Don’t fight the Fed
The Federal Reserve System is the central banking system in the United States. It was created on December 23, 1913, after a series of financial panics to alleviate financial crises.
What does don’t the fight the Fed mean?
“Don’t fight the Fed” is an investing mantra that suggests you should align your choices with the action of the Federal Reserve “ (the Fed)”. The basic premise of not fighting the Fed is that the Fed has significant power and influence over the economy and financial markets. The Fed controls interest rates, regulates the money supply and promotes economic growth. As a result, it’s important to follow the Fed’s lead and not try to go against its policies or actions.
The Federal Reserve’s primary goals are to ensure the economy is growing at the desired rate, create full employment and keep inflation under control. Despite the Federal Reserve creating a low unemployment rate, they have failed to control inflation. To weaken the job market and bring down inflation, they have continued to raise interest rates from their current rate until inflation settles at its desired rate, which is 2%.
The outbreak of Covid-19 brought about the worst global pandemic in more than a century. The Federal Reserve printed a lot of money during the pandemic and lowered the interest rate to its lowest in history.
For example, if the Federal Reserve prints a lot of money and lowers interest rates, that improves liquidity and helps the economy to expand. It allows corporations and consumers to borrow money cheaply as a result, which helps asset prices to rise. This also allows risk premiums to fall and asset prices to rise which resulted in the market recovery after the pandemic primarily driven by the Federal Reserve’s ultra-low interest rates policy supported by flooding a lot of money into the system.
It is estimated around £500 billion was printed by the Bank of England and $6.72 trillion by the Federal Reserve. As Milton Friedman once said, “Inflation is always and everywhere a monetary phenomenon.” Money creation was the main driver of inflation as figures increased and the Federal Reserve started raising interest rates to tackle inflation.
In contrast, now the Federal Reserve continues to raise interest rates to fight inflation which will deflate asset prices and slow the global economy because the high cost of debt translates into lower consumer spending and corporate profit. As a result of lower corporate profits, companies can reduce their expenditure and investments.
The impact of don’t fight the Fed on the stock market
The value of an asset is the discounted present value of its future cash flow. If the discount rate is lower, the present value of an asset is higher, and if the interest rate is higher, the present value of an asset is lower. If the interest rate is low, it lifts asset prices; they create a wealth effect that makes people feel richer, which makes them more willing to spend. Optimism grows around the things that are doing exceptionally well. Capital excess strengthens the stock market and makes valuations excessive, leading investors to invest without hesitation in the next big things.
As greed grows relative to fear, the fear of missing out replaces the fear of losing money and risk aversion and caution reduce. The bull market doesn’t last forever, as Warren Buffet said “a bull market is like sex. It feels best just before it ends.”
There will come a time when the market concludes that there is no such thing as a price too high. This will leave the market open to exogenous events, such as the current war in Ukraine, the Covid-19 lockdown, or any other unanticipated risk that might arise.
The assets that are the most inflated and investors who are overweight in them often experience the most painful corrections. The market is most dangerous when it looks at its best. It is at its most inviting when it looks at its worst. As Isaac Newton said once, “I can calculate the movement of the stars, but not the madness of men and physics would be much harder if electrons had feelings.”
Therefore, economies, markets and companies are made up of humans and humans have feelings. Humans are prone to overestimate how much we understand about the world and underestimate the role of chance in events. Don’t fight the Fed is an important concept for investors to consider before making an investment decision. Nevertheless, it is important to take into account other factors as well, such as geopolitics, global health crises, trade policies as well as oil prices and energy costs in order to make informed decisions.
Awet Ghirmay, Head of Investment Research
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Risk warnings
*The value of investments and the income derived from them may fall as well as rise. You may not get back what you invest. This communication is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action. All statements concerning the tax treatment of products and their benefits are based on our understanding of current tax law and HM Revenue and Customs practice. Levels and bases of tax relief are subject to change. This blog is based on my own observations and opinions.
