How Does the Fed Affect Stock & Bond Mutual Funds?

The U.S. Federal Reserve has a statutory mandate to maintain stable prices, maximum employment and moderate long-term interest rates. Fed monetary policy is how the Federal Reserve Board of Governors achieves this mandate, employing strategic monetary tactics through Fed open market operations, interest rate manipulations and changes in bank reserve requirements. Since all these tactics move the economy by altering the amount of money floating through the system, they also affect stock and bond prices in the marketplace as well as their asset values in all portfolios, including mutual funds.

Monetary Policy

An expansionary monetary policy is used to bring the economy out of recession by adding money to the system by decreasing bank reserve requirements, lowering interest rates to encourage borrowing and by purchasing U.S. Treasury securities in the open market. A restrictive monetary policy is used to cool an overheated economy by removing money from the system through increasing bank reserve requirements, raising interest rates to discourage borrowing and selling Treasuries in the open market. When the Fed adds money to the system, the stock market rallies and bond interest rates fall. Stocks and bonds held in mutual funds appreciate in price during periods of expansionary Fed monetary policy.

Expansionary Policy Effects

The Fed conducts open market operations by purchasing and selling Treasury bills, notes and bonds in the open market. When it buys Treasuries, prices across the broad bond market rise and interest rates fall. Lower interest rates help companies borrow inexpensively to fund expansion and inventory. They also spur consumers to buy retail goods, autos and houses. All this buying creates corporate profits, which translate to higher stock prices. During expansionary monetary policy, the net asset values -- the total market value minus fund expenses -- of mutual funds holding stocks or bonds can be expected to rise. The interest income from bond mutual funds falls, however, because fund managers tend to take profits when the stocks and bonds in their portfolios rise in price. They also reinvest the proceeds of sales in current coupon bonds and other stocks in industries that are expected to appreciate more in price as the economy improves, such as consumer retail and travel industries. Since interest rates decline during periods of expansionary Fed monetary policy, current coupon bonds carry interest rates that are lower than the bonds sold to take profits.

Restrictive Policy Effects

During periods of restrictive monetary policy, the Fed sells bills, notes and bonds into the open market. This lowers the prices of bonds and raises interest rates. Higher interest rates make operations more expensive for companies, lowering their earnings or profits. Their customers slow buying activity, which also lowers revenues, or money coming into the company. Lower corporate earnings drive stock prices down, and higher interest rates drive bond prices down. The result for mutual funds: lower market values for both stocks and bonds in their portfolios but higher interest income from bond mutual funds. Interest income rises as portfolio managers buy bonds that are yielding more income, because market interest rates are higher during periods of restrictive Fed monetary policy.

Discount Rate and Bank Reserves

Raising the discount rate and increasing required bank reserves discourages banks from lending and -- at the same time, owing to higher interest rates -- discourages borrowing by corporations and consumers. This puts downward pressure on mutual fund values but increases interest income. Lowering the discount rate and decreasing required reserves has the opposite effect.