The importance of interest rates to the economy in general and the stock market in particular cannot be over emphasized. Like the mercury in a thermometer, as the economy begins to heat, interest rates rise and the stock market moves the other way.

The longest free market expansion in the history of the world can be partially explained by the enlightened monetary policy implemented by the Federal Reserve in conjunction with Congress and a variety of presidential administrations. For 17 years, our economy has continued an almost unabated growth and expansion. With the exception of three quarters in 1990, Gross Domestic Product has increased every quarter since 1982.

At the helm of this powerful economic ship of state has been an increasingly powerful Federal Reserve. The Fed has learned to guide this huge economic boat with carefully controlled adjustments to money supply and the Federal funds rates, which in turn have impacted longer-term interest rates.

Federal Reserve adjustments directly affect short-term borrowing rates. They do not directly control long term rates; these are controlled by market forces. If the bond market perceives inflationary pressures rising, the price of bonds fall and yields rise. Purchasers of long-term bonds, mortgage lenders, and others who lend money for longer periods want higher returns to offset anticipated decreases in purchasing power. This causes bond prices to fall and bond yields to rise.

The Federal Reserve has learned to make quick, small adjustments in money supply and short-term rates, whenever inflationary pressures have increased. These quick subtle adjustments have helped keep our inflation at rates impossible to imagine when this expansion began in 1982. This type of activity has served as a sea anchor on prices, much as the gold standard of the 19th century served to stabilize prices more than a century ago.

The yield on the 30-year Treasury, the bell-weather of market expectations for inflation, has been slowly creeping up. Recently its yield rose to 5.7%, the highest it has been in the past six months. Market pressures on bond prices will be monitored carefully by the Federal Reserve. If inflationary pressures increase, the Fed could make adjustments by cutting money supply with a slight increase in the Fed Funds rate.

However, the Fed has to keep a close eye on the economy. Such an increase in interest rates with an economy slowing could lead to the first negative growth quarter since 1990. This is not what the Fed, Congress, nor this Administration has in mind.

Stock market investors are once again being reminded of the relation between interest rates and stock prices. Rising interest rates push down the prices of growth stocks. Rising interest rates pull money from stocks in favor of the higher yielding bonds. This ripples through the stock market by causing investors to appraise stocks at lower price multiples of earnings. Unless earnings go up to bring down the price-earnings ratios, prices adjust by falling.

This relationship of interest rates to growth stock prices helps explain the occasional slumps we have experienced in the S&P and NASDAQ stock indices. These indices are strongly influenced by the stock prices of growth stocks like Microsoft, Cisco, Intel, and Dell.

Going forward from here, those who see the glass half full should get their checkbooks out and take advantage of the growth stock "sale" prices when this happens. Those who see the glass half empty may want to take their money off the table and wait until bond prices stop rising.

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