Definition and Examples of "Don't Fight the Fed"
"Don't fight the Fed" is an old investor saying that cautions you to align your investments with the current monetary policies of the Fed rather than against them.
The Fed is the central bank in the United States of America. It was created in 1913 to make the financial system of the U.S. more safe, stable, and flexible.
Advocates of the "Don't fight the Fed" investing theory suggest working with the Fed's policies by investing more aggressively when the Fed is lowering rates. Conversely, when the Fed raises rates, you'd be more conservative in your choices.
The saying suggests you should keep your money in stocks (up to your level of risk tolerance) when the Fed's FOMC is actively lowering rates or keeping them low.
For example, suppose the Fed cuts interest rates to spur economic growth in the United States. Those with a higher risk tolerance would align their portfolio allocation to 100% in equities, whether in individual stocks or stock mutual funds and exchange traded funds (ETFs).
Although the Fed cut might occur when the economy is experiencing slow growth or in a recession, the accommodative or easy monetary policy would likely lift the economy out of its challenging period, which would spur more risk-taking and equity purchases.
How "Don't Fight the Fed" Works
One of the key duties of the Fed is to guide the economy through interest rates on borrowing. As the Fed raises or lowers these rates, it becomes more or less expensive for businesses to borrow money. In turn, this action varies the opportunities for investors.
The Fed's Responsibilities
The Fed has five responsibilities:
- It enacts changes within the financial system (monetary policy) to promote stability and employment. One way it does that is to raise or lower interest rates.
- The Fed supervises and regulates banks and other financial institutions with interpretations of the law and publishes guidelines and policies.
- It attempts to maintain the stability of the financial system and to contain risk in the financial markets.
- The Fed provides financial services to the U.S. government, foreign institutions, and other U.S. institutions.
- It researches the impact that policies and financial services have on communities and consumers and publishes the findings to increase understanding.
The Fed's Impact on the Markets and the Economy
When the Fed sets low rates, it does so to help the economy expand. Consumers and corporations can then borrow money more cheaply and decrease the cost of debt, which translates into higher consumer spending and corporate profits. Higher profits mean that companies can spend more, create new jobs, and reinvest back into their businesses. As companies hire more people to increase output, they have a positive effect on the economy.
When the Fed raises rates, it does so to keep the economy from growing too quickly. A rate of growth that is too high can fuel higher rates of inflation, which is the pace of rising prices. Contractionary monetary policy limits the amount of borrowing that can be done, which slows corporate growth and profits.
Corporate stocks tend to do well when their balance sheets reflect higher cash flow, reinvestment, and equity. When rates are low, their stocks can be good investments. However, when rates are high or rising, stocks can be less attractive. This correlation between interest rates and equity investing is the core concept of the "Don't fight the Fed" mantra.
Economic Outlook and the Markets
The stock market is a forward-looking mechanism. Some economists call it a "discounting mechanism," because it leads the business cycle. When investors have a good outlook on the economy, and rates are low, they tend to invest in businesses through stocks, which fuels growth in the economy.
When investors feel that growth will slow or that rates will begin to rise, they tend to stop buying stocks. Some also start taking money out of stocks and placing it in securities that preserve capital, like U.S. Treasuries.
You're fighting the Fed if you remain fully invested when the Fed raises rates. You're also fighting it if you are conservatively invested when it is lowering rates or keeping them low.
Is "Don't Fight the Fed" Good Advice?
When the Fed sets monetary policy, it uses historical data to measure the health of the economy. It then uses that information to set the stage for any changes. For example, the FOMC meets eight times per year. It discusses the economy and decides the stance it will take on monetary policy. Any changes that the committee recommends, and that the Fed makes, can take some time to affect the economy.
Many people base decisions on policy changes from the Fed after these meetings. It's important to keep in mind that the lag time between the economy and monetary policy can lead to different market scenarios. If you invest counter to the Fed's current policy, you could end up losing money when you could be making gains.
The Fed only makes changes when necessary, because it takes a long time for the effects of any changes to be seen.
In general, you shouldn't base your decision solely on the policies of the Fed. Many other factors impact the economy, including:
- Geopolitical changes
- Oil and energy costs
- Global health crises
- Trade policy
The Fed's interest rates and monetary policy are among many factors that influence stock prices and economic trends. It's important to consider all of these factors, as well as your risk tolerance and financial goals, when making investment decisions.
- "Don't fight the Fed" is a mantra that suggests you should align your choices with the actions of the Fed.
- Aligning with the Fed means you should invest aggressively when rates are low, and conservatively when rates are high.
- When the Fed sets low rates, it helps the economy expand, which lets corporations and consumers borrow money more cheaply.
- When the Fed starts to raise rates, it does so to prevent the economy from growing too quickly and fueling higher rates of inflation.
- Fed policy is just one of many economic indicators you should pay attention to.