CENTRAL BANK POLICY
Central bank policy is of primary importance to financial markets. Mar-
tin Zweig, a noted money manager has described the relationship this
way:
In the stock market, as with horse racing, money makes the mare go. Mon-
etary conditions exert an enormous influence on stock prices. Indeed, the
monetary climate—primarily the trend in interest rates and Federal Re-
serve policy—is the dominant factor in determining the stock market’s
major direction.^3
Chapter 13 showed that four of the top five largest one-day rallies
in Wall Street history were involved with monetary policy. Lowering
short-term interest rates and providing more credit to the banking sys-
tem is almost always extremely welcome by stock investors. When the
central bank eases credit, it lowers the rate at which stock future cash
flows are discounted and stimulates demand, which increases future
earnings.
Chapter 11 showed that over the past half century, tightening by
the Fed was associated with poor returns over the next year while easing
boosted the market. Although the impact of changes in the fed funds
rate on 3- to 12-month returns has not been as reliable in recent years as
in the past, surprise intermeeting moves by the central bank are as pow-
erful as ever. The unexpected one-half-point cut in the funds rate from
6.5 to 6 percent that took place on January 3, 2001, sent the S&P 500 Index
up 5 percent and the tech-heavy Nasdaq up an all-time record 14.2 per-
cent. A smaller, but still substantial response met the Fed’s decision to
lower the discount rate on August 17, 2007, during the subprime mort-
gage crisis.
The only case in which stocks will react poorly is if the central bank
eases excessively, so that the market fears an increase in inflation. But if
the central bank eases excessively, an investor would prefer to be in
stocks than bonds, as fixed-income assets are hurt more than stocks by
unexpected inflation.CONCLUSION
The reactions of financial markets to the release of economic data are not
random but instead can be predicted by economic analysis. Strong eco-
nomic growth invariably raises interest rates, but it has an ambiguousCHAPTER 14 Stocks, Bonds, and the Flow of Economic Data 247
(^3) Martin Zweig, Winning on Wall Street, New York: Warner Books, 1986, p. 43.