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The Fed Funds Rate and How it Impacts the Stock Market

By Jane Young, CFP, EA 

The Federal Reserve is the central bank of the United States. It has two primary jobs, to maintain stable prices and support maximum employment. The Federal Reserve (Fed) was formed by Congress in 1913 to keep the U.S. economy running smoothly. The federal funds rate is one of the primary tools that the Fed uses to maintain stable prices and manage inflation.

The federal funds rate is the target interest rate that banks charge each other for overnight loans. A change in the federal funds rate ripples throughout the economy influencing how much consumers and businesses pay to borrow and how much investors can earn on bank accounts, CDs, and bonds.

The Fed seeks to maintain an annual inflation rate of 2%. Due to an imbalance between supply and demand, U.S. inflation rose to 8.5% in March, the highest annual rate since 1981. This was largely driven by accelerating costs for food and energy. With inflation at a 40-year high, many economists believe the Fed is behind the curve and has been slow to address rising inflation. To help curb inflation, the Fed increased interest rates by .5% in May and is expected to raise rates several more times this year.

The Fed hopes to cool down the economy and decrease inflation by influencing rates on mortgages, credit cards, car loans, and business loans to decrease demand and slow down the flow of money.

Higher interest rates reduce profit margins resulting in lower stock prices. The higher cost to borrow, increases operational expenses and discourages capital expenditure needed to fuel growth. Additionally, as consumers experience higher borrowing costs, demand for goods and services decreases.

A federal rate increase can also negatively impact consumer confidence. Due to a drop in confidence and the opportunity to earn more interest on certificates of deposits (CDs) and bonds, risk averse investors are likely to move money from the stock market to interest earning options.

Over the last four decades, interest rates and inflation have been relatively low. This was a favorable environment for the stock market. With low interest rates, investors had limited investment options outside of the stock market. As interest rates increase, CD’s and bonds may become more attractive.

Despite the challenges facing the stock market due to rising interest rates, equities remain a key component of your portfolio. The market will undoubtably experience tremendous volatility over the next year and equities are unlikely to provide double digit returns, as we have seen over the last few years. Stock performance will vary by industry. Stock in high growth technology companies, with a strong focus on future projects, is likely to be the most severely impacted by rising rates.

Stick to the fundamentals. Maintain a well-diversified portfolio that supports your financial goals, investment timeframe and tolerance for risk. It is all about balance and over time, returns on equities and interest earning investments should return to reasonable levels.