The Impact of Interest Rates on the Stock Market

By Stock Research Pro • November 13th, 2008

The direction of interest rates is very important to stock market investors. In fact, the impact of interest rates is so important to investors that the market reacts to the direction it believes interest rates are going long before the Fed implements any changes. But while interest rates do affect the stock market significantly, it is not a direct affect.

Interest Rates Control the Flow of Money

Interest rates are used to control how money flows through the economy. Rates can be lowered to increase consumer spending and enable businesses to borrow money for expansion and other needs at a lower cost. Rates are raised when there are signs over an over-heated economy and inflation.

The interest rate that applies to investors is the federal funds rate- the cost that banks are charged for borrowing money from Federal Reserve banks. It is in managing this rate that the Federal Reserve attempts to stimulate the economy or control inflation, depending on the current economic climate. Changes in the rate cause a ripple effect for both individuals and businesses.

The Affect on Individuals and Businesses

For individuals, an increase in interest rate makes it more expensive to borrow money, affecting credit card and mortgage interest rates. Especially impacted are those carrying variable rates as their expenses fluctuate with the rate changes. The overall impact is a decrease in the amount of money consumers can spend. This decrease in discretionary money impacts consumer spending and has a negative impact in both the top and bottom lines of businesses.

But businesses are negatively impacted in a more direct way as the higher rates make it more expensive to borrow for expansion of operations.

A decrease in interest rates has the opposite affect, making it less expensive for individuals to borrow money for spending and less expensive for businesses to fund expansion. All of this is meant to stimulate economic growth and can have a positive impact of peoples’ perception of stocks as an investment. The decreased rates will also leave bond investors with less of an opportunity to make money and more likely to shift their investment to equities. This influx of money can help to drive up stock prices along with the newly stimulated economy.

More on interest rates, the economy, and the stock market


The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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