How the Fed Affects Stock Prices

The federal agency that has the highest effect on national stock prices is the Federal Reserve Board’s Open Market Committee. This committee determines the federal funds rate and this rate has implications for both economic performance – and in turn stock prices – in the United States (and abroad).

The Open Market Committee meets eight times a year and at these meetings, targets for the federal funds rate are identified. This target is either reduced, increased or it remains unchanged. The decision made by the committee is usually taken as an indication of whether access to credit will be cheaper or more expensive. With a higher rate, interest rates across the country will increase, whereas interest rates fall when the rate is adjusted downwards.

Banks across the United States follow the committee’s decisions closely. The decision made by the committee is thereby usually taken into consideration when these banks set their interest rates. Banks are affected by the federal funds rate because that rate equals the interest rate banks charge when they loan credits to other banks. When the costs associated with acquiring credits increases, banks have incentives to increase the interest rate the bank’s customers are charged for loaning money from the bank.

The market response to the federal funds rate
When interest rates across the country fall, businesses and individuals become more likely to loan money from banks because the costs associated with the loan are lower than what they would be with a higher interest rate. Lower prices thus raise the demand of loans. This in turn also improves the national economy since higher access to credits leads to increased aggregate demand. Raising or lowering the federal funds rate is thus closely related with the committee’s judgement of whether the economic growth is high enough, too high or not high enough etc.

The effect the committee’s decision has on the national aggregate demand means that the rate also has implications for the national stock market. The stock market responds to the economic situation in a country and when the federal funds rate is reduced, it is therefore likely that the stock market response is more positive than when the rate is increased. Since the committee’s decision has profound implications, however, the market attempts to anticipate what the committee will do, and very often, what the committee decides corresponds with the anticipated act. In this case, the stock market response comes in advance to the actual decision since the stock market gradually adjusts to what it anticipates. When the stock market fails to anticipate the committee’s actions, however, the result can be very different, with chaos and high fluctuations at stock exchanges.