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Why The Fed Interest Rate Affects The Stock Market

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In layman’s terms, which is what the title was put in, the reason why the interest rate, dictated by the Fed, affects the stock market is because it affects the interest rate on loans that businesses can get to grow their businesses. When the interest rate goes up, loan rates go out and businesses have to pay more on their loans and thus have less to put back into the business. The interest rate also affects consumers because the rates on their loans are going to go up and thus their ability to spend money is going to go down. If consumers are spending less, businesses are making less; yet another hit to the future growth potential. Since the stock market is supposed to track the business, rate hikes affect growth projections and thus the price of the stock. The price of a stock is based on those projections, so increased costs (rate hike) means potentially decreased future growth, and so the price goes down. Rate hike means stocks weaken, rate drop means stocks strengthen. That’s the layman’s version and that’s basically like explaining the waves at the top of the ocean without looking at the multitude of forces at play below the surface.

The Fed

In actuality, when people say “the Fed,” short for Federal Reserve, they actually mean the Federal Open Market Committee. The committee consists of the Board of Governors of the Federal Reserve System, the President of the Federal Reserve Bank of New York, and four of the eleven remaining Federal Reserve Banks on a rotating basis. The FOMC meets eight times a year and Ben Bernanke is the Chairman of the Board of Governors. The Board of Governors is in charge of setting the discount rate (what people commonly call the “interest rate”) and the reserve requirement.

The discount rate is what the Federal Reserve will charge banks to borrow money from them. The reserve requirement is how much, percentage-wise, a bank must hold in its reserves to cover deposit requirements. This idea kind of blew my mind when I first heard about it like ten years ago. So when you deposit $100 at the bank, if the reserve requirement is 10%, then the bank must keep $10 on hand but it can lend out the $90. Let’s say they lend that $90 to another bank. The second bank must keep $9 in reserves but it can lend out the $81. This can happen, in theory, forever and so the original $100 actually ends up becoming really really close to $1000 in total value across however many instruments when it’s all said and done.

The Discount Rate

So, how does the discount rate affect the interest rate? Well, as mentioned earlier, the discount rate is the rate at which commercial banks can borrow money from the Federal Reserve. If the rate increases, then the cost to banks increases and that cost is passed onto its borrowers. Then the borrowers, who are themselves consumers of the products and services of businesses, will be spending less in stores and thus reducing the revenue stream of the businesses they frequent. Businesses are hit with a double whammy – if they need loans, those are more expensive; plus their customers are spending less. Businesses that are earning less, hire less people, those people who are thus not hired will find themselves spending less… and so you can see how the cycle can feed itself. The public barometer that the Fed uses to see how well this cycle is operating is inflation. The hard part about dealing with inflation is that interest rate changes are the cause but the effects aren’t seen for years, so it’s a difficult game to be playing.

Update: In addition to the discount rate, the Fed also sets the federal funds rate but it generally moves lockstep with the discount rate. For a discussion on the difference, please refer to this article on the differences between the discount rate and the Federal funds rate.

As you can see, the basics are pretty easy to understand: rates go up, market goes down; rates go down, market goes up (in general). However, there are so many factors at play in there that to boil it down to that one liner doesn’t do it any justice.

{ 12 comments, please add your thoughts now! }

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12 Responses to “Why The Fed Interest Rate Affects The Stock Market”

  1. John Forman says:

    I would toss in to the mix the fact that as interest rates go down, stocks become more attractive in terms of returns in relation to things like bonds, encouraging investors to shift their allocations.

  2. jim says:

    Very true John, I left that out because I felt that was a bit of a secondary factor (the fact that the interest rate fall will negatively affect bonds and thus positively affect stocks) but still an important idea that should be understood.

  3. FIRE Finance says:

    You have written in an easy-to-understand manner, that is good. It would help a layman if the following were also discussed explicitly:

    1. relationship between bank deposit rates (Certificate of Deposit, Savings account etc.) and the discount rate.
    2. relationship between bond prices and the discount rate.

    Cheers,
    FIRE Finance

  4. Great explanation! There are historical examples of times when Fed Chairmen and other politicians (namely Presidents) have spoken publicly in general terms about the market, and have impacted the markets greatly without even a fiscal or monetary policy shift; just the words and speculation alone!

  5. Ali says:

    Why does icreasing the discount rate affect the dollar like it did now.

  6. jim says:

    When the fed drops the rate, that means that demand for the USD will be lower and thus dollar will fall in value.

  7. Ames Tiedeman says:

    In the U.S. interest rate are going lower, Gold is going higher, Oil is going higher, inflation is going higher, the dollar is going lower. What is wrong with this? Everything! At some point the FED is going to have to raise rates bigtime. We are in a very, very, precarious situation at the moment. I think Gold will tripple to over $2,000 an ounce when the market finally wakes up and sees the real inflation. Last I checked a lower dollar = higher import prices. There is no inlfation deflator here. With commoditioes on fire you can forget about that. Bernanke should have never lowered rates last week. However, the Fed might be doing something that few have talked about. Maybe the Fed has abandoned the dollar the crush teh trade deficit. Good luck, it will take 20 years to correct our 6% of GDP trade deficit and move it back to under 1% of GDP, unless you want to seriously disrupt the global economy. We are in for tough times people. Very tough!

  8. Joey says:

    Ames: Let me guess, you’re a big Ron Paul fan? Tin foil a good hat does not make.

    • IvoryPalaces says:

      May I ask what you see wrong about Ames’ reasoning? Please state your reasons and logic. Thank you.

  9. Jay says:

    Thank you Jim for writing this. It gives the average non-finance person (like myself) a better insight on what’s going on when interest rates move.

  10. emylene says:

    Hi!

    I would just like to say thank you for making your explanations brief and easy to understand. It just shows that you know the subject a great deal. Perhaps you are an economics professo. If not, well you should be! People will learn alot from you…

  11. Ames Tiedeman says:

    Lower taxes? Higher taxes? Does anyone actually think being plus or minus 5% on taxes will make a lick of difference for the U.S. economy at this stage in the game? The economy will never again work the way we all want it to work with the current account deficit at 6 or 7 percent of GDP. You cannot get unemployment even under 6% without a credit bubble, with a current account deficit as large as ours. We have not had a trade surplus since 1974. We have been in decline for 40 years and this decline has only accelerated in recent years. We closed 55,000 plants in the United States since 1980. Your politicians won’t tell you this because some of them fed you the false promise of free trade. Others don’t want to admit NAFTA has been a complete failure for America. Great for Mexico as that giant “sucking sound” Ross Perot predicted has materialized. Clinton and Gore promised the American people ever bigger trade surpluses with Mexico and ten’s of thousands of new high paying jobs. Just pass NAFTA they exclaimed! Quite laughable, really. We have gone from a trade surplus of a few billion a year to a trade deficit nearing 100 billion per annum with Mexico. What is equally as laughable or insulting is the trade deal Obama has just signed with Columbia. Do we make anything they can afford? Of course not. Columbia will simply become a new launch pad to make textiles and sell them into America. How about the trade deal Obama signed with South Korea? This is an interesting one. Within the bill on the U.S. side is a provision to provide worker training for displaced Americans. So we are now so stupid that we are signing trade deals that we know will diminish the U.S. labor force. The insanity is just that! Does anyone think the South Koreans would agree to a trade deal if they were not sure to win? Does Obama understand that the South Koreans are fierce nationalists who will never let America win a trade contest? Did my ancestors lead pre-Revolutionary War skirmishes against the British at Lexington and Concord in 1775 and early 1776 only to have America end up how it is today? My blood has been on this land since 1635. How many of my ancestors ever dreamed that America would be so deep in debt and short on ideas? Would any of them ever have thought that such mediocre men would one day be leading this nation? America has done a terrific job of creating a low employment and low wage society, for millions. Quite sad indeed. No civilization has succeeded by consuming more than it produces. We must massively restructure. Until America decides to produce what it consumes you can forget about any long term economic recovery. The financial games all failed. The credit bubble is gone and now the U.S. economy is exposed as the biggest joke of all time. Credit bubbles have a way of masking the real issues. How do we fix the American economy? Start by making every American who has received a Nobel Prize in economics return the award. Why? because they were either 100% wrong or their work proved to be of no benefit to the American economy. Next, round up every economist who advised Nixon that if America left the gold standard and moved the world to a floating currency regime; that America would never, ever, run a current account deficit. And I am very sorry to inform everyone that this would include the late and great Milton Friedman. Sorry Milton, you were dead wrong too! Next, leave the WTO, end NAFTA, and go about setting up country-by-country trade deals that are realistic based on where America stands today. It is not 1955 anymore. The world has either matched us or surpassed us in industry after industry. We have literally become an emerging economy is some industries as we have faltered so badly. Next, move to a flat tax, and end all farm subsidies. Cancel most government social programs like food stamps and deport 100% of the people living in America illegally. Make it a high crime to employ anyone not here legally. Finally, for major industries such as steel and automobiles, move to a must-be-made-in-America policy. No longer allow imports of products in specific industries. They must all be made in America. We must employ our people. We can no longer employ the world via our consumption as so many Americans remain unemployed. We must use our 50 state union to our advantage. We must promote massive trade between the states. We must socialize CAPITALISM to avoid becoming a socialist state! We must reinvigorate the American people. We must manufacture. And who running for office can lead America on this grand and pious endeavor? Who running for office today has the passion of a General MacArthur or the skill of a Chester Nimitz? Who has the energy of a Teddy Roosevelt? The men who command the attention of the electorate in this age of mediocre ambition are all too small to make a difference…


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