What Increasing the Federal Funds Rate Means for the Stock Market

Since the Great Recession rocked the U.S. and world economy in 2007, the federal funds rate in the U.S. has been at or near zero, falling from its pre-recession level of 5.25%. The hallmark of post-recession years has been the Fed’s strict adherence to low interest rates for fear that raising them could send the United States back into a recession.

But now, this period may finally be coming to an end. For the first time in nine years interest rates may be set to climb as Janet Yellen announced at the Fed’s annual Jackson Hole meeting two weeks ago that the Fed is likely to increase interest rates in the coming months.

In Jackson Hole, Wyoming the Fed Chair expressed optimism about the economy and believes businesses are prepared to deal with increased interest rates. Pessimists who disagree with this strategy point to the Fed’s attempt to raise the federal funds rate last December only to have the economy slow down as businesses suffered from higher costs. While optimists like Yellen believe the economy is ready for a higher rate and expect that higher interest rates will help stabilize employment and inflation.

This debate highlights the fact higher rates are certain to have consequences on the U.S. and world economy but it’s tough to tell exactly what those consequences will be. Though the direct effects of higher interest rates are known, the broader effects interest rates have on the economy at large can be hard to predict and economists and financial experts alike are in debate what the impending rate hike could mean for the economy.What makes this issue particularly challenging is that the federal funds rate affects many areas of the economy.

One area that will surely be impacted is the stock market which has already been hurt just by the potential for an increase. Here are the basics you need to know about the federal funds rate, the stock market, and what it could mean for the economy.

Generally the Fed raises the federal funds rate by decreasing the amount of money in circulation effectively heightening the demand for money. The direct effect of this is that it will be more expensive for banks to borrow money from the Fed and from each other. It will also be more expensive for consumers to buy a house or car and more costly for businesses to operate as their costs for renting and borrowing will increase.

There are obviously advantages to raising the federal funds rate, notably stabilizing inflation and employment, however economies run the risk of heading towards a recession if businesses slow down and consumption falls. These are some of the current issues the Fed is considering when determining whether or not to raise the federal funds rate.

Another impact to consider is that raising the federal funds rate dis incentivizes investment in the stock market for two reasons: 1) it increases the interest on debts companies have to pay and 2) increases the return of government securities and Treasury bills in relation stocks. Therefore the impending federal funds rate increase has investors worried.

If interest rates rise companies with debts to pay could face increased expenses and potentially lower revenue as their debt becomes more difficult to pay off. This could lead to lower cash flow and consequently lower stock prices. Combine this with potentially better returns from other investment opportunities and its no wonder that demand for stocks has fallen at remarkably high rates (no pun intended) over the past month.

The S&P 500 has fallen more than 2% since Yellen made her announcement while the Nasdaq dropped 1.75% in the same time. Stock selloff is not only happening in the U.S. In Japan, the Nikkei index has fallen 1.46% the past month with the FTSE in England falling 3% in that time. More striking the Chinese index, Shanghai SE Composite, has fallen 2% just in the month of September.

If the federal funds rate rises stock prices are sure to continue falling though no one knows how far or for how long. Though the stock market is not always a reliable barometer of the economy, a weakening market is seldom a good sign. What worries economists is that a dramatic decrease in global markets could cause recessions around the world. Compounded with a potential for a decrease in consumer and business confidence, tumbing markets would surely lead to an economic slowdown and possibly another recession.

Though the stock market cannot tell us a lot, much less everything about the economy, the fact it will not fare well if the federal fund rate is increased may be foreshadowing of what will happen to the larger economy. And this is enough to have even optimists a little concerned.

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