Updated: Aug 7, 2019
Donald Trump has recently came out against the Federal Reserve saying that interest rates are too high. While Donald Trump’s statements usually get met with highly polarized reactions, his stance is common among past presidents. Disputes with the Federal Reserve and their interest rate policies go back as far as Lyndon B Johnson and Richard Nixon. So what does it mean when the Federal Reserve changes interest rates? How does it affect the economy and the stock market? Here is the 1,000 foot view of how interest rates work.
The Federal Reserve controls the discount rate which indirectly impacts the federal funds rate. What the federal funds rate does is set the rate banks charge other banks for lending out their excess reserves. This federal funds rate also heavily influences something called the prime interest rate. Prime interest rate is what banks charge their most creditworthy borrowers for certain short term loans. The federal funds rate affects the prime interest rate, and the cascade effect goes on from there. These rates influence rates of things like car loans, credit cards, home equity loans, CDs, savings accounts, and business loans. So essentially federal funds rate changes find their way to the rest of interest rates products available to consumers.
So how does this impact the economy?
When interest rates are lower it makes borrowing for consumers easier. This can allow businesses to make large equipment purchases and other capital expenditures to grow their business and increase productivity. Individuals also benefit by having to pay less interest every month. The lower interest rate expense causes consumers to have more disposable income that they can spend. With the increased in business expenditures and spending by individual consumers, this usually causes the economy to expand. When interest rates are higher, the exact opposite happens. Businesses and individuals often invest and spend less and the economy starts to slow down.
Before you ask “Why don’t we just always keep interest rates low so the economy always grows?” it is very important to note that low interest rates over a long period of time can lead to inflation. High amounts of inflation can cause major problems for the economy and individual consumers. The Federal Reserve’s number one objective is supposed to be controlling inflation. This is the reason interest rates can’t stay low forever.
How do interest rates impact the stock market?
When interest rates are low, the economy is growing as a result of increased productivity, causing the stock market to rise. When interest rates are higher and the economy is slowing, the stock market declines. This is not the only reason lower interest rates positively impact the stock market. When individuals are trying to find a place to invest they have to evaluate the risk of the stock market with what rate of return they can get with less risky assets. When savings accounts and CD rates are paying virtually nothing, investors will be more likely to take on the risk of the stock market to generate returns. If CDs and savings accounts are paying high rates, investors will be more likely to place their money into these savings vehicles as opposed to taking on the risk of the stock market. When money flows into the stock market, it drives the stock market up. When money is leaving the stock market and going into less risky assets, this drives the stock market down.
There are obviously multiple factors outside of interest rates that impact both the stock market and the economy. However interest rates can impact both the economy and the stock market fairly significantly. As a result of this, interest rates are often a hot topic among presidential administrations and will continue to be one as we head towards the next election.
The information on this site is provided “AS IS” and without warranties of any kind either express or implied. To the fullest extent permissible pursuant to applicable laws, Recker Financial LLC (referred to as "Recker Financial") disclaims all warranties, express or implied, including, but not limited to, implied warranties of merchantability, non-infringement and suitability for a particular purpose. Recker Financial does not warrant that the information will be free from error. None of the information provided on this website is intended as investment, tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. Under no circumstances shall Recker Financial be liable for any direct, indirect, special or consequential damages that result from the use of, or the inability to use, the materials in this site, even if Recker Financial or a Recker Financial authorized representative has been advised of the possibility of such damages. In no event shall Recker Financial LLC have any liability to you for damages, losses and causes of action for accessing this site. Information on this website should not be considered a solicitation to buy, an offer to sell, or a recommendation of any security in any jurisdiction where such offer, solicitation, or recommendation would be unlawful or unauthorized.
Recker Financial LLC (“Recker Financial”) is a registered investment adviser offering advisory services in the State(s) of Michigan and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by Recker Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption.
All written content on this site is for information purposes only. Opinions expressed herein are solely those of Recker Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.