by Jonathan Buhalis
What is Economics
Basic Laws of Economics
How Fed Policy Affects the Markets
What is Economics?
Economics is the study of how money flows through a society. It studies the impact of public and private sector decision on the economy as a whole. We can apply economics to nearly all facets of our lives including an economy (macroeconomics), governments, companies, and individuals (microeconomics). Because economics deals with scarcity of resources, it applies to nearly every facet of our life. For this reason, people sometimes call economics the "dismal science."
Most people think of economics in term of government fiscal and monetary policy, and its impact on prosperity and their individual lives. Government spending decisions, Fed interest rate changes and foreign currency transactions have a direct impact on our daily lives.
Basic Laws of Economics
Supply and Demand
The basis for economics is supply and demand. In a free economy, all other factors being equal, demand is inversely proportional to price and supply is directly proportional to price. That means that as prices rise people consume less of that product and that manufacturers produce more of it. The point where supply and demand balance is the market equilibrium. The supply and demand curves are dynamic and change on a moment to moment basis. Think of the stock market that will fluctuate dramatically based on changing news. Again, with more buyers in the market, price goes up and with fewer buyers in the market, the price drops. Supply and demand is the cornerstone on which economics is based.
Macroeconomics deals with studying how Federal spending and interest rate changes affect the economy as a whole. We all know that decisions in the state capitals affect our everyday lives. Macroeconomics basically boils down to two schools of thought. They are the Keynesian and the monetary theories. The Keynesian theorists believe that the Federal government should use spending to moderate the swings in the business cycle. Monetarists believe that the government should moderate the economy by changing interest rates.
Whichever theory you believe has more validity, increasing government spending and lowering interest rates have the same effect, which is to increase growth at the risk of inflation. The opposite holds true also. Cutting government spending and/or raising the interest rate slows inflation at the risk of recession. Government spending is at the discretion of Congress while the Federal Reserve Board of Governors (Fed) controls interest rate changes.
Fed Policy and How It Affects the Markets
Now that you know that the Fed controls the interest rates, let's see how that happens. Every two months on the second Tuesday of that month, the Fed meets to discuss policy changes. They release results on Wednesday. The Fed typically adjusts the discount rate, which is the interest rate they charge to member banks for overnight loans. The irony is that commercial banks hardly ever use the discount window, as it is commonly called.
When the Fed announces an increase in the interest rate, the bond market will decline in response to the news. Bond buyers know that the change will slow the economy in nine months or so. That will make it harder to pay the interest and principal. The increased risk makes the bonds less creditworthy and worth less. As a result, the yield, based on the price paid, not the face value, increases. In turn, stock investors know that the economy will slow and reduce corporate earnings, making their stock worth less. As a result, you will see traders anticipating the Fed's decision and selling off or rallying from just before the Tuesday meeting until the announcement the next day. Typically, the market has already adjusted for the announcement by late Tuesday.