Why does the Fed matter? Why is the financial community so obsessed with the rate that the Federal Reserve Open Market Committee (FOMC) sets? Here’s how it works, in theory. There is something taught at every business school in the country, called Net Present Value, or NPV. It is something companies do to determine whether to undertake a project. When a business decides yes on a project, then work gets done, people are hired, and Gross Domestic Product goes up.
Somehow or another, you forecast your cash flows, i.e. revenue minus costs. Let’s say you run a clothing company, and you want to determine whether you need to open a new factory. You estimate how many shirts you can sell over the next five years. You multiply by how much you charge for each shirt. That total is the revenue. You have that for each year, quarter, month, or week. You subtract your estimate of the cost to produce them. Now you have an estimate of profit for each month, or week. In order to compare these future cash flows to those of any other project, which might have a different timing, you project all of those cash flows back to the present. There is a standard way of doing this, and everyone does it that way. And in order to do that, you need to have an interest rate at all those times in the future. Each company will have their own interest rate to use, but the base rate, the place where everyone starts, is the interest rate set by the central bank.
So what? So this. When the central bank changes its rate, every company in the country will go into their Excel spreadsheets, change the cell for that rate, and then redo their Net Present Value calculation for all the projects in their hopper. You didn’t know they had a hopper? Oh, they have a hopper. A big one. Just a little comedic pause, here, for the laughter at the Seinfeld reference to Kramer. But laughter aside, this affects the decision of every company in the country, and whether they decide to take on a new project. New projects mean new purchases, also known as capital expenditure, and new labor, which means hiring workers, and income for them, and higher GDP for the country.
Therefore, in order to measure risk in an anticipatory way, you have to pay attention to the moves by the central banks. Period. Full stop.
