Interest rates play an important role in the economy of a country. When the Federal Reserve (Fed) changes interest rates, it impacts borrowing, spending, and investment. This, in turn, affects the stock market in the US and around the world. Let’s talk about how this works.
Table of Contents
What is Federal Reserve?
The Federal Reserve, also known as the Fed, is the central bank of the USA, which controls the interest rates for borrowing money. It creates monetary policies to influence the availability and cost of money. The Fed controls three tools of monetary policy:
- open market operations
- the discount rate
- reserve requirements.
What is the impact of Interest Rates on Economic Activities?
Borrowing Costs
When the Fed raises interest rates, borrowing money becomes more expensive. This means:
- Higher Loan Costs: Loans for buying homes, cars, and funding businesses become costlier. There comes a decline in the number of people availing this loan. And also comes the decline in the sales of the company dealing such products and services.
- Reduced Borrowing: People and businesses borrow less because loans are more expensive.
- Lower Spending and Investment: With higher borrowing costs, spending and investment decrease, slowing down economic activity.
Savings
Higher interest rates also make saving money more appealing:
- Higher Returns: Banks offer better interest rates on savings accounts and bonds.
- Increased Savings: People save more money instead of spending it.
Demand-Side Effects
When borrowing is costly and saving is attractive, people spend less:
- Reduced Spending: Less money is spent on goods and services.
- Lower Demand: Lower demand for goods and services can help control inflation.
Inflation Control
Higher interest rates help control inflation:
- Lower Prices: With reduced spending and investment, demand for goods and services decreases. This can help keep prices from rising too fast.
- Expectation Management: If people believe the Fed will control inflation, they are less likely to demand higher wages and prices, which helps keep actual inflation low.
Also Read – Inflation and CPI Explained – What’s the Effect on the Stock Market?
Impact on the US Stock Market
Higher interest rates can significantly affect the stock market in the US:
Lower Borrowing Costs
- Increased Expenses: Companies face higher costs for loans, which can reduce their profits.
- Lower Profits: When company profits decrease, their stock prices might go down.
Consumer Spending
- Reduced Spending: Higher interest rates mean people are less likely to borrow and spend money.
- Lower Sales: Companies sell fewer products and services, which can lead to lower stock prices.
Investment Decisions
- Bond Attraction: Higher interest rates make bonds and savings accounts more attractive than stocks.
- Stock Selling: Investors might sell stocks to invest in bonds, causing stock prices to fall.
Business Investments
- Fewer Projects: Companies might cut back on new projects or expansions due to higher borrowing costs.
- Slower Growth: Slower growth can make investors sell shares, leading to lower stock prices.
Market Sentiment
- Uncertainty: Higher interest rates can create uncertainty about the economy’s future.
- Market Volatility: This uncertainty can lead to more ups and downs in the stock market as investors react to news about interest rates.
Sector Impact
- Tech and Growth Stocks: Companies that rely on borrowing to grow can see their stock prices drop more sharply.
- Financial Stocks: Banks and financial institutions might benefit from higher interest rates because they can charge more for loans, potentially raising their stock prices.
Global Impact of US Interest Rates
1. Global Borrowing Costs
- Higher Costs for Companies: When the US raises its interest rates, the cost of borrowing money in US dollars goes up for companies all over the world. Many companies, even those outside the US, take out loans in US dollars because the dollar is a stable and widely used currency. But when interest rates rise, these companies have to pay more money back on their loans. This can reduce their profits because they have to spend more on interest payments. As a result, their stock prices might go down because investors expect lower profits.
2. Investment Flows
- Attraction to US Investments: Higher US interest rates make investments in the US more appealing. For example, US government bonds become more attractive because they offer higher returns. This means that investors from all over the world might move their money into US investments to take advantage of these better returns.
- Outflows from Other Markets: When investors move their money to the US, they often pull it out of other countries’ stock markets. This can lead to lower stock prices in those countries because there’s less investment money flowing into them. For countries that rely on foreign investments to grow their economies, this can be a big problem.
3. Currency Exchange Rates
- Stronger US Dollar: When US interest rates go up, the US dollar often becomes stronger compared to other currencies. This happens because higher interest rates attract more foreign investment into the US, which increases the demand for the dollar. A stronger dollar means that American goods become more expensive for buyers in other countries. At the same time, goods from other countries become cheaper for American buyers.
- Impact on Other Countries: Countries that export a lot of goods to the US may struggle when the dollar strengthens. Their products become more expensive in the US, so they might sell less. This can hurt their economies because they earn less from their exports. If these countries rely heavily on exports to the US, their stock markets might also suffer as their companies’ profits decline.
4. Market Sentiment
- Uncertainty: Higher US interest rates can create uncertainty in global financial markets. Investors might worry about how these higher rates will impact economic growth, not just in the US but worldwide. When investors are uncertain, they tend to be more cautious, which can lead to slower economic growth.
- Volatility: This uncertainty can also cause more volatility in global stock markets. Volatility means that stock prices can swing up and down more dramatically than usual. For example, if there’s news that the US might raise interest rates again, stock markets around the world could react sharply, either rising or falling depending on how investors feel about the news.
5. Trade and Commodities
- Higher Trade Costs: When US interest rates rise, it can become more expensive to finance international trade. Businesses that need to borrow money to buy and sell goods across borders might face higher costs, which can slow down global trade. This can be especially challenging for countries that rely heavily on exports.
- Commodity Prices: Many commodities, like oil and gold, are priced in US dollars. When the dollar gets stronger, it usually leads to lower prices for these commodities. This can hurt countries that export these goods because they earn less money for each unit they sell. For instance, if a country relies on oil exports, a stronger dollar might mean they earn less for each barrel of oil they sell.
6. Emerging Markets
- Capital Flight: Emerging markets, or developing countries, can be hit hard by rising US interest rates. Investors might decide to pull their money out of these markets and invest in the US instead, where they can get better returns. This outflow of money, known as capital flight, can cause problems for these countries because they lose the investment they need for growth.
- Currency Depreciation: When money leaves emerging markets, the value of their currencies can drop. This depreciation makes it more expensive for these countries to pay back loans that are in US dollars. If their currencies weaken too much, it can lead to a financial crisis because they might struggle to pay back their debts.
Conclusion
Interest rates set by the Fed have a broad impact. They influence borrowing, spending, and saving in the US. These changes affect the US stock market, with impacts on profits, consumer spending, and investment. Furthermore, US interest rate changes ripple across global markets, affecting borrowing costs, investment flows, currency values, and market sentiment. Understanding these relationships helps in making informed investment decisions.