Central banks move markets

Each day in every major financial newspaper, one can find at least one article or reference pertaining to central banks and what they're doing. Why are they so important to investors? Because everything from a major interest rate decision to something as minor as a bank official's comments can move markets in a significant way. From bonds, stocks, currencies among many other assets, central bankers have more influence over the markets' direction than anyone else.

Why, you might ask, would central bankers want to slow an economy down? After all, strong economies create jobs and increase real wages and thus raise the public's disposable income. Constant upward movement in markets raises the wealth of all those involved. The rise in disposable income due to the real wage increase coupled with this "wealth effect" ultimately results in a greater quality of life.

Despite popular support for expansionary monetary policy, central banks realize the importance of having to tighten the money supply. They must look past the short-term interest of the markets to maintain price stability, and thus the Fed's credibility. Although tightening credit usually results in short-term pain, the long-term gains (usually) outweigh those costs. If credit becomes over-extended, a speculative bubble may form, promising a harder fall later on.

Inflation is never far behind a speculative bubble, as growth in the money supply outpaces growth in the supply of goods. As the saying goes, "Central bankers are the person that brings fruit punch to the party to start it up. When everyone is having a great time, central bankers take the punch away and end the party." But, they have the power to move markets upward, too. In an economy experiencing recession, central banks can also stimulate growth by lowering interest rates.