Monetary Policy

Monetary policy is one of the most powerful forces affecting securities markets. Investment advisers must understand how the Federal Reserve's actions influence interest rates, asset prices, and the overall economy to make sound recommendations for their clients.

What Is Monetary Policy?

Monetary policy refers to actions taken by the Federal Reserve (the Fed) to influence the money supply, credit conditions, and interest rates to achieve economic objectives. Unlike fiscal policy (controlled by Congress and the President), monetary policy is managed by an independent central bank.

The Federal Reserve System

The Federal Reserve is the central bank of the United States, established in 1913 following a series of banking panics.

Structure of the Fed

The FOMC consists of the 7 Board Governors plus 5 of the 12 Regional Bank Presidents (rotating).

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The Fed's Dual Mandate

Congress gave the Federal Reserve two primary objectives, known as the dual mandate:

1. Maximum Employment — Keep unemployment as low as possible without triggering inflation
2. Price Stability — Keep inflation under control (current target: 2% annually)

These goals can sometimes conflict. Low unemployment can lead to rising wages and inflation, forcing the Fed to make trade-offs between the two objectives.

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Tools of Monetary Policy

The Fed uses several tools to implement monetary policy, each with different effects on the economy and markets.

1. Open Market Operations (Most Frequently Used)

Open market operations involve the buying and selling of government securities by the Fed:

How it works: When the Fed buys Treasury securities from banks, it credits their reserve accounts with new money. Banks then have more money to lend, increasing the money supply and pushing down interest rates.

2. Federal Funds Rate

The federal funds rate is the interest rate banks charge each other for overnight loans of reserve balances. The FOMC sets a target range (e.g., 5.25%-5.50%), and uses open market operations to keep the actual rate within that range.

The federal funds rate influences many other rates in the economy, including the prime rate (typically fed funds + 3%), which in turn affects mortgages, credit cards, and business loans.

3. Discount Rate

The discount rate is the interest rate the Fed charges banks for direct loans from the discount window. It's typically higher than the federal funds rate and serves as a "lender of last resort."

4. Reserve Requirements

Reserve requirements determine what percentage of deposits banks must hold in reserve (not lend out):

Note: The Fed reduced reserve requirements to zero in March 2020 during the COVID-19 pandemic and has not reinstated them as of 2025. This tool is now rarely used.

5. Regulation T (Margin Requirements)

Though less commonly discussed, the Fed also sets Regulation T, which governs how much investors can borrow to purchase securities (currently 50% initial margin). Lowering Reg T requirements is expansionary; raising them is contractionary.

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Expansionary vs. Contractionary Policy

Understanding when and why the Fed uses each type of policy is crucial for investment advisers.

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Quantitative Easing (QE)

When conventional tools aren't enough (rates already near zero), the Fed may use quantitative easing:

1. Fed creates new money electronically
2. Uses it to buy large quantities of Treasury bonds and mortgage-backed securities
3. Injects massive liquidity into the financial system
4. Pushes down long-term interest rates

The Fed used QE extensively after the 2008 financial crisis and during the COVID-19 pandemic, growing its balance sheet from under $1 trillion to over $8 trillion.

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Impact on Investments

Monetary policy affects virtually every asset class:

Bonds

Stocks

Different Sectors React Differently

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In Practice: How Investment Advisers Apply This

When the Fed is raising rates:

• Review client bond portfolios for duration risk
• Consider shorter-duration bonds to reduce interest rate sensitivity
• Evaluate rate-sensitive sectors (utilities, REITs) for potential underweights
• Discuss with clients that rate increases often precede economic slowdowns

When the Fed is lowering rates:

• Look for opportunities in rate-sensitive sectors
• Consider extending bond duration to capture price appreciation
• Recognize that rate cuts often signal economic concerns
• Help clients understand that "good news" for bonds may signal "bad news" for the economy

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On the Exam

The Series 65 exam frequently tests:

1. The Fed's dual mandate (maximum employment and price stability)
2. Tools of monetary policy (open market operations, discount rate, reserve requirements)
3. Expansionary vs. contractionary actions and when each is appropriate
4. Impact on securities (inverse relationship between rates and bond prices)
5. FOMC as the policymaking body

Expect 2-3 questions on monetary policy. A common question format is: "If the Fed wants to stimulate the economy, it would..."

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Key Takeaways

• Monetary policy is controlled by the Federal Reserve, not Congress
• The Fed has a dual mandate: maximum employment and price stability (2% inflation target)
• Open market operations (buying/selling securities) is the primary tool
• Buying securities = expansionary; selling securities = contractionary
• Fed funds rate is the benchmark for short-term rates
• Bond prices move inversely to interest rates
• Stock valuations are generally negatively affected by rising rates
• The Fed operates independently from political pressure