Bonds and the Fed

When the Chairman of the Federal Reserve Board gives a speech or testifies before Congress, the financial markets carefully sift and sort his words for nuance and hidden meaning.

All this attention can be explained in two words: interest rates. Because the Federal Reserve, or Fed, can influence the direction of interest rates, the Chairman's pronouncements can move financial markets and foreshadow the path that the overall economy may take.

For bond investors, interest rates are a critical element in determining how well a bond portfolio will fare. Bond prices typically move in the opposite direction of interest rates. With so much riding on whether interest rates will rise or fall, it's no wonder that the Fed Chairman's words are so closely scrutinized.

As a bond investor, you can benefit from a greater understanding of how the Fed influences interest rates and the variety of factors that the Fed considers in forging monetary policy.

William McChesney Martin, Fed Chairman from 1951 to 1970, said the central bank's role was to "take away the punch bowl just when the party gets going." On a very basic level, the Fed may be viewed as the host of a party where the attendees are the various segments of the economy. If the party gets too dull, the Fed may spike the punch bowl to liven things up. But if the party gets too lively, the Fed may pull away the punch bowl to produce a more subdued atmosphere. The Fed strives to achieve a healthy balance.

The "party" is the U.S. economy. If the Fed senses slower-than-adequate growth, it may lower interest rates, thus sparking economic activity. If the Fed thinks the economy is too hot and is worried that inflation will rise, it may raise interest rates, thus curtailing spending.

In deciding policies to pursue, the Fed considers such things as trends in prices and wages, employment and production, consumer income and spending, residential and commercial construction, business investment and inventories, interest rates, and government policies on spending and taxation.

Low unemployment is viewed as a potential inflation risk because a tight labor market could cause employers to increase wages to attract or retain workers. Higher labor cost may in turn tempt companies to raise the price of their goods and services to offset wage hikes.

The Fed tries to anticipate these and other scenarios in its efforts to guide economic activity.

If the Fed believes a credit crunch may severely dampen economic growth, it will also step in, as it did in 1998. That year, the Fed cut interest rates three times in as many months to calm financial markets.

"The Federal Reserve can contribute to financial stability and better economic performance by limiting the scope of financial disruptions and preventing their spread outside the financial sector," states the Fed's web site.

As a prudent investor, it would be beneficial to keep your pulse on what's happening in the economy. That way, you can get a general sense of how your various investments – both stocks and bonds – might be affected.

The Fed's own web site, www.federalreserve.gov, is an excellent resource for basic information on the Fed's operations, annual reports to Congress, and the minutes of meetings held to discuss monetary policy. And you can read for yourself the Fed Chairman's speeches that invite such scrutiny.

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