How changes in benchmark interest rate affect your investments

For good reason, the investment community and financial media obsess over interest rates. The cost of borrowing someone else’s money is referred to as interest rates.

When the Federal Open Market Committee (FOMC), which consists of seven Federal Reserve Board governors and five Federal Reserve Bank presidents, sets the target for the federal funds rate—the rate at which banks borrow from and lend to one another overnight—it has repercussions throughout the United States, including the stock market. While a change in the interest rate normally takes at least a year to have a wider economic impact, the stock market’s reaction to a change is sometimes much faster.

The Federal Reserve also sets a discount rate in addition to the federal funds rate. The discount rate is the interest rate that the Federal Reserve charges banks that borrow directly from it. This rate is usually greater than the federal funds rate objective (in part, to encourage banks to borrow from other banks at the lower federal funds rate).

IMPORTANT TAKEAWAYS

The economy and stock markets are both affected when the Federal Open Market Committee (FOMC) raises the interest rate because borrowing becomes more or less expensive for individuals and corporations.

Any influence on the stock market from interest rate increases is often felt immediately, although any widespread impact on the rest of the economy may take up to a year to manifest.

Higher interest rates have been shown to have a detrimental impact on earnings and stock values (except in the financial sector).

Understanding the relationship between interest rates and the stock market can assist investors in determining how changes in both variables may affect their assets. They may also be better equipped to make more informed financial decisions.

The Federal Funds Rate is the rate at which the government borrows money

The federal funds rate is the interest rate that has an impact on the stock market. The federal funds rate is the interest rate that depository institutions—banks, savings and loans, and credit unions—charge each other for overnight loans (whereas the discount rate is the interest rate that Federal Reserve Banks charge depository institutions when they make collateralized loans, usually overnight).

To keep inflation under control, the Federal Reserve manipulates the federal funds rate. The Federal Reserve is effectively seeking to reduce the amount of money available for purchase by raising the federal funds rate. As a result, money becomes more expensive to obtain. In contrast, when the Federal Reserve lowers the federal funds rate, the money supply expands. This increases spending by making borrowing more affordable. Other countries’ central banks follow similar patterns.

The federal funds rate is crucial because it is mostly based on the prime interest rate, which is the interest rate that commercial banks charge their most credit-worthy customers. Mortgage loan rates, credit card annual percentage rates (APRs), and a variety of other consumer and corporate loan rates are all based on it.

Final Thoughts

Although interest rates and the stock market have a skewed relationship, they tend to move in different ways. When the Federal Reserve lowers interest rates, the stock market rises; when the Federal Reserve raises interest rates, the stock market falls. However, no one can predict how the market would react to a change in interest rates.