The Federal Reserve, also known as ‘The Fed’ is considered the central bank of the United States. Its mission is to keep the U.S. economy operating at its most efficient capacity. It was created by the Federal Reserve Act of 1913. There are twelve regional Federal Reserve Banks throughout the US however it is headquartered in Washington, DC. The current Chairman is Jerome Powell.
Interest rates are dictated by the Federal Reserve through voting by the FOMC – the Federal Open Market Committee. The FOMC consists of 12 people, seven members of the Board of Governors, the President of the Federal Reserve Bank of New York and four other Federal Reserve bank presidents.
This group is responsible for setting monetary policy by voting whether the interest target range is appropriate in helping to achieve maximum employment and price stability. The target rate is known as the Federal Funds rate and is used by banks and other depository institutions to lend money to one another overnight.
Inflation is the increase of anything that’s consumed. When inflation rises it decreases the buying power of consumers. If wages are not keeping up with inflation people have less money to spend on the purchases they need to or would like to make.
Whenever the Fed decides to adjust interest rates, there is a cause. There have been instances where years have gone by without a rate adjustment and then there are years where multiple announcements are made raising or lowering rates.
The impact of The Fed on the economy and stock market for that matter, simply cannot be overstated. By raising interest rates, they want to make borrowing money more expensive. It also encourages people to save money. Additionally, as less money circulates in the economy, most economic activity such as large purchases decreases, and home buying slows considerably.
When it comes to the stock market most investors don’t welcome rate hikes. The reasoning is not as complex as one might feel – when the cost of borrowing money increases companies is not too eager to add financing to expand and grow their business. This leads to lower revenues that affect profitability. The outcome here is by lowering expectations for future returns and growth will generally cause investors to sell their positions as they look for other more profitable places to put their money. This leads to lower stock prices and cycle of almost self-fulfilling prophecy ensues where the markets begin to lose value.
Conversely please note that there are certain sectors in the market that outperform the market in general due to rising interest rates. They may or may not make a profit, however any downturns in that sector will not be as severe as the market as a whole. These sectors could include financial institutions like a bank where the opportunity to become quite profitable in a higher interest rate environment is possible.
Rising interest rates are not kind to the Bond Market generally. A rule of thumb is that when interest rates rise, bond prices lower. When interest rates lower, bond prices increase. If someone is invested in a portfolio more exposed to bonds (hopefully the investor is fully aware of this) it is advisable to consider alternatives.
It is important to keep in mind that the reason interest rates are allowed to increase causes less money to circulate in the economy which creates slower economic growth and less inflation.
