In the previous lesson we began our discussion on Monetary Policy with a look at one of its primary components, interest rates. In this lesson we are going to continue this discussion with another look at how interest rates affect the economy and therefore the markets, and by introducing the institution which implements Monetary Policy, the Federal Reserve.
As we saw in our previous example, small movements in interest rates can have dramatic effects on the economy. Just as small changes in interest rates can dramatically increase the costs for individuals to own a home or borrow money to purchase other goods, they can also have a dramatic affect on the cost of doing business.
It is for this reason that when interest rates rise, making borrowed money more costly, that people will also be less likely to start or expand a business. This not only has an effect on the business owner themselves but filters throughout the entire economy as less businesses being started and expanded means less jobs, which means less people getting paychecks, which means less people spending money and on and on down the line. The opposite is of course also true for when interest rates fall and business owners take advantage of access to cheaper borrowed money.
In addition to interest rates affecting the stock market, interest rates also have direct and indirect affects on the bond, foreign exchange, and futures markets. Here are a couple of quick examples of this which we will expand on in later lessons:
The Bond Market: When interest rates rise the value of existing bonds fall as investors can now purchase the same bond with a higher interest rate and vice versa.
The Forex Market: When Interest rates rise it becomes more attractive from a yield standpoint to own the dollar against other currencies or to invest in interest bearing dollar based assets. This creates a demand for dollars which will many times cause the dollar to strengthen. The reverse is also true when interest rates fall.
The Commodities Market: When economies grow at a greater rate as a result of lower interest rates this will mean a greater demand for commodities so their value will rise and vice versa.
We are going to go into more specifics on each of these examples in the series of lessons which will be devoted to individual markets so if you do not understand this part don’t worry. I am simply giving these examples here to help further demonstrate the huge affect that interest rate levels have.
Now that we understand the importance of interest rates to economic growth and therefore the markets and our own trading, the next thing to understand is how this relates to our discussion on the government’s role in the economy. As we have learned in previous lessons the government has two options when trying to influence the business cycle to keep prices stable and work towards full employment.
The first which we have already discussed is Fiscal Policy, or exerting control over government spending and taxation to try and influence the business cycle.
The second and perhaps most important to us as traders is Monetary Policy, which is exerting control over the money supply (which has a direct relationship with interest rates) also with the goal of influencing the economy and business cycle.
The Federal Reserve or Fed as it is often called, is the institution responsible for administering monetary policy, and therefore can increase or decrease the money supply with the goal of trying to affect the level of interest rates in the United States. As the level of interest rates has such a large effect on everything in the economy from unemployment to inflation, this makes the Fed one of if not the most powerful institutions in the world.
In the next lesson we will learn more about the Fed and some of its key players so we can begin to have a better understanding of Monetary policy and how we as traders can profit from this knowledge, so we hope to see you in that lesson.