Stocks obey the basic economic laws of supply and demand. When demand is high, prices rise but when demand drops, prices go the opposite direction and drop. When Federal Reserver Chairman announced it will increase federal funds rate .75% to 3 1/4% on September 21 2022 and will likely need to continue to increase the rate in next FOMC meeting, stocks dropped. The Federal Reserve is using higher interest rate to tame a 40 year high 8% inflation rate. Higher interest rate has many effects on the economy.
As earnings on savings accounts go up with interest rate, one effect is that it makes these non risk savings accounts more desirable when compared to stocks which bear risk. Consumers and money managers will adjusts their allocation and move some money that was invested in stock to bonds, savings accounts or certificates of deposits. This movement away from stocks reduces its demand and thus lowers its prices.
Higher interest rate also reduces demand for housing, cars, expensive appliances and the high ticket items that are often purchased with a loan. As interest rate goes up, the monthly payment increases significantly. As the net effect of the total purchasing cost goes up, the demand drops and prices fall. The fall in price reduces inflation which aligns with the Federal Reserve’s monetary policy goal. The drop in demand affects sales for companies directly involved with these big ticket items as well as companies not directly involved. Automobile manufacturers will have lower sales. Home builders and mortgage companies will see fewer customers. Home improvement and electronics retailers sales will drop as a result of fewer home being sold and less demand for new TV and appliances.
Consumers that have credit card balance will experience higher interest payments. This lowers their spending power and they will go out to restaurants less frequently, take fewer air travel trips, book fewer hotels, and make fewer purchases on discretionary products. Companies involved in travel such as hotels and restaurants are impacted. Consumer electronics will see fewer customer upgrade to the latest version.
Interest rate has direct impact on the economy. A rise in interest rate reduces economic activity and lowers stock prices as companies experience drop in revenue. Once inflation is under control and the job demand and supply is in balance, the interest rate can be adjustment lower. Lowering interesting will do the opposite and increase economic activity. When that happens the economic cycle will reverse and corporate revenue will be in the upswing.
Reference:
September 21, 2022 Federal Reserve issues FOMC statement https://www.federalreserve.gov/newsevents/pressreleases/monetary20220921a.htm