When the markets dropped so heavily on the morning of 9/11 this year, media blamed the downward trend on somber attitudes, delayed quarterly reports, and downgrades. But the subtle news included within all those stories was an interest in the Federal Reserve Bank's meeting slated for this month. One AP article stated that, "Investors have been trading cautiously" in preparation for any change in current interest rates. To answer the question about why investors tiptoe around Federal Reserve Bank meetings, an explanation is in order.

The Federal Reserve Board that governs the Federal Reserve Bank controls three tools in this country's monetary policy. Some of the tools and their operations are overseen through a committee called the Federal Open Market Committee (FOMC). This committee is comprised of 12 members: Seven members from the Federal Reserve Board and five from the 12 Federal Reserve Bank Presidents:

1. Open Market Operations: In this country, a central institution - the Federal Reserve Bank - controls the national money supply, or Federal Reserve, and establishes monetary policy through the purchase and sale of government securities or other instruments like gold. The FOMC specifies the purchases and sales, but the most important task assigned to this committee was established in 1995. That's when the FOMC began to set monetary policy by specifying the short-term objective for those operations through target levels for the federal funds rate, or the discount rate?
   
   
2. The Discount Rate: Also known as the federal funds rate or the primary credit rate, or the rate that holds everyone's interest. The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from district Federal Reserve Bank lending facilities. These loans are created through "discount windows" that include variable fully secured credits. These loans help commercial institutions to maintain liquidity. As the discount rate rises, commercial lenders establish an increased incentive to keep more cash on hand and to lend less cash out to their customers. Rising interest rates, therefore, help to curb spending because less money "is to be had" through commercial loans.
   
   
3. Reserve Requirements: This is a bank requirement reserve ratio that sets the amount that any given commercial bank must hold to meet customer demand for withdrawals. The commercial bank's reserve is held in vault cash or in deposits with any one of the twelve regional Federal Reserve Banks. The amount held is usually determined by the number of transactions over a period of time within that bank and by the ratios set by the Federal Reserve Board, not by the FOMC.

The brief summary above cannot fully explain the impact that the FOMC holds on this country's markets when they determine interest rates. Alternately, the same explanations cannot fully detail how this country's microeconomics modify how the FOMC will react to sudden drops in employment or equally sudden spikes in consumer confidence ratings. Add a few other issues, like impacts created by national and international politics and changes in foreign currency rates, and the FOMC has quite a few points to consider at their meetings.

If you want to peruse the issues that the FOMC ponders and the timeframes that they use for comparisons, take a look at the minutes for past meetings available at the Federal Reserve Board site. A few items in the 8 August 2006 meeting included manufacturers' inventory levels, farm and non-farm payrolls and production levels, and housing - including residential construction. A closer look at how these categories were presented shows that current values were compared to recent timeframes for valuation.

While the sitting FOMC determines interest rates, Federal Reserve Bank presidents who don't sit on the current committee have the right to speak out about Fed policies. And, investors and analysts listen closely to those individuals to glean hints about behind-the-scene developments.

For instance, in that same AP story mentioned at the beginning of this article, Federal Reserve Bank of Boston President Cathy Minehan was reported to state that, "the economy should slow in coming months and reduce inflationary pressures." On that same day, St. Louis Federal Reserve Bank President William Poole addressed the National Association for Business Economics. Rex Nutting, in an article for MarketWatch, summed up Poole's rhetoric in one sentence:

"In an ideal world, the Fed [FOMC] would never have to comment on current economic events, because the financial markets would have perfect knowledge and rational expectations of the Fed's goals and its plan for getting there."

Both Minehan's comment and Poole's desire for a crystal ball struck chords with the media and - seemingly - with the markets as well. Minehan's statement was said to have caused the upward trend that followed the deep sink in the markets that Monday morning, because her remarks appeared to reassure people that interest rates would not rise. Another news agency reported that the upward trend went "flat" after Poole's speech. No reason was given, but perhaps the rationale was that Poole voiced a seemingly impossible dream on a day and during a time when people wanted to hear positive news.

For the record, the FOMC ceased their more than two-year interest rate hike at the 8 August meeting, and kept interest rates stable at 5.25 percent. Investors and analysts felt at the beginning of this month that interest rates would remain stable after the September meeting. But, one never knows, really, what will happen during the FOMC September meeting, as housing seems to have hit a slump and predictions about holiday spending might play a hand in this decision. Will interest rates stay the same, decrease, or increase?

The only way to avoid impacts created by this interest rate dance and by any accompanying market wobbles is to avoid credit cards, pay for your house outright, save for your children's college education now, and look to long-term investments rather than short-term trades. But, even if we avoid the dance, the music will play on?

Until Next Week,
Linda Goin