Monetary policy refers to the strategies employed by a nation’s central bank with regard to the amount of money circulating in the economy, and what that money is worth. While the ultimate objective of monetary policy is to achieve long-term economic growth, central banks may have different stated goals toward this end. In the U.S. the Federal Reserve’s monetary policy goals are to promote maximum employment, stable prices and moderate long-term interest rates. The Bank of Canada’s goal is to keep inflation near 2 percent, based on the view that low and stable inflation is the best contribution that monetary policy can make to a productive and well-functioning economy.

Investors should have a basic understanding of monetary policy, as it can have a significant impact on investment portfolios and net worth.

Impact on Investments

Monetary policy can be restrictive (tight). accommodative (loose) or neutral (somewhere in between). When the economy is growing too fast and inflation is moving significantly higher, the central bank may take steps to cool the economy by raising short-term interest rates, which constitutes restrictive or tight monetary policy. Conversely, when the economy is sluggish, the central bank will adopt an accommodative policy by lowering short-term interest rates to stimulate growth and get the economy back on track.

The impact of monetary policy on investments is thus direct as well as indirect. The direct impact is through the level and direction of interest rates, while the indirect effect is through expectations about where inflation is headed.

Monetary Policy Tools

Central banks have a number of tools at their disposal to influence monetary policy. The Federal Reserve, for example, has three main policy tools:

• Open market operations, which involve the purchase and sale of financial instruments by the Federal Reserve;
• The discount rate, or the interest rate charged by the Federal Reserve to depository institutions on short-term loans; and
• Reserve requirements,or the proportion of deposits that banks must maintain as reserves.

Central banks may also resort to unconventional monetary policy tools during particularly challenging times. In the aftermath of the 2008-09 global credit crisis, the Federal Reserve was forced to keep short-term interest rates near zero to stimulate the U.S. economy. When this strategy did not have the desired effect, the Federal Reserve used successive rounds of quantitative easing (QE), which involved buying longer-term mortgage-backed securities directly from financial institutions. This policy put downward pressure on longer-term interest rates and pumped hundreds of billions of dollars into the U.S. economy.

Effect On Specific Asset Classes

Monetary policy affects the primary asset classes across the board – equities, bonds, cash, real estate, commodities and currencies. The effect of monetary policy changes is summarized below (it should be noted that the impact of such changes is variable and may not follow the same pattern every time).

Accommodative monetary policy

• During periods of accommodative policy or “easy money, equities typically rally strongly. The Dow Jones Industrial Average and S&P 500, for instance, reached record highs in the first half of 2013. This occurred a few months after the Federal Reserve unleashed QE3 in September 2012 by pledging to buy $85 billion of longer-term securities monthly until the labor market showed substantial improvement.

• With interest rates at low levels, bond yields trend lower, and their inverse relationship with bond prices means that most fixed-income instruments post sizeable price gains. U.S. Treasury yields were at record lows in mid-2012, with 10-year Treasuries yielding less than 1.40 percent and 30-year Treasuries yielding about 2.46 percent. The demand for higher yield in this low-yield environment led to a great deal of bidding for corporate bonds, sending their yields to new lows as well, and enabling numerous companies to issue bonds with record low coupons. However, this premise is only valid as long as investors are confident that inflation is under control. If policy is accommodative for too long, inflation concerns may send bonds sharply lower as yields adjust to higher inflationary expectations.

• Cash is not king during periods of accommodative policy, as investors prefer to deploy their money anywhere rather than parking it in deposits that provide minimal returns.

• Real estate tends to do well when interest rates are low, since homeowners and investors will take advantage of low mortgage rates to snap up properties. It is widely acknowledged that the low level of U.S. real interest rates from 2001-04 was instrumental in fuelling the nation’s real estate bubble that peaked in 2006-07.

• Commodities are the quintessential “risky asset”, and they tend to appreciate during periods of accommodative policy for a number of reasons. Risk appetite is stoked by low interest rates, physical demand is robust when economies are growing strongly, and unusually low rates may lead to inflation concerns percolating below the surface.

• The impact on currencies during such times is harder to ascertain, although it would be logical to expect a nation’s currency with an accommodative policy to depreciate against its peers. But what if most currencies have low interest rates, as was the case in 2013? The impact on currencies then depends on the extent of monetary stimulus, as well as the economic outlook for a specific nation. An example of the former can be seen in the performance of the Japanese yen, which declined sharply against most major currencies in the first half of 2013. The currency fell as speculation mounted that the Bank of Japan would continue to ease monetary policy. It did so in April, pledging to double the country’s monetary base by 2014 in an unprecedented move. The U.S. dollar’s unexpected strength, also in the first half of 2013, demonstrates the effect of the economic outlook on a currency. The greenback rallied against practically every currency as significant improvements in housing and employment fueled global demand for U.S. financial assets.

Restrictive monetary policy

• Equities underperform during tight monetary policy periods, as higher interest rates restrict risk appetite and make it relatively expensive to buy securities on margin. However, there is typically a substantial lag between the time when a central bank commences tightening monetary policy and when equities peak. As an example, while the Federal Reserve began raising short-term interest rates in June 2003, U.S. equities only peaked in October 2007, almost 3½ years later. This lag effect is attributed to investor confidence that the economy was growing strongly enough for corporate earnings to absorb the impact of higher interest rates in the early stages of tightening.

• Higher short-term interest rates are a big negative for bonds, as investor demand for higher yields sends their prices lower. Bonds suffered one of their worst bear markets in 1994, as the Federal Reserve raised its key federal funds rate from 3% at the beginning of the year to 5.5% by year-end.

• Cash tends to do well during tight monetary policy periods, since higher deposit rates induce consumers to save rather than spend. Short-term deposits are generally favored during such periods to take advantage of rising rates.

• As is to be expected, real estate slumps when interest rates are rising since it costs more to service mortgage debt, leading to a decline in demand among homeowners and investors. The classic example of the sometimes disastrous impact of rising rates on housing is, of course, the bursting of the U.S. housing bubble from 2006 onward. This was largely precipitated by a steep rise in variable mortgage interest rates, tracking the federal funds rate, which rose from 2.25% at the beginning of 2005 to 5.25% by the end of 2006. The Federal Reserve ratcheted up the federal funds rate no less than 12 times over this two-year period, in increments of 25 basis points.

• Commodities trade in a manner similar to equities during periods of tight policy, maintaining their upward momentum in the initial phase of tightening and declining sharply later on as higher interest rates succeed in slowing the economy.

• Higher interest rates, or even the prospect of higher rates, generally tend to boost the national currency. The Canadian dollar, for example, traded at or above parity with the U.S. dollar for much of the time between 2010 and 2012, as Canada remained the only G-7 nation to maintain a tightening bias to its monetary policy over this period. However, the currency fell against the greenback in 2013 once it became apparent that the Canadian economy was headed for a period of slower growth than the U.S. leading to expectations that the Bank of Canada would be forced to drop its tightening bias.

Portfolio Positioning

Investors can boost their returns by positioning portfolios to benefit from monetary policy changes. Such portfolio positioning depends on the type of investor you are, since risk tolerance and investment horizon are key determinants in deciding on such moves.

• Aggressive investors . Younger investors with lengthy investment horizons and a high degree of risk tolerance would be well served by a heavy weighting in relatively risky assets such as stocks and real estate (or proxies such as REITs) during accommodative policy periods. This weighting should be lowered as policy gets more restrictive. With the benefit of hindsight, being heavily invested in stocks and real estate from 2003 to 2006, taking part of the profits from these assets and deploying them in bonds from 2007 to 2008, then moving back into equities in 2009 would have been the ideal portfolio moves for an aggressive investor to make.

• Conservative investors . While such investors cannot afford to be unduly aggressive with their portfolios, they also need to take action to conserve capital and protect gains. This is especially true for retirees, for whom investment portfolios are a key source of retirement income. For such investors, recommended strategies are to trim equity exposure as markets march higher, eschew commodities and leveraged investments, and lock in higher rates on term deposits if interest rates appear to be trending lower. The rule of thumb for the equity component of a conservative investor is approximately 100 minus the investor’s age; this means that a 60-year-old should have no more than 40% invested in equities. However, if this proves to be too aggressive for a conservative investor, the equity component of a portfolio should be trimmed further.

Conclusion

Monetary policy changes can have a significant impact on every asset class. But by being aware of the nuances of monetary policy, investors can position their portfolios to benefit from policy changes and boost returns.

More From Investopedia