Last month, the Fed increased the interest rate by three-quarters of a percentage point for the fourth time this year as it works hard to curb the rampant inflation. The goal is clear, the institution is seeking to slow down overall demand in the economy, and hopefully, this will slow the price growth. The tough measures have had to be taken as prices of goods and services hit an all-time high over the past four decades. The Fed notes that “spending and production have softened while job gains are strong and the unemployment rate is low despite the inflation.”
What isn’t clear among economic analysts is if the Fed will be able to balance lower price growth while avoiding broader economic damage. Some worry that the high inflation rate at a four-decade high and the gross domestic product that has contracted over the past two quarters might spell a recession. However, only the National Bureau of Economic Research has the power to make such a statement.
Normally, when the Fed raises interest rates, the larger impact on the economy should be felt after 12 months. However, this isn’t the case for some sectors, such as the stock market. Interest rate and stock markets have an interesting relationship as the impact is felt immediately as markets try to price based on what they expect will be the impact of price hikes. As an investor, you stand to make better decisions in the market if you have a better understanding of the relationship between the two.
The Fed sets the federal funds rate and the discount rate. The rate that impacts the stock market is the federal funds rate which is the interest rate that depository institutions such as banks and credit unions charge each other for overnight loans. On the other hand, the discount rate is the interest rate the Fed charges banks that borrow from it directly. This discount rate is higher than the federal funds rate to encourage banks to borrow from other banks at the lower federal funds rate.
The Fed is responsible for influencing the federal funds rate to combat inflation. So, whenever the Fed increases the federal funds rate, which has been the case this year, the institution is trying to reduce the supply of money that is available to make purchases. Consequently, money becomes more expensive to obtain. The opposite is true; a lower federal funds rate increases the money supply, encouraging spending and making it cheaper to borrow. If you are not based in the US, your central bank will undertake this role.
That said, you need to understand that the federal funds rate plays a crucial role, especially regarding the prime interest rate commercial banks use to charge their most credit-worthy customers. The rate also plays a role in other consumer and business loan rates.
As mentioned earlier, high-interest rates make borrowing expensive. Imagine a company decides to cut back on its growth or becomes less profitable due to high debt expenses or less revenue. Its cash flows are likely to suffer, negatively impacting the company’s stock. If such scenarios are witnessed across other companies, the whole market will likely tank as expectations dim. Many investors will be unwilling to buy stocks. Also, few will be ready to get into equities which can be deemed too risky compared to other investments.
But it’s not all doom and gloom. Some sectors get to benefit in times of high-interest rates. One such sector is the financial industry. Higher rates mean more profits for banks, brokerages, mortgage, and insurance companies that get to charge lenders more. Investing in the tech and healthcare industries can also bring better earnings since companies in both sectors tend to keep most of their profits and invest in growth opportunities. Additionally, bonds with short-term maturity dates can help hedge volatility in your investment portfolio.