How Greenspan affects markets

You’ve seen it happen repeatedly in recent years. The Federal Reserve raises interest rates, and the stock market quickly takes a plunge. How is it possible that one institution could have so much power over the market? More importantly, should you care what the Fed says? Yes, you should. Understanding why the Fed moves interest rates will show you how those changes affect your investments.

The power of the Fed

In the 60s and 70s, broker E.F. Hutton ran a series of well-known ads claiming “When E.F. Hutton talks, people listen.” Today, there is a man who has captured Wall Street’s ear in much the same way. His name is Alan Greenspan, and he is the chairman of the board of governors of the Federal Reserve System.

The Fed, the nation’s central bank, conducts U. S. monetary policy. The Fed’s main goals are to promote economic output, employment and stable prices. It does so mainly by raising or lowering short-term interest rates, and Greenspan is the person who makes this decision.

The Fed has two main reasons to fiddle with the federal funds rate; the rate banks charge each other for overnight loans. For example, the Fed could raise interest rates to slow down the economy because it fears an increase in the inflation rate. High inflation means that consumer prices go up because of an increase in the volume of money and credit relative to available goods and services. A strong job market will also make prices climb higher.

As unemployment continues to decline that creates a situation where workers hold out for higher wages. As that happens those wage increases are passed on to consumers in the way of higher prices. That’s fine if the wage increases and the higher prices are accompanied by increases in productivity, which to a large extent they have been in the last couple of years. As long as productivity gains are being experienced, inflation is basically kept under control. But if the economy grows unchecked, then we eventually reach a point where consumers are not any better off -- we’re just paying higher prices for everything.

Interest rates and the stock market

Why does the Fed raising interest rates slow down the economy? It’s because a higher Fed funds rate also has the effect of raising the prime rate -- the rate charged by commercial banks to their best, most credit-worthy customers. If loan interest rates are high, then people are less likely to apply for a mortgage or car loan. High interest rates also result in more people keeping their money in the bank rather than in the stock market. Why play the stock market when you can earn a good return in bonds and CDs with much less risk?

The second reason why the Fed changes the rates is related to a recession. Lower interest rates can spark the economy because people are encouraged to take out loans to buy goods and services. Lowering the interest rates also means smaller returns from your bank, so you’re more likely to put your money in the stock market instead.

In simple terms, if interest rates are high, stock prices generally go down and vice versa.

The reason for that is that interest rates are direct competition for the stock market. Keep in mind what drives the stock market higher is money flowing into the stock market, namely investors buying stocks.

Higher interest rates present competition to the stock market in the form of fixed-income investments, such as money market accounts, bonds and CDs. This is because the banks, in this scenario, earn higher rates of return.

“Investors are making a decision that these higher rate investments -- like bonds -- are better investments, so the money is flowing there, maybe flowing out of the market and into bonds.”

Economists and the media spend countless hours trying to predict how the Fed will react to current market conditions. These groups are fairly reliable prognosticators of the Fed’s actions. What often occurs is an obvious reaction from the market to the Fed when there is an anticipated rate increase or decrease -- before it’s even announced.

There has always been a lag between any interest rate change and its effect on the economy. Experts had previously calculated that the changes took from six to 12 months to take full effect. However, rate changes often have immediate psychological effects on the stock market, especially if the change comes as a surprise.

If I’m the chair of the Federal Reserve and nobody expected me to raise interest rates, and I come out and say we’re raising rates by half a point, that is going to have a devastating effect on the marketplace. The reality of it, of course, is that those rising interest rates take a while to filter through the market place. It’s like ripples when you throw a stone into water and it ripples out.

Individual investors

So what should you do with your portfolio when you hear that interest rates are changing? The rates should not be the deciding factor in how you invest your money.

Interest rates are more of a technical factor driving conditions in the present. What should mostly influence an investor are more the personal issues. Basic things like your goals and objectives for investing. What is your time frame? What is your tolerance to risk? What experience do you have with investing? Do you need income, or can you invest in the long term and reinvest? These are the factors that should most influence your investments.

A small individual investor should be in the market for the long haul. Most experts would advise great caution for investors in getting in and out of the market very quickly. … On an individual level, increasing and decreasing of interest rates should not make a great deal of difference. It only affects very short-term investments.

Planning for retirement and thinking twice before dodging in and out of volatile markets will help ensure that the ripples don't affect you when the next stone is pitched by the Fed.