The Federal Reserve And Interest Rates: Theory Against Reality
Anyone who is a student of economics would agree that most of the charts and ratios
from your class did not seem to be too practical, meaning you could not take the things you were learning and immediately apply them in real life. This background in economics, however, is essential to understanding the core relationships in the global economy if you want to make real investments in stock markets or the foreign exchange market.
When it comes to trading the forex market, understanding certain fundamental factors such as interest rates and how they relate to a specific country's economy should become second nature, and it is the boring theory that you learned in your economics class that can help to solidify this essential understanding. In order to go out in the real world and find profitable investments, you need to first learn all of the theories that allegedly govern the behavior of money and the financial markets. It is only when you understand how most people think the economy should behave that you can then identify which instances that it is going against typical economic theory, which then might present a viable buying or selling opportunity.
Much of the foreign exchange activity that occurs today between the major currencies centers around the United States dollar, and the currency pairs that most brokers call the "majors" are currencies like the pound or euro that are traded against the dollar. As such, when there is a fundamental shift in the American economy, such as a shift in short-term interest rates, there is a profit opportunity to either buy or sell the dollar against these other currencies.
As traditional economic theory goes, when the Federal Reserve lowers short-term interest rates it should stimulate business growth in the economy since the cost of conducting business is lower. This is why the Fed will usually lower interest rates when it is time to grow the economy, and they will increase interest rates when it comes time to curtail economic growth.
An important issue to understand is that an interest rate is literally the cost of money. When the interest rate is low, money is cheaper and borrowing should increase (in theory), and with high interest rates people are more motivated to save their money and not borrow any more. But when a currency has a high interest rate, this will also increase foreign investment and the levels of foreign capital coming into the country, because if people in Europe or Britain can earn more interest by buying dollars, this is where a profitable foreign exchange opportunity arises.
But so far, this is just theory. In theory the foreign exchange market will follow this exact relationship to changing interest rates, but the market is composed of people and most people are insecure and unpredictable. It is when the markets go against established theory that the real big profit opportunities arise. A good historical example of the theories about the Federal Reserve not matching reality is around the years 2001-2002.
At about this time the stock market dropped as there was a massive loss of interest in internet companies, and the US government was trying to fund a new war effort. In the year 2001 the Fed dropped interest rates over 4% and in 2002 interest rates fell another 1%, as this action should have stimulated economic growth and increased business.
This time however, it did not increase economic growth as expected. The lowering of interest rates was expected to stimulate the economy, but instead the results were fear in the markets and a decrease of business in America. While in theory it might have been a good time to buy the dollar as it might go up in value, the real money was made by the people who saw fear in the markets and sold the dollar as it decreased in value. This illustrates why it is important to know basic fundamental economic theory, because in the complicated world of foreign exchange trading theory does not always match up with reality.
by: Ricky Weber
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