The price of money

Every analyst worth their salt is wondering what the incoming Chairman of the Federal Reserve Board will bring to the table. On the surface, Ben Bernanke looks like a reasonable fellow, indicating that he has no plans to reverse or even significantly alter the policies of the current Chairman, Alan Greenspan. To the extent that the stock market can influence his actions, there's a good chance Benanke

Every analyst worth their salt is wondering what the incoming Chairman of the Federal Reserve Board will bring to the table. On the surface, Ben Bernanke looks like a reasonable fellow, indicating that he has no plans to reverse or even significantly alter the policies of the current Chairman, Alan Greenspan.

To the extent that the stock market can influence his actions, there's a good chance Benanke will keep his word. In no mood for a significant change of policy, the market reacted positively to his initial statements.

It's crucial that Benanke signal his commitment to the status quo, at least until he is better acquainted with the nuances of the relationship between the Federal Reserve and the markets.

Historically, former Chairman Arthur Burns had a much easier time setting policy because his actions had a more predictable impact on the economy. With each succeeding Chairman, however, the tools at their disposal became less potent in terms of their effect on the markets and on economic activity in general.

More recently, we've been hearing from the other members of the Federal Reserve Board, partly to reassure the public that there will be a smooth transition when Greenspan retires. People continue to be concerned about inflation, so the near-term actions of the Federal Reserve will most likely be geared toward putting downward pressure on the monetary forces that could cause inflation to rise. It remains to be seen whether the Federal Reserve will be successful in achieving that outcome.

Interest rates, which are simply the price of money, are based on three factors: supply and demand at the time of purchase; how likely the borrower is to repay it on time; and expectations about inflation and the economy in general.

The role of the Federal Reserve in establishing the price of money cannot be underestimated; it has the ability to impact all three factors.

It can affect the supply of money by changing the amount of money that financial institutions must keep in reserve. When reserve requirements are increased, there's less money available to borrow. There are several ways the Federal Reserve can accomplish this. The first involves changing the base rate, which is the rate banks must pay to borrow money. These “primary borrowers” then have to pass the cost increase on to their customers — individuals and institutions. Depending on market conditions, the bank might pass on part of the increase, all of the increase, or even more than the increase (known as a “premium”) to customers.

The Federal Reserve can also influence the standards banks use when deciding whom to loan money to. In addition, they can determine the percentage of so-called risky loans banks can hold in their portfolios. Currently, the Federal Reserve is concerned that in some instances banks are being more liberal than is typical in their mortgage approval process. Consequently, it may require some banks to make shifts in their loan portfolios, which means the loans will become much more expensive, or perhaps harder to get in the first place.

Finally, the Federal Reserve sets the mood for expectations regarding future inflation. If the Federal Reserve is perceived as in the business of fighting inflation, then financial investments like stocks, for example, are considered less risky. Rising inflation-or even the perception that inflation will rise-will make people less likely to invest in financial instruments.

Setting a realistic expectation in the minds of the Monday-morning quarterbacks is another story altogether. The result is especially important to trucking, since interest rates will impact the demand for goods, as well as increase or decrease the costs involved in sustaining such a capital-intensive industry.

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