How do Fed rate hikes work and why do rumours of rate changes send the stock market into a frenzy? While the Federal Reserve’s decision to change their interest rates does not have any direct impact on stocks, the aftershock throughout the market can be huge.
Here’s a quick look at the history of Fed rate hikes and their relationship to the stock market.
The Fed 101
The Federal Reserve hasn’t been around forever. It was founded in 1913 by an act of Congress in order to help solve the banking panics that plagued the Gilded Age. Economic depressions like the Panic of 1893, the Panic of 1896, the Panic of 1907, and many more, were epidemic in the decades surrounding the turn of the century. The creation of the Federal Reserve provided greater supervision in general over U.S. banks and financial institutions, helping to stem these crises.
Formed as a “banker’s bank” and a government bank, the Federal Reserve provides loans, and regulation, to large U.S. banks. It also holds the U.S. Treasury’s checking account, sells and redeems U.S. bonds, and issues currency, among its many responsibilities.
The Chair of the Federal Reserve is a position nominated by the President of the United States and approved by the United States Senate. There have been 16 Chairs since its inception in 1913.
Fed Rate Hikes And The Economy
One of the responsibilities of the Federal Reserve is raising and lowering the federal funds rate, which is the interest rate for borrowing money from the Fed. Why does it change? Fed rate hikes can be used to control inflation, while lowering the rate can be used to encourage spending and stimulate the economy. The Federal Open Market Committee meet regularly throughout the year to make this decision, and decide on other fiscal policy.
The preferred federal funds interest rate is between 2% and 5%. Whenever this rate changes, it can have a big impact on the economy. That’s because any rate change begins a trickle-down effect from the Federal Reserve bank (the “banker’s bank”) to businesses and everyday consumers as consumer banks adjust their own rates to reflect the new rate changes from the Fed. Business loans become more expensive, as do credit cards and mortgages. As a result, people and businesses have less discretionary spending money. This can slow economic growth overall.
How Fed Rate Hikes Impact Stocks
On top of the economic impacts, rate changes can also hurt or help the stock market. During rate hikes, for example, the combination of more expensive loans and less consumer spending means that businesses might report lower than expected earnings the following calendar quarter. Plus, higher debt expenses and lower revenue also mean less cash flow, which can itself lower stock price. When many companies are suffering these effects together, that can bring down the market as a whole. Utility and real estate stocks tend to take the biggest hits during a Fed rate hike.
On the other hand, some stocks can actually benefit from Fed rate hikes. Financial stocks, like banks, insurance companies, and mortgage companies, can charge more for lending and make more money.
Expectations also play a big role. If the public expects a big rate hike, and the Fed comes out with a small one, that can have a positive impact on the market.
A Few Examples
Historically, Fed rate hikes and decreases have played a big role in the direction of the stock market. For example, following the 2008 crash, the Fed rate was lowered to almost zero for seven years. This was meant to encourage spending and stimulate the economy during the recession.
The highest Fed rate in history occurred from 1979 to 1980 when it was raised to 20%. This was an attempt to control rampant inflation, which had recently tripled. This huge Fed rate hike led to a recession in 1980, but eventually solved the runaway inflation problem.
In conclusion, although Fed rate hikes don’t directly impact the market, they can have big influence on what happens to it. While Fed rate hikes can hurt consumers and provoke recessions, when used strategically they can help control inflation numbers and stimulate economic growth.