There is no doubt that trends in levels of interest rates are one of the most crucial variables in driving an investment strategy (Fig. 6-1). The reason is that they determine the kind of environment that impacts the stock market, the U.S. economy, inflation and the U.S. dollar vis a vis other currencies. For these reasons it is important to understand how short-term interest rates are driven, by whom, and how.

The central bank of any country and the Federal Reserve for the United States are the institutions that have the power and the authority to impact trends and levels of short-term interest rates. Because of their huge impact on the financial markets, we are devoting an entire chapter to the functions of the central bank. We will deal in detail with the central bank of the United States, which is called the Federal Reserve. Other central banks around the world have copied the procedures and the disciplines followed by the U.S. model.

We will look at how the Federal Reserve system is organized, how they conduct monetary policy, what monetary policy is, how they impact the growth of the money supply, and what the instruments of monetary policy are. Another important variable that is controlled by the Federal Reserve is the level of real interest rates, and we have seen in the previous chapter how this is a crucial variable to determine the kind of financial markets we should expect.

Growth in the money supply is one of the major driving forces of the business and financial cycles. There have been seven cycles in the growth of the MZM since 1955. In 1995 the eighth financial cycles began unleashing the same forces experienced in the previous seven cycles.

It is also important to recognize that at a time of crisis, central banks intervene to cushion the crisis. This happened in the 1970s when there were several bank failures. The main reasons for bank failures are usually twofold. The first one is rising interest rates, which represent the rising costs for banks, since banks have to borrow money to re-lend it at a higher interest rate. As short-term interest rates rise, because of Fed tightening and strong economic conditions accompanied by inflationary pressures, bank profit margins are squeezed.

The second reason for bank failure is that some banks have a loan portfolio that has been extended to marginal clients. During times of rising interest rates, these clients find it difficult to repay the loans. As a result, because of rising short-term rates, the raw material for banks, and problems with loan portfolios, bank failures are more likely. It occurred in 1992-1993 when there were real estate problems in the U.S. and the savings and loan debacle. It happened again during the financial crisis, which began in 1997 in Asia and expanded throughout the world, particularly in Brazil and in Russia in 1998.

During financial crises, a central bank has the crucial role of providing liquidity to the banking system in order to keep it viable and to make sure the crisis does not spread to other sectors of the economy and other economies around the world. The central bank recognizes the difficulties the banking system causes by rising short-term interest rates and issues related to the loan portfolio of the banks. These are typical problems the central bank follows very closely. The failure of a major bank, however, or a major global region, like Asia in 1997, forces the central bank to provide extra liquidity to the banking system, trying to make sure that the problems of the banking system do not spill over to the rest of the economy. The tools to increase liquidity in the banking system will be discussed in detail in the rest of this chapter.

Finally, we will look at how monetary policy impacts the economy, inflation, and the financial markets. The last section will deal with investment implications and how to use this chapter to recognize risk and opportunities in investing your money. It is clear, that the Federal Reserve has an enormous impact, not only on the U.S. economy, inflation, and its money supply, but also in providing assistance to institutions and countries that have difficulties so that the economy continues to expand in an orderly fashion.

(From Chapter 6 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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1 comment:

Sandra Lee said...

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