Therefore, the Interest rate is an essential tool that the Fed uses to influence the money market. It prohibits or encourages borrowing, determines the price of stocks, and could stifle or grow the economy. Also, interest rates determine the amount of money in the economy for spending and investing. Therefore, a country’s central bank uses interest rates to control economic activities. In particular, the Fed delivers its rake hike to control inflation and spur economic activities.
So when the fed feels that inflation is high, it raises the rate to discourage borrowing and spending. On the contrary, during deflationary periods, the bank lowers the rate to encourage spending. But hiking interest rates to curb inflation comes with economic ramifications. It slows down economic activities, increases unemployment, and can pull down the stock market. Read on to see how interest rate and stock markets relate and associated dangers.
Impact Of Interest Rate On Stocks
Interest rates and stocks have an inverse relationship. So, as the interest rate rises, the stock prices fall. On the contrary, when the interest rate falls, stock prices move up. However, stock markets react fast to changes in interest rates, even though it takes some time before the changes filter into the economy. What happens is that changes in interest rates, especially when they increase, make investors lower expectations about stock performance. So, when investors envisage that the returns they will get from stocks in the future will be low, they may decide to invest their money in bonds and government bills.
Ostensibly, treasury bills and bond prices rise as the interest rate increases. In the same breadth, high-interest rates imply that companies can only access credit by paying more. The rates eat into their revenue, making them unprofitable. So, very few investors get attracted to such companies, and so it brings their share prices down.
In the same breadth, when interests rise, companies borrow less, so their earnings grow at a low pace. It also increases the risk of investing in these companies; hence investors may opt to put their money in the less risky bonds, which further pulls down the prices of stocks.
Note that all other rates, interbank lending rates, and the rate banks charge on loans are connected to the central bank rate. So when the Fed increases the rate, it leads to a domino effect on all other charges. As a result, rising interest rate discourages people from borrowing. Besides, it weakens spending and helps to curb inflation.
Thus, other than discouraging people from investing in stocks, a rise in interest rates reduces the amount of money in circulation. Consequently, combining it with a high inflation rate makes it hard for people to afford the basics. It results in a situation where they have little or no money to spend on stocks. Therefore, a rise in interest reduces the demand for stocks and pulls the prices down.
High-interest rates pose challenges to the economy. It constricts economic activities and hurts business performance. For instance, the current high-interest rate has negatively impacted companies’ share performance in the S&P 500 category. So far, most of them have had their share prices fall despite reporting positive growth and increased earnings.
High-interest rates discourage borrowing and hence constrict investment. Also, high-interest rates reduce economic activities because it reduces the demand for goods and services. If left to persist, it can pull the economy into recession. A persistent high-interest rate increases unemployment and can sometimes result in unrest and political instability.
Generally, high-interest rates reduce economic activities by discouraging borrowing and investment. Furthermore, it slows down economic growth, and if left to persist, it can lead to recession. So the fed uses the tool solely to bring down inflation, and once the objective is accomplished, the rates are adjusted downward to spur economic growth.