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Why Investors Watch The Fed Interest Rate Closely?

Views 11932022.12.16

The Fed interest rates have been the center of attention for investors around the world. Why is this percentage so important that it seems like it can move the markets?

In this article, we'll explore the crucial importance of the Federal Reserve interest rate and its impact on the global stock market.

What Is The Fed Interest Rate?

When investors refer to the Fed interest rate, they are potentially referring to two different terms:

The federal discount rate

The federal funds rate

The Federal Reserve (called the Fed for short) is the central banking system of the United States. Two of their goals are ensuring stable prices and creating maximum employment.

To achieve that outcome, the Fed sets monetary policies which include the Fed funds rate and discount rate. The Federal discount rate is the interest rate the Fed charges banks that want to borrow money from them.

Investing 101: What Is An Interest Rate?

With every loan, there are some potential risks that the borrower may not repay the money. This is known as defaulting. To compensate lenders for that risk, there needs to be an incentive for them.

This incentive takes the form of interest. Interest is the amount of money that lenders earn when they make a loan that the borrowers repay. The interest rate is the percentage of the loan amount that the lenders charge to the borrowers.

By borrowing money, consumers can immediately spend money instead of saving up. The lower the interest rate, the more likely people are to make big purchases like houses and cars.

Let us now return to the main topic of the Fed interest rate.

Eight times a year, a Fed reserve committee examines key economic indicators like the consumer price index (CPI) and the producer price index (PPI). This committee is called the Federal Open Market Committee, or FOMC for short.

Based on this data, the FOMC decides whether rates should go up or down, or remain the same. As the largest economy in the world right now, the decision the FOMC makes has a huge influence on other countries and the world.

Each decision has large economic implications which we will explain later in this article.

Now, let us clarify the difference between the Fed funds rate, Fed discount rate, and Prime interest rate.

Comparing The Fed Funds Rate, Fed Discount Rate and Prime Interest Rate

The Fed funds rate is the target interest rate at which banks borrow and lend money to one another. This interest rate is set by the Fed.

Usually, the Fed funds rate tends to be lower than the Fed discount rate. This encourages banks to borrow from one another instead of the Fed reserve itself.

For consumers, the Fed funds rate determines the prime interest rate, which is the interest rate that commercial banks charge their most credit-worthy customers.

Generally, the prime rate is about 3% higher than the Fed funds rate. The prime interest rate also forms the basis for mortgage loan rates, credit card annual percentage rates (APRs) and other consumer and business loan rates.

With the different terms in mind, let's now go back to exploring the Fed rate and its effect on the stock market.

How Does The Fed Rate Affect The Stock Market?

Knowing the correlation between interest rates and the stock market would help investors better decide their portfolio allocation and growth.

By accounting for changes in the Fed rate and what it signals about the economic health, investors can decide how aggressive or defensive they want to be in their capital allocation.

This is because interest rates can affect the entire economy, including other assets like bond prices as well. The Fed rate can also have an effect on inflation and recessions.

When the Fed decides to adjust interest rates, different asset classes like stocks and bonds can be affected. Additionally, changes in the US economy can affect the global economy as well.

The Fed has two simple choices with complicated outcomes: they can either raise or lower.

Should they lower the rates, this is likely to happen:

Lowering rates makes borrowing money cheaper. When consumers pay less in interest, they have more money to spend.

This encourages consumers and businesses to spend more. It can create a ripple effect throughout the economy.

Businesses are likely to make larger plant, property and equipment investments as well. Done correctly, this increases the output of the business and helps them to grow.

From an investment standpoint, lower interest rates can cause stock prices to go up.

Lowering rates might also lead to problems like inflation and liquidity traps, which cause a different set of problems.

Should they raise the rates, this is likely to happen:

Raising rates makes borrowing money more expensive.

Higher interest rates mean that consumers have less disposable income.

This prompts consumers and businesses to spend less.

When higher interest rates are coupled with tighter regulation, banks tend to lend out less capital to businesses and consumers.

With less money to go around, businesses start becoming less profitable. This forces them to cut spending, slow down growth and might even lay off employees.

For investments, higher interest rates tend to cause company earnings and stock prices to fall (unless it's the financial sector).

Raising rates can potentially cause a recession.

Which Factors Influence The Fed Interest Rate?

The FOMC raises or lowers the interest rate based on key economic indicators. The indicators can include measures such as the core inflation rate and non-farm payrolls.

By analyzing these indicators, the FOMC can spot signs of recession, inflation, or other issues that may likely affect sustainable economic growth.

Based on their analysis, the FOMC will either head towards a hawkish or dovish policy. This naming is inspired by the hawks and doves.

Hawks In Monetary Policy

Hawks are usually supportive of raising the interest rates in order to keep inflation under control. They are willing to accept the consequences of slower economic growth, reduced spending and fewer jobs in the economy. In doing so, hawks aim to control the rising costs of living.

However, hawkish policies that lower inflation can also cause the economy to shrink. This can cut the number of jobs in the market and even lead to currency deflation.

Doves In Monetary Policy

On the other hand, doves prefer an interest rate policy that is more relaxed and leans towards lower interest rates. This helps to stimulate spending in the economy, promoting growth and increasing employment.

However, this can easily lead to uncontrolled inflation that ultimately hurts consumers within an economy.

Depending on the market conditions, the FOMC has to switch between hawkish and dovish monetary policies. Their role is to balance the goals of achieving stable prices while increasing employment.

They have to account for the current economic strength and other macroeconomic factors (e.g. war, climate change).

Pursuing both goals may require a balance of keeping a lid on inflation by tightening interest rates so prices are stable and easing interest rates to achieve maximum employment.

Case Study: The 2020-2021 COVID Pandemic

Back in 2020, the world was suddenly hit by COVID. This caused many countries to enter lockdowns, disrupting the supply chains and operations of many businesses.

For example, airlines and live event businesses saw their revenues plunge. Many had to let their employees go as well. During this time, the stock market plunged hard and fast from February to March 2020.

In response, the FOMC lowered rates and injected multiple economic stimuli into the economy. This was done to revive economic growth after COVID had affected the world.

With the increased amount of capital, more people started spending once again, causing the stock market to rally from April 2020 to Dec 2021. This was a period of unexpected growth.

However, the unexpected growth in the economy also caused inflation to surge to an all-time high. To curb the new problem of inflation, the FOMC had to introduce drastic rate hikes to bring inflation back under control.

As a result, 2022 has been an extended bear market, and the FOMC has indicated more rate hikes to come.

Start Investing With The moomoo App

By understanding how interest rates can help move the stock market, we can make sense of the volatile changes which have happened over the past three years.

This view of macroeconomics can help investors adjust their risk profile and expected returns based on the Fed's monetary policies.

With moomoo, you can get 24/7 global news so you can catch up with the latest financial news and trends. This includes the latest announcements on interest rates and FOMC meetings.

You can sign up and download the moomoo app here to get real-time information you need to make better investment decisions.

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