Everyone talks about monetary policy and what the Fed will or will not do, but the real important issue is understanding the channels of monetary policy. First, how the Fed perceives its actions may affect the economy and second, how will Fed actions impact markets and the real economy.
Our simple schema shows that there are three channels for monetary policy: the neoclassical or traditional channel, the credit channel, and the risk-taking channel. Each will impact markets slightly differently and each has its own narrative associated with monetary policy.
The neoclassical channel can impact markets and the economy three ways: one, the cost of capital, two, wealth effects, and the three the exchange rate. An increase in rates will increase the cost of borrowing, will reduce wealth, and increase the value of the dollar. However, there is less discussion on how policy may affect individual companies or households. the credit channel focuses on the impact of higher rates on net worth and cash flows which will impact the availability of credit. The third channel is the effect of a rate shock on risk-taking. Monetary policy can increase risk premium and change risk appetite which will affect what investments are undertaken.
The Fed will likely increase rates in March, so an investor should walk through each channel and think about how different markets will be affected by a policy tightening. This process will allow for better cross-market and sector differential with portfolio trades.
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