“What happens to interest rates?” “Where does the prime minister go?” “Is the Fed announcing a rate hike next month?”
Interest rates, expenses that someone pays to use other people’s money, tend to gain the investment community and financial media — and not without reason.
When the Federal Open Market Committee (FOMC) sets a target rate for rates on federal funds at which banks take loans and provide loans to each other, it has a ripple effect throughout the US economy, not to mention the US stock market.
And, although it usually takes at least 12 months for any increase or decrease in interest rates to be felt in a widespread way, the market reaction to the change (or news of the change) is often more direct.
Interest rate affecting stocks
The interest rate that moves markets is the federal funds rate. Also known as an overnight rate, this is the cost that depository institutions charge for borrowing money from the banks of the Federal Reserve — so to speak, an interbank lending rate.
The federal funds rate is how the Fed is trying to control inflation (price increases caused by too much money chasing too few goods: demand outstrips supply). Basically, by increasing the rate of federal funds, the Fed is trying to compress the supply of money available for purchases or things, making money more expensive to receive. Conversely, when it reduces the rate of federal funds, the Fed increases the money supply and, making it cheaper to borrow, encouraging costs. The central banks of other countries do the same for the same reason.
Why is the number that one bank pays another so significant? Since the basic interest rate or basic credit rate is the interest rate that commercial banks charge from their most worthy customer loans, it is largely based on the rate of federal funds. And the main condition is the basis for mortgage rates, APR credit cards and many other rates on consumer and business loans.
What happens when interest rates rise?
When the Fed increases the federal funds rate, it does not directly affect the stock market. The only truly direct effect is that banks become more expensive to borrow money from the Fed. But, as noted above, an increase in the federal funds rate has a ripple effect.
First ripple: because they are better off taking money, financial institutions often increase the rates they charge their customers to take money. People suffer from higher interest rates on credit cards and mortgages, especially if these loans carry a variable interest rate. This leads to a decrease in the amount of money that consumers can spend. In the end, people still have to pay bills, and when these bills get more expensive, households are left with lower disposable income. This means that people will spend less discretionary money, which will affect the upper and lower positions of enterprises (that is, income and profit).