What Happens When The Federal Funds Rate Changes?
There is a lot in the news about interest rate changes, and in particular, the federal interest rate. We hear about interest rates all the time, but understand how the federal interest rate influences stock investors can be a bit misunderstood.
What is the federal interest rate, and how does it relate to interest rates in general? Why does the government change that rate, and how does this all influence the economy? How does it influence the stock market?
Read on to dive in!
What’s the Federal Interest Rate?
An interest rate refers to the cost someone pays for the use of someone else’s money. When you hear the term “interest rate”, you likely think about how credit cards have interest rates. Think American Express.
AXP stock performance as of September 2020 from EEON
Interests rates are everywhere. However, the rate that influences the stock market the most is the federal funds rate (also called the discount rate). That rate is the rate that depository institutions, such as banks, are charged for borrowing money from the Federal Reserve banks.
It’s arguably one of the most important interest rates because it’s a benchmark of sorts for interest rates on credit cards, bank loans, mortgages, and much more.
Let’s say that the economy is in a financial recession. To combat the recession, the government has a couple of strategies at it’s disposal. One of these is expansionary monetary policy.
The government can make it easier for banks, and people, to borrow money and therefore have money to spend on things. They can do this by reducing the federal funds rate, thus lowering the cost for banks to borrow money and therefore people to borrow money. This also creates a new, lower benchmark for credit card interest rates and beyond.
As a result, consumers will be inclined to shop more, which helps businesses and raises demand for products and services. Those businesses can pay their workers more since the business is more on demand. Home loans become cheaper. In a cycle of sorts, prices increase and people are less likely to be hurt by financial troubles. This stimulates the economy to bring an economy out of a recession.
One interesting area that this is important is the unemployment rate. Data suggests that there is a correlation between low prices and high unemployment. On the other hand, as prices go higher, unemployment tends to decrease.
Why not just have this strategy forever? Rising prices can be an issue in itself. If prices are too high, that means inflation, which make it harder for people to afford products and services. When there is too much consumption and prices are too high, the government needs to take opposite measures to bring inflation down. Of course, this risks increasing unemployment accordingly.
Implication on the Stock Market
Due to the COVID-19, the government lowered the federal funds rate to combat the financial burden the pandemic has put on many people. When the federal funds rate goes down, that usually helps the stock market almost immediately (prices will increases).
That’s because borrowing money is made easier for everyone when that rate goes down, encouraging consumption from these publicly-traded companies. The influences on the economy from the rate changes actually take a bit more time to settle in.
[Note: This article is not financial advice.]