In this post we’ll go over how low interest rates boost the economy and the stock market.
The Federal Reserve is currently in a rate hiking cycle (hawkish), which is expected to terminate some time next year with the fed funds rate having been moved to about 2.75% – 3.00%. This is a moving target, however, so don’t expect the current target terminal rate and timing for reaching that rate to remain unchanged.
Following the last financial crisis, the Federal Reserve lowered the fed funds rate (dovish) to 0.00% to stimulate the economy.
Why are low interest rates stimulative (or accommodative, to borrow from Fed parlance)?
Low interest rates stimulate the economy because 70% of the economy is consumer spending, and lower interest rates encourage individuals and businesses to borrow to purchase goods for consumption and to grow their businesses.
This increased consumption reduces unemployment, and, in theory, should boost inflation.
Low rates also boost the stock market in a number of ways.
First, by encouraging spending, low rates increase business income to public companies, which leads to higher stock prices as investors assign higher stock values to companies when earnings are growing.
Second, low interest rates encourage stock buy-backs, which occur when companies buy back their own stock and thereby reduce the number of shares outstanding, which results in higher share prices because there is the same shareholder equity over a smaller amount of shares.
Third, low interest rates encourage investors to move more funds into the stock market, thereby bidding up stock prices, because yields on alternative investments such as bonds and savings accounts are low when the Fed cuts rates. Cutting rates lower yields on existing bonds because bond prices of previously existing bonds go up until the yield on those bonds matches the new, lower bond yields. Savers and bond investors may feel pushed into the stock market in what is called a “hunt for yield.” In this way low rates can encourage risk-taking behavior.
In summary, low rates affect more than just consumer spending. Low rates alter company, investor, and saver behavior as well.