When the feds raise interest rates, how does that affect the stock market?

Answer 1

It shrinks the money supply.

When interest rates rise it costs more for businesses to borrow money. It is standard operating practice for businesses to borrow a lot of money. When they want to expand they need to borrow the money first, then use the profits from the expansion to pay off the loan.

Tighten up the money supply and companies can’t borrow, and can’t expand as fast. This slows down business and causes the price for businesses; stocks to fall.

As the interest rate increases then the interest rate for other loan programs increases as well, they are all linked. So if treasury bills have a higher interest rate then it makes more sense to invest in them. Therefore when the interest rate increases people pull their investment money out of stocks and put it into loans and higher interest accounts.

The Federal Reserve sets the interest rates for the entire nation. They set the Prime Rate; that which a major bank would charge a major company. Few private individuals would ever see that rate. But, credit cards, bank interest, and everything else is tied to the Prime Rate. When the rate goes up so do those rates. That’s why the Federal Reserve is so careful when they change the interest rate. Lately they have been increasing it by one-quarter of a percent per 3 month quarter, or leaving it alone.

The recent rise in foreclosures and the rise in people losing their homes are due to the increase in the interest rate. These people bought their home with a variable interest rate that was set by the Prime Interest Rate. When the rate was low or falling that was a great idea, but now that the interest rate has been steadily increasing more people can’t pay their variable rate mortgage.

So why raise the interest rate at all. If you don’t’ then more and more businesses borrow more and more money and more of those businesses fail. If you are not careful then the number of failures could trigger a stock collapse. This is what caused the Great Depression. As those businesses fail their stock becomes worthless. Increase the failure rate, with easy loans, and you threaten the stock market by making some stocks worthless.

Answer 2

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