The Importance of Monetary Policy

  1. INTRODUCTION

In the fall of 2010, I attended a presentation held at a local trust bank.  The presentation was given by a New York-based securities analyst who was there primarily to present some stock picks.  This analyst, however, took a “top-down” approach to security selection, so a discussion of the macro economy was very much a part of his presentation.  Although the presentation was structured for the presenter to take questions from the audience at the end of the presentation, many members could not contain themselves and continued to interrupt the presenter with their questions.  This was, I suppose, understandable.  In 2010, we were still in the early stages of a very fragile recovery from the global financial crisis.  What struck me, however, was just how many questions were related to the unprecedented actions of the Federal Reserve.

I should note that trust banks generally provide their services to high-net worth individuals.  So most of the audience members were retired or active small business owners, corporate executives, and professionals.  Despite the relative sophistication of these clients, it was clear to me from their questions that these individuals were not particularly clear on the role of the Federal Reserve on asset prices and the overall U.S. economy.  While I would normally label many of these individuals as “enterprising investors”, a term that we use often at our firm to refer to business minded retail investors, I believe these individuals fail to appreciate the role of money, banking, and interest rates on assets prices and the economy.  I have written this article series to better inform such individuals.

As I have explained elsewhere, my motivation behind the articles and the essays on this website is to eventually provide a comprehensive education in security analysis to anyone interested in studying the material.  Admittedly, the material is written with a bias towards a “value” approach to security analysis and thus stands in contrast with the conventional “modern finance theory” approach to security analysis taught at most U.S. universities.

I have had a long-standing interest in financial and business history.  I believe that a study of these subjects is indispensable for investors, and yet these subjects are conspicuously absent from coursework in standard finance curriculums.  Perhaps my more ambitious goal is to contribute to the field of security analysis by writing extensively, particularly in the form of essays, on matters of financial history.  Since money and banking will play a role, sometimes central, in these essays, the articles in this series should provide necessary background for interested readers.

  1. WHY INVESTORS SHOULD UNDERSTAND MONETARY POLICY AND INTEREST RATES

Interest rates play a significant role in investment valuation.  For a credit instrument, the worth of the instrument is defined as the present value of the instrument’s future contractual payments.  For an equity security, the worth of the security is the present value of expected future earnings1.  The Federal Reserve (and other central banks) influences interest rates through various policy mechanisms.  Thus, policy actions by the Federal Reserve will impact asset prices by influencing the discount rates which investors use to calculate the present value of future cash flows.

For equity investors, the Federal Reserve’s role in the business cycle, and thus on corporate profits also impacts share prices.  Thus, enterprising investors should be at least aware of the Federal Reserve’s policy actions and how they many impact security prices.

1 I use the term earnings in a generic sense.  Most valuation texts advocate using a cash flow measure, rather than accounting earnings.  See for example, Kohler, et. al. (2015).

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

Are your investment returns falling short?

Learn about the money management industry and key performance constraints in investment management with our e-book.

Complete the form below and a copy of the e-book will be emailed to you.