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Monetary Policy 101: What You Should Know ahead of the FOMC

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Monetary policy stance

The Federal Reserve seems ready to tighten its monetary policy stance. But before we move ahead with our analysis, let’s make sure we understand why the Fed’s tightening in the first place. To understand that, we have to understand two types of monetary policy stances:

  • expansionary or accommodative
  • contractionary or restrictive

Implementing the first type is policy loosening, while the second is policy tightening.

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Monetary policy stance

An expansionary monetary policy infuses money into the financial system. One way a central bank can increase its money flow is by reducing its key rate. It reduces its key rate when economic growth slows and people are unwilling or unable to spend.

This action helps stimulate economic growth. Taking a cue from the central bank, commercial banks lower their rates. This in turn deters savings because money will earn less than it did before. The central bank also lowers rates on loans. This encourages people to buy goods, which increases spending and feeds into economic output.

On the other hand, a contractionary policy takes money out of the financial system. The central bank raises its rates, among other policy moves, to control inflation. By raising rates, it encourages people to save money. They’re deterred from taking loans due to the higher rates.

Why is the Fed tightening?

The US Fed is data-driven as far its monetary policy stance and actions are concerned. Since the non-farm payroll report for October came out, voices from within the Fed—including Chief Janet Yellen—have started indicating that the economy may be ready for a rate hike.

If a central bank misses a chance to raise rates at a crucial juncture, it risks runaway inflation, which would force it to rise rates aggressively. A rise in rates affects short-term instruments negatively, while reinvestment risk affects long-term bonds. So investors in bond mutual funds (PGSIX) (MSBAX) should be mindful of a potential negative impact on their investments.

Financials like US Bancorp (USB), Bank of America Corporation (BAC), and Wells Fargo & Company (WFC), though, are looking forward to a rate hike, as this may help boost their earnings.

Why has the US Fed been unable to hike rates in 2015 so far? Let’s look at this question in the next article of this series.

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