Question: Why are the Federal Reserve’s recent interest rate hikes of such concern to the stock market?
Answer: Wall Street has paid very close attention to the Federal Reserve and its interest rate policy this year because of the effect rates can have on the economy. A strong economy means higher corporate profits, and thus higher stock prices and better returns. A weaker economy, of course, means the opposite.
The Fed uses interest rates to combat inflation by raising short-term interest rates, which makes the cost of borrowing more expensive. That means companies will pay more for the capital they need to grow and expand, and consumers will pay more on their credit cards and other variable-rate loans.
“The average household only has a certain amount of money,” said Ken Tower, chief market strategist for Charles Schwab &Co.’s Cybertrader unit. “If more of it needs to be spent on debt repayment, less is available to go shopping or out for dinner, or for any number of other things.”
Because both companies and consumers will essentially have less money to work with due to higher borrowing costs, demand will lessen and prices will remain stable.
The danger, however, lies in the fact that because spending will, in theory, be curtailed, the overall economy won’t grow as fast. Less spending means companies will sell less products, and profits will fall. And if corporate profits fall, the companies’ stocks won’t be worth as much, prompting investors to sell and driving the market lower.
Right now, the economy is growing, but has slowed somewhat in 2005 and is expected to slow even more in 2006. That’s not just because of interest rates, either – record-high oil prices this year have increased prices across the board, from energy to raw materials, for example.
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