Jim Cramer's guide to investing: What does the Federal Reserve do?

CNBC

15 hours ago

It's important for investors to understand how the Federal Reserve operates and why it can drive market action, CNBC's Jim Cramer said.
"We fear the Fed because the Fed sets interest rates, and if they get it wrong, they can allow inflation to run unchecked or do some real damage to the economy and to you," he said. "We adore the Fed because when they get it right, the results can be very, very good for the stock market."
The Fed is the U.S.'s central bank, tasked with regulating monetary policy and setting the federal funds rate, which is the short-term interest rate banks can use to borrow from each other overnight. The Fed is charged with keeping inflation in check without sending the economy into a recession, encouraging employment while keeping prices stable. It is considered an independent agency, as board members are appointed to serve terms, not elected. This independence relieves reelection pressure that might discourage Fed members from being "ruthless enough" if it's necessary to make unpopular policy decisions that bring the market down, Cramer said.
When the economy seems to be slowing down, the Fed cuts interest rates to stimulate business action. Rate cuts, he said, make it easier to own stocks and can send the market soaring. But when inflation heats up, the Fed raises rates, sometimes aggressively. While rate hikes hinder inflation, they also hurt the economy. Banks pass on increased borrowing fees to customers, which makes businesses more cautious and less apt to expand or hire new employees. Cramer said there have been Fed-induced recessions followed by Fed-induced recoveries.
Even though part of the Fed's job is to promote employment, Cramer said it must sometimes encourage layoffs to quell fiery inflation. Inflation "destroys a lot of wealth, and high prices make life miserable for everyone," Cramer said, adding that it can be "very difficult to stamp out."
Wage inflation is the most dangerous kind of inflation to the Fed, he continued. When businesses feel they must raise wages to keep employees, they raise their prices to compensate, Cramer continued. As workers have more money to spend, demand increases, so prices continue to rise, and "suddenly there's inflation everywhere," Cramer said. He added that higher wages then become meaningless to consumers because everything is so expensive.
"When you see inflation, that should scare you," Cramer said. "Because that means the Fed will raise interest rates to stamp it out. They're going to do their job, even if it means sending the economy into a tailspin."
Click here to download Jim Cramer's Guide to Investing at no cost to help you build long-term wealth and invest smarter.Disclaimer