The President of the United States may be the "most important man" in the world.
But when it comes to the investment markets, there's little doubt that the man of the
hour is Ben Bernanke, the chairman of the Federal Reserve (the Fed).
The reason is simple — the Fed's policy-making authority can have a
major impact on the financial markets, indirectly affecting everything from
interest rates on your bank savings account to mortgage rates to activity
in the bond market, which can reach all the way to the stock market.
All of this happens because the Fed sets interest rates on a couple of short-term instruments that primarily affect banks. But those actions have a snowballing effect on other parts of the markets.
Can be active or quiet
The Fed sometimes moves in very aggressive ways, and at other times is more cautious. In 2001, the Fed was extremely aggressive, cutting short-term interest rates 11 different times in an effort to help jumpstart the U.S. economy.
Keeping an eye on the Fed and trying to predict its next move is practically a fulltime job for a number of investment professionals. Here are some of the factors that can drive Fed policy.
Inflation
More than anything, the Fed is focused on making sure inflation doesn't run rampant. So the Fed closely watches not just the most popular measure of price activity — the Consumer Price Index — but
other measures as well, including the Producer Price Index (a measure of inflation at the wholesale level). If the Fed senses a serious inflation threat is developing, look for interest rates to rise in an effort to slow the economy's growth, and hopefully, the inflation risk.
Employment
This is a measuring stick that might give the Fed a clue as to the direction of the economy. If hiring is up and unemployment down, there could be a risk of wage inflation, which might lead the Fed to
raise interest rates. A sour employment picture could spur the Fed into lowering rates to give the economy a boost.
Economic growth
The broad economy is measured by Gross Domestic Product (GDP), which helps quantify the pace of economic activity. In 2001, the Fed was clearly concerned about the very slow rate of growth,
and reduced interest rates in an effort to boost economic activity. If GDP growth is
strong, the Fed is more likely to hold the line on interest rates, or possibly raise them if
fast growth is perceived to result in higher inflation.
Other factors
In certain situations, the strength or weakness of the U.S. dollar compared to other major currencies may affect the Fed's policy. A strong dollar indicates that foreign investors are attracted to U.S. investments, including interest rates paid on bonds. If the dollar weakens too much, the Fed may want to create a situation to attract more investors, possibly by raising interest rates.
The stock market may impact Fed policy, though this is a matter of some controversy. It isn't clear that market performance has directly affected Fed policy.
The bottom line is to watch how fast the economy is growing, and whether that could create a threat of higher inflation or a lingering recession. More than anything, the Fed tries to balance a consistent
pattern of economic growth with a focus on maintaining modest increases in the cost of living.
