What Does "Don't Fight the Fed" Mean?

"Don't Fight the Fed" Explained in Less Than 5 Minutes

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"Don't fight the Fed" is an investing mantra. It suggests that you should align your choices with the actions taken by the Board of Governors of the Federal Reserve and the Federal Open Market Committee (FOMC) regarding interest rates, economic growth, and price stability. Aligning with the Federal Reserve System (the Fed) means buying stocks when rates are low and not high.

What Does "Don't Fight the Fed" Mean?

"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.

To work with the Fed's policies, you would invest more aggressively when the Fed is lowering rates. When it 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 is actively lowering rates or keeping them low. For instance, if you have a high tolerance for risk, you could keep your allocation of 100% stock funds when monetary policy is "easing" or "accommodative." Easing is the term used when the Fed is keeping rates low to spur growth.

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 and lowers these rates, it becomes more or less expensive for businesses to borrow money. In turn, this varies the opportunities for those that invest.

The Fed has five responsibilities:

  • It enacts changes within the financial system (monetary policy) to promote stability and employment. One way it does this 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 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 policies and financial services have on communities and consumers and publishes the findings to increase understanding.

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. This translates into higher consumer spending and corporate profits. Higher profits mean businesses can spend more. They can create new jobs or reinvest in themselves. Companies can hire more people to increase output, which has a positive effect on the economy also.

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. This limits the amount of borrowing that can be done, which slows corporate growth and profits.

Corporate stocks do well when their balance sheets reflect higher cash flow, reinvestment, and equity. When rates are low, their stocks are good investments. When rates are high or rising, stocks are less attractive. This is the concept that feeds the mantra "don't fight the Fed."

Rising rates also tend to happen during the late phase of the business cycle. This usually precedes a bear market and recession of a growth cycle. Therefore, a bull market in stocks peaks before the economy peaks.

The stock market is a forward-looking mechanism. It is also called a "discounting mechanism" by some economists. This is because it leads the business cycle. When investors have a good outlook toward the economy and rates are low, they tend to invest in businesses through stocks. This fuels growth in the economy.

When investors feel that growth is going to slow or rates begin to rise, they 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" Worth It?

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 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. This is 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:

  • Geopolitical changes
  • Oil and energy costs
  • Global health crises
  • Trade policy

The Fed's interest rates and monetary policy are one of many factors that influence stock prices and economic trends. You should consider all of these to help you make a decision.

Key Takeaways

  • "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. This 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.