How Do the Fed Decisions Affect the Markets?

The U.S. Federal Reserve is tasked with managing monetary policy, moderating inflation and promoting healthy employment levels. To accomplish these tasks, the central bank often turns to manipulating the federal funds rate. But these rate decisions don’t just impact consumers: they also affect the markets.  

What is the federal funds rate?

The federal funds rate, or FFR, is the Fed’s primary tool to fight inflation and promote economic growth. 

The FFR is the interest rate that banks charge each other for overnight loans. As the FFR moves, other rates (like credit card and mortgage rates) tend to follow. 

Broadly speaking, a rising FFR increases borrowing costs for consumers and businesses. (Sometimes referred to as “shrinking the money supply.) Higher financing costs discourage lending and spending, which slows economic growth. 

By contrast, a falling FFR decreases borrowing costs. (Often referred to as “increasing the money supply.) As consumer and business credit gets cheaper, an uptick in borrowing and spending stimulates the economy.  

How do the Fed decisions affect the markets?

The stock market and economy aren’t the same, but they are closely linked. Naturally, that means that Fed decisions impact investors alongside consumers and businesses. 

When the federal funds rate rises

As the FFR rises, the cost to finance business growth, auto and home purchases, and borrow on credit cards grows. Decreased consumer spending and business activity shrinks corporate profits and leads to layoffs and consumer pessimism. (And, hopefully, lowers inflation.) 

In turn, stock prices may drop as investors dump higher-risk assets for defensive positions. Sectors like consumer staples and finance, dividend-paying stocks and fixed-income assets like bonds often perform well in these periods. Meanwhile, the broader market may experience price swings or slip into bear country. 

When the federal funds rate falls

Conversely, a falling FFR means that the cost to finance business growth and consumer lending products gets cheaper. Increased consumer spending and business activity (hopefully) sparks economic growth, including rising business profits, expanding real estate activity and even venture capitalism.   

In response, investors typically move into higher-risk assets to capitalize on future growth potential. The influx of funds into stocks and high-growth assets like tech and small-cap securities may spark a price boom as interest (and prices) grow. 

At the same time, fixed-income assets may experience an exodus as savings accounts and newly-issued bonds offer lower interest rates. 

The power of expectations

Sometimes, just the specter of Fed decisions can be enough to dampen or lift consumer spending and asset prices.

For instance, when investors expect a 0.50% rate hike, asset prices can drop preemptively to “price in” the expectation. Then, when the rate hike actually occurs, markets may move only marginally, as current prices already reflect the change. 

But these same expectations can lead to price spirals, particularly when investors fear an upcoming recession. If investors grow concerned enough about Fed decisions, they may abandon higher-risk assets en masse, sparking market volatility and increased demand for “safer” assets.  

What this means for investors

It’s important to remember that Fed decisions impact the market short-term. But investing isn’t about the sprint: savvy investors know that wealth-building is a slow and steady process. 

With a diverse mix of AI-backed Investment Kits for every risk tolerance, Q.ai can help position your portfolio for the long-term success you deserve – no matter what Fed decision comes next.