For weeks, the financial markets have been trading on worries that the Federal Reserve could hike interest rates on signs that inflation growth was breaking above the central bank’s comfort zone. On June 28, the Federal Open Market Committee, the Fed’s policy-making arm, chose to hold the Fed funds rate steady at 5.25%, the level at which it’s been for the past year.

Any sense of relief that the Fed no longer saw core inflation as “elevated” was overwhelmed, however, by its statement that “a sustained moderation of inflation pressures has yet to be convincingly demonstrated.” Bond yields climbed higher as the market concluded that Ben Bernanke & Co. was still leaning toward raising interest rates somewhere down the line. Stocks ended slightly lower, resuming a downward trend after a brief respite on June 27.

Will subprime lending problems spread to other sectors? Will consumer spending dry up as gasoline prices continue to rise and cash-out options on mortgages disappear? Will the economy continue to grow at the pace seen in the second quarter? Decisions about your investment portfolio can be a headache amid such uncertain conditions. That’s one reason that Doug Roberts, founder and chief investment strategist of Channel Capital Research, came up with his “Follow the Fed” strategy.

Roberts is a former Wall Street analyst and small-cap value manager, as well as an individual investor with a multimillion dollar portfolio. Disgruntled with high-priced, underperforming offerings from Wall Street, he began to do extensive research to develop an investment strategy linked to moves by the Fed and informed by the availability of credit.

He says the strategy can help investors decide whether to be in large- or small-cap stocks and also saves them a lot of time and money, as it results in lower fees and better tax efficiency. He recommends index mutual funds and exchange-traded funds as a way to get the benefits of diversification and cut down on trading costs.

BusinessWeek’s david_bogoslaw@businessweek.com interviewed Roberts by telephone not long after the FOMC announced its decision to keep interest rates flat. Edited excerpts from their conversation follow:

What’s the best option for investors following the Fed’s move today to keep interest rates at 5.25%?
[The Fed’s decision] has convinced Wall Street that money is going to be relatively tight for the foreseeable future.The “Follow the Fed” strategy favors large-cap stocks when money is tight, vs. smaller-cap stocks. That’s where you can generate substantial returns over time, relative to the Standard & Poor’s 500, which is a large-stock index. The way we measure that is current short-term borrowing rates vs. the rate of inflation. If the borrowing rate is greater than the rate of inflation, it indicates a tighter monetary environment. If it’s less, it indicates a looser monetary environment.

A tighter monetary environment tends to favor larger stocks. Companies like General Electric («www.businessweek.com») can borrow under any circumstances. They always have access to the capital markets. A $2 million cap company is constrained by the cost of capital. If they can’t go to the capital markets, they can’t grow their business. And if they can’t grow their business, they can’t increase their stock price.

Over the past five years, the Fed’s attempt to ward off a severe recession has injected a fair amount of liquidity into the economy. The small-cap outperformance we’ve seen is limited to this kind of environment [where money supply is plentiful].

So what’s the best way to invest in large-cap funds?
The best way is no-load mutual funds, preferably index funds because of the low cost and the fact that over prolonged periods of time more actively traded funds tend to underperform the benchmark, mostly due to asset allocation and stockpicking.

The best bet is to get an index fund that matches your benchmark and then change your benchmark at the appropriate time. It’s also the least time-consuming method of investing. You can use this type of strategy in 401(k) and 529 plans and you always have the choice of large- or small-cap funds.

Pakistan’s decision to release a suspect al-Qaida expert accused of training suicide bombers and plotting to attack Heathrow airport met with surprise and dismay in London and Washington yesterday, with officials describing the Pakistani computer engineer as a “significant individual”.

Pakistan’s supreme court heard this week that Muhammad Naeem Noor Khan, 28, from Karachi, had returned home after three years’ detention at the hands of Pakistan’s intelligence agencies. His lawyer, Babar Awan, said that all charges had “gone with the wind”.

The media has been prevented from interviewing Mr Khan, who remains under tight surveillance. His low-key release contrasted with the clamour that followed his capture in July 2004, which authorities celebrated as a big blow for al-Qaida.

Mr Khan was alleged to have been the conduit for scrambled email communications between the al-Qaida leaders in the tribal belt and the outside world.

A seized laptop contained a “treasure trove” of intelligence, officials said, describing blueprints of potential targets for al-Qaida, in Britain and the US, including photographs and plans of Heathrow airport and underpasses in London.

His arrest led British police and security service officers to Dhiren Barot, who was imprisoned last year for 40 years for planning a bombing campaign, including a plan to fill expensive cars with explosives and gas cylinders, park them in car parks beneath buildings and then detonate them. It also led to the capture of Ahmed Khalfan Ghailani, a Tanzanian who allegedly helped bomb American embassies in Africa in 1998.

Mr Khan was reported to have told Pakistani officials about a terrorist network in Britain and how he often relayed messages from Pakistan to the leader of the British cell, described as a top al-Qaida operative. His release appeared to be a reward for cooperation.

But officials in London expressed disappointment at the release, with one describing Mr Khan as a “significant individual”. US officials and analysts said they were dismayed at his release.

“I find it strange and baffling,” said Seth Jones, of the Rand Corporation, a Washington thinktank. “It is also deeply reprehensible since Khan was involved in training al-Qaida operatives. He presents a major threat to the west.”

But human rights activists questioned whether Mr Khan was really a terrorist mastermind as portrayed. “If he is so dangerous a suspect in the war on terror then why has he not been charged for the last three years?” said Ali Dayan Hasan, of Human Rights Watch.

Mr Khan’s release in mid-July was all the more puzzling considering the Pakistani government’s claims about his seniority in al-Qaida. In his autobiography published last year, Pervez Musharraf, Pakistan’s president, describes an unnamed al-Qaida operative with an identical profile to that of Mr Khan as the organisation’s “information technology chief in Pakistan”.

President Musharraf said the man had been recruited by the 9/11 mastermind, Khalid Shaikh Muhammad, had trained a 12-man suicide squad intended to hit US interests around the world, and conducted reconnaissance of Heathrow airport in preparation for a possible attack.

Now Mr Khan, believed to be living with his parents in Karachi, is subject to speculation that he was an al-Qaida double agent, or had been “turned” by the Pakistan’s Inter Services Intelligence agency. But his release also comes amid unprecedented action by Pakistan’s supreme court, which is pressing the government to locate hundreds of people detained without trial. One former intelligence official told the BBC that Mr Khan’s story was a “murky tale” in which there were “no clear answers”.

NEW YORK: U.S. stocks plunged early Friday as investors worried that a plan to ease a liquidity crisis at Bear Stearns

indicates how severe credit troubles have become. Each of the major indexes lost more than 1 percent; the Dow Jones industrials fell more than 250 points.

Investors were busy examining a plan from JPMorgan Chase and the New York Federal Reserve to provide secured funding to Bear Stearns for an initial period of 28 days. The move offers Bear Stearns relief from a sudden liquidity crunch and could help instill confidence in the stagnant credit markets.

Bear Stearns shares fell sharply, dragging down other financial companies. The stock fell $14.05, or 25 percent, to $42.95.

Stocks showed moderate gains in the early going after a Labor Department report showed the consumer price index remained flat for February. Wall Street has been expecting inflation would show an increase.

But the gains quickly disappeared after investors learned more about how close Bear Stearns appeared to have come to financial implosion.

“The Bear Stearns news reversed the early positive sentiment from the inflation data,” said Peter Cardillo, chief market economist at Avalon Partners. “There had been nervousness about Bear Stearns for some time and now the markets concerns about the company have been proven true.”

In the first hour of trading, the Dow Jones industrial average fell about 257 points to the 11,888 level.