Interest Rate can impact the stock market. There are some links between interest rates and the stock market. The first, I want to explain about interest rate. Essentially, interest is nothing more than the cost someone pays for the use of someone else’s money. For example, people have to use a bank’s money (through a mortgage) to purchase a home, and they have to pay the bank for the privilege. It also happened when the credit card used. They borrow money for the short term in order to buy something right away. But, it is more than that. The term usually refers to something other than the above examples.
The interest rate that applies to investors is Central Bank’s funds rate (in the U.S we called The Fed, for example). This is the cost that banks are charged for borrowing money from Federal Reserve Banks. The number is so important because it is the way the Federal reserve attempts to control inflation. Inflation is caused by too much money chasing too few goods (or too much demand for too little supply), which causes prices to increase. By influencing the amount of money available for purchasing goods, the Central Bank can
control inflation. Basically, by Increasing the federal funds rate, the Fed attempts to lower the supply of money by making it more expensive to obtain.The Effects of an Increase. When the Central Bank increases the funds rate, it does not have an immediate impact on the stock market. Instead, the increased federal funds rate has a single direct effect, it becomes more expensive for banks to borrow money from the Central Bank. However, increases in the discount rate also cause a ripple effect, and factors that influence both individuals and businesses are affected.
The first effect of an increased federal funds rate is that banks increase the rates taht they charge their customers to borrow money. Individuals are affected through increases to credit card and mortgage interest rates, especially if they carry a variable interest rate. This has the effect of decreasing the amount of money consumers can spend. After all, people still have to pay the bills, and when those bills become more expensive, households are left with less disposable income. This means that people will spend less discretionary money, which will affect businesses’ revenues and profits.
Therefore, businesses are also affected by an increase in the federal funds rate as a result of the actions of individul consumers. But, businesses are affected in a more direct way as well. They, too, borrow money from banks to run and expand their operations. When the banks make borrowing more expensive, companies might not borrow as much and will pay a higher rate of interest rate on their loans. Less business spending can slow down the growth of a company, resulting in decreases in profit.
The Stock Price Effects. Clearly, changes in the federal funds rate affect the behavior of consumers and business, but the stock market is also affected. Remember that one methid of valuing a company is to take the sum of all the expected future cash flows from that company discounted back to the present. To get a stock price, take the sum of the future discounted cash flow and divide it by the number of shares available. This price fluctuates as a result of the different expectations taht people have about the company at different times.
Because of those differences, they are willing to buy or sell shares at different prices.
If a company is seen as cutting back on its growth spending or making less profit (higher debt expenses or less revenue from consumers) then the estimated amount of future cash flows will drop. All being equal, this will lower the price of the company’s stock. If many companies experience a decline in their stock prices, the whole market, or the indexes will go down (for example, IHSG).
Investment Effects. For many investors, a declining market or stock price is not a desirable outcome. Investors wish to see their invested money increase in value. Such gains come from stock price appreciation, the payment of dividens or both. With a lowered expectation in the growth and future cash flows of the company, investors will not get as much growth from stock price appreciation, making stock ownership less desirable.
Furthermore, investing in stocks can be viewed as too risky compared to other investments. When nthe Central Bank raises the federal funds rate, newly offered government securities, such bonds, often viewed as the safest investments. In other words, the “risk-free” rate of return goes up, making these investments more desirable. When people invest in stocks, they need to be compensate for taking on the additional risk involved in such an investment, or a premium above the risk-free rate. The desired return for investing in stocks is the sum of the risk-free rate and the risk premium. Of course, different people have different risk premiums, depending on their own tolarance for risk and the company they are buying. However, in general, as the risk-free rate goes up, the total return required for investing in stocks also increases. Therefore, if the required risk premium decreases while the potential return remains the same or becomes lower, investors might feel that stocks have become too risky, and will put their money elsewhere.
The interest rate has a wide and varied impact upon the economy. When it is raised the general effect is to lessen the amount of money in circulation, which works to keep inflation low. It also makes borrowing money more expensive, which affects how consumers and businesses spend their money. This increases expenses for companies, lowering earnings for those with debt to pay. Finally, it tends to make the stock market a slightly less attractive place to investment.
However, interest rate are not the only determinant of stock prices and there are many considerations that go into stock prices and the general trend of market. An increased interest rate is only one of them. The above just explain how the interest rate affect the stock market.
Citra Amanda
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