Definition and Examples of "Don't Fight the Fed"
"Don't fight the Fed" is a famous saying from an experienced investor. This sentence warns you to keep your investment in line with the Fed's current monetary policy, not against it.
The Federal Reserve is the central bank of the United States. It was created in 1913 to make the US financial system safer, more stable and more flexible.
Advocates of the "don't fight the Fed" investment theory recommend matching Fed policy by investing more aggressively when the Fed cuts rates. Instead, when the Fed raises rates , your options should be more conservative.
What this means is that you should invest your money in stocks (within your risk tolerance ) when the Federal Open Market Committee (FOMC) is aggressively cutting rates or keeping them low.
For example, suppose the Federal Reserve cut interest rates to stimulate growth in the U.S. economy. Those investors with a higher risk tolerance will adjust their portfolio allocation to 100% equities, either in individual stocks or stock mutual funds and exchange-traded funds (ETFs) .
While a Fed rate cut could come at a time when the economy is growing sluggishly or in recession , looser monetary policy could lift the economy out of a challenging period, spurring more risky investment and stock buying.
How "Don't Fight the Fed" Works
One of the Fed's main responsibilities is to steer the economy through borrowing rates. When the Fed raises or lowers these rates, it makes it more or less expensive for businesses to borrow. This action, in turn, changes opportunities for investors.
Fed's Responsibilities
The Fed has five responsibilities:
It enacts changes within the financial system (monetary policy) to promote stability and employment. One of these ways is by raising or lowering interest rates.
The Federal Reserve supervises and regulates banks and other financial institutions through its interpretation of laws and issues guidelines and policies.
It attempts to maintain the stability of the financial system and contain risks in financial markets.
The Federal Reserve provides financial services to the U.S. government, foreign institutions, and other U.S. institutions.
It researches the impact of policy and financial services on communities and consumers, and publishes its findings to improve understanding.
The Fed's Impact on Markets and the Economy
When the Fed sets interest rates low, it does so to help the economy expand. Consumers and businesses can borrow money cheaper, lowering the cost of debt, which translates into higher consumer spending and corporate profits. Higher profits mean businesses can increase spending, create new jobs, and reinvest in their businesses. When companies hire more people to increase output, they have a positive effect on the economy.
When the Fed raises rates, it does so to prevent the economy from growing too fast. Too high an economic growth rate leads to higher inflation , the rate at which prices rise. Tight monetary policy limits the amount of borrowing, slowing corporate growth and earnings.
When a company's balance sheet reflects higher cash flow, reinvestment, and equity, company stocks tend to do well. Their stocks can be good investments when interest rates are low. However, when interest rates are high or rising, stocks are less attractive. This correlation between interest rates and stock investing is at the heart of the Don't Fight the Fed philosophy.
Rising interest rates also tend to occur late in the business cycle , which typically precedes bear markets and growth cycle recessions. As a result, bull markets in stocks typically peak before the economy peaks.
Economic Outlook and Markets
The stock market is a forward-looking mechanism. Some economists call it the "discount mechanism" because it leads the business cycle. When investors are optimistic about the economic outlook and interest rates are low, they tend to invest in companies through stocks, which drive economic growth.
When investors feel that economic growth will slow or that interest rates will start to rise, they tend to stop buying stocks. Some have also begun pulling money out of stocks and investing in value-preserving securities such as U.S. Treasuries.
If you're still fully invested in stocks when the Fed raises rates, you're fighting the Fed. If you invest conservatively when the Fed lowers rates or keeps them low, you are also working against it.
Is 'Don't Fight the Fed' Good Advice?
When the Fed sets monetary policy, it uses historical data to gauge the health of the economy. It then uses this information to condition any policy changes. For example, the FOMC meets eight times a year where it discusses the economy and decides the monetary policy stance it will take. Any changes suggested by the FOMC, and any changes made by the Fed, will take time to have an impact on the economy.
Many will base their decisions on the Fed's policy changes after these meetings. It is important to remember that the lag time between economic and monetary policy can lead to different market conditions. If your investments go against current Fed policy, you could end up losing money when you could have made a profit.
The Fed only makes changes when necessary because the effects of any changes take a long time to be seen.
In general, you shouldn't base your decisions solely on Fed policy. There are many other factors that affect the economy, including:
geopolitical changes
Oil and Energy Costs
global health crisis
trade policy
The Federal Reserve's interest rate and monetary policy is one of many factors that influence stock prices and economic trends. It is important to consider all of these factors, along with your risk tolerance and financial goals, when making investment decisions.
summary:
"Don't fight the Fed" is a mantra that suggests you should base your choices on the Fed's actions.
Aligning with the Fed means you should invest aggressively when interest rates are low and conservatively when rates are high.
When the Fed sets interest rates low, it helps the economy expand, making it cheaper for businesses and consumers to get loans.
When the Fed starts raising rates, it does so to prevent the economy from growing too fast and inflation rising.
Fed policy is just one of many economic indicators you should be watching.