Kavan Choksi Discusses How The Fed Impacts the Stock Market

The Federal Reserve, widely known as “the Fed,” plays an important role in shaping the dynamics of the stock market through its monetary policies and actions. Kavan Choksi mentions that for a few days every month, the market seems to go on hold as traders and investors await the end of the Fed’s monthly meeting and the announcements that follow. This is primarily because the Fed sets interest rates or the federal funds rate.

Kavan Choksi highlights how the Fed impacts the stock market 

For investors, it especially is important to keep an eye on the Federal Open Market Committee (FOMC), which is the group that sets monetary policy. That is mainly done by making changes to the interest rates. FOMC also controls liquidity in the financial system, which basically influences how much available cash banks and other financial entities have.

While the Fed does not set interest rates on mortgages or other loans directly, it does influence them. It acts as the main short-term lender to banks. The money it lends is known as the “Federal Funds” and it sets the interest rate on the money borrowed from them. As banks pay more to borrow money, they also charge more to lend funds. By managing the amount of assets it buys and sells, the Fed also controls the amount of liquidity in the financial system. It can purchase assets like bonds from banks, thereby replacing those assets on the banks’ books with cash. The bank subsequently lends out this cash, thereby supporting economic growth. This is what the Fed did with the quantitative easing (QE) that was used to stabilize the economy after the Covid-19 pandemic shutdown in 2020. However, in case the Fed wants to slow the economy to control inflation, it sells assets to take cash out of the system.

Kavan Choksi mentions that the Fed may also increase interest rates to slow the economy. As the interest rates go up, it makes borrowing more expensive, thereby slowing consumer spending and having a negative impact on the growth of companies.  When the Fed either pushes interest rates higher or reduces liquidity in another way, it slows the economy. When interest rates rise, it discourages borrowing and makes it more expensive, which slows consumer spending and negatively impacts the growth of companies. Reducing liquidity just means less cash in the system for investment, whether it is for investments that drive economic growth or for investing in assets such as stocks. Under normal conditions, higher interest rates and/or diminished liquidity tend to result in a decline in stock prices. On the other hand, cutting interest rates or increasing liquidity typically has the opposite effect, leading to higher stock prices. As the Fed typically signals its intentions ahead of time, the stock market is always looking forward.

That forward-looking nature of the stock market makes it important to be aware of what the Fed is saying. After each FOMC meeting, the Fed issues a statement detailing any policy changes or the absence of changes. These statements are closely monitored by institutional traders and analysts, and investors must do the same. It is crucial for investors to stay informed about the Fed’s anticipated direction and stated intentions instead of solely focusing on its past actions.