.
• Investors can weather changes to policies with a diversified portfolio, owning assets that outpace inflation, active portfolio management, and taking advantage of the interest rate environment.

Monetary Policy Tools

Monetary policy is commonly categorized as expansionary or contractionary. Monetary policy affects all asset classes, including equities, bonds, cash, real estate, commodities, and currencies. The U.S. Federal Reserve uses various tools to influence monetary policy, such as:

• Open market operations with the purchase and sale of financial instruments by the Federal Reserve
• Changes to the discount rate, or the interest rate charged by the Federal Reserve to depository institutions on short-term loans
• Changes to reserve requirements, or the proportion of deposits that banks must maintain as reserves

When inflation increases too fast, a central bank employs contractionary policies. If the economy is sluggish, the central bank will adopt expansionary measures.

Effects of Expansionary Policy on Investments

When the economy is sluggish or recessionary, the central bank will adopt an expansionary policy by lowering short-term interest rates to stimulate growth and boost the economy.

• Bond yields trend lower, and their inverse relationship with bond prices means that most fixed-income instruments post sizeable price gains.
• Low-interest rates make saving less attractive to depositors, and spending and business investment grow.
• Stock prices and equities typically rally.
• Real estate tends to do well when interest rates are low since homeowners and investors will take advantage of low mortgage rates.
• The impact on currencies depends on the extent of monetary stimulus and the economic outlook for a specific nation.

Lower interest rates decrease the cost of borrowing money, encouraging consumers to increase spending on goods and services and businesses to invest in new equipment.

Effects of Contractionary Policy on Investments

Central banks employ contractionary monetary policy when economic growth is robust with a real risk of runaway inflation. Raising interest rates makes borrowing more expensive.

• Equities underperform during tight monetary policy periods, as higher interest rates make it relatively expensive to buy securities on margin.
• Higher short-term interest rates are a negative for bonds, as investor demand for higher yields lowers prices.
• Cash tends to do well during tight monetary policy periods since higher deposit rates induce consumers to save rather than spend.
• Real estate slumps when interest rates rise since it costs more to service mortgage debt, leading to declining demand among homeowners and investors.
• Higher interest rates, or even the prospect of higher rates, generally tend to boost the national currency.

Aggressive vs. Conservative Investors

Investors can position portfolios to benefit from monetary policy changes. Such portfolio positioning depends on the investor's risk tolerance and investment horizon. Investors with lengthy investment horizons and a higher risk tolerance commonly follow relatively risky assets during expansionary policy periods.

Conservative investors are not aggressive with their portfolios to conserve capital and protect gains. This is especially true for many retirees, for whom investment portfolios are a key source of retirement income.

Portfolio Management

All investors, whether aggressive or conservative, will weather changes to policies better with a diversified portfolio, owning assets that outpace inflation, considering active portfolio management, and taking advantage of the interest rate environment.

• Diversification: One asset class may generate meaningful returns even as others struggle during volatile market conditions.
• Assets and Interest Rates: Rising interest rates may make returns from fixed-income holdings lackluster. Assets that counteract low-interest rate drag include equities or higher-yielding bonds. When rates are low, investors with high-interest loans may take advantage of lower rates or refinance before interest rates rise.
• Active Portfolio Management: Creates a better hedge against market volatility and fluctuations and can in certain cases outperform passive strategies.

Can Investors Lock Into Higher Interest Rates?

If interest rates are trending lower, investors can lock in higher rates on term deposits and savings instruments like Certificates of Deposit.

What Is the Role of the U.S. Federal Reserve?

The role of the Fed is to maintain a stable inflation rate, maximize employment rates, and maintain moderate long-term interest rates.

What Is Considered Unconventional Monetary Policy?

Central banks may resort to unconventional monetary policy tools during particularly challenging times. In the aftermath of the 2007-08 global credit crisis, the Federal Reserve established a near-zero target short-term interest rate in an attempt to stimulate the U.S. economy. When this strategy did not have the desired effect, the Federal Reserve used successive rounds of quantitative easing (QE) by buying longer-term mortgage-backed securities directly from financial institutions, putting downward pressure on longer-term interest rates.

What Is an Example of Interest Rate Risk and Real Rate of Return?

If an investor's portfolio only earns a 2% rate of return at a time when inflation rises to 5%, the portfolio is generating a negative 3% real rate of return.

The Bottom Line

Monetary policy changes can have a significant impact on every asset class. Whether in a period of expansionary or contractionary policy, investors can position their portfolios to benefit from policy changes or preserve their holdings.

1. Federal Reserve Bank of New York. "Monetary Policy Implementation."
2. U.S. Bank. "Federal Reserve Focuses Monetary Policy on Fighting Inflation."
3. Federal Reserve Bank of St. Louis. "Quantitative Easing: How Well Does This Tool Work?"

Foreign exchange intervention is a monetary policy tool used by the central banks of countries that actively seek to weaken or strengthen their currencies.

Currency is a generally accepted form of payment, including coins and paper notes, which is circulated within an economy and usually issued by a government.

The overnight rate is the interest rate at which a depository institution can lend or borrow funds that are required to meet overnight balances.

Regulation CC is a federal policy that sets certain standards on the check-clearing process for endorsements and processing of funds.

A floating interest rate is an interest rate that periodically adjusts up or down to reflect economic or financial conditions. It's tied to a benchmark rate or an index.

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