Today’s surprise Fed cut of 0.75% to the federal funds rate was a bit of a shocker considering that it was a very large cut. Normal changes to the this rate are usually 0.25% or 0.5%. While there is certainly a risk of recession in the US, it doesn’t seem so inevitable that a large cut is all that necessary. Given the timing of the reduction and the dropping markets overseas while the US markets were closed yesterday, it’s hard not to think that maybe the Fed was managing the markets rather than the economy. To a lesser extent, the same argument applies to the Bank of Canada which lowered its rate by 0.25%.
And now a related reader question! (no pun intended)
I got an email today from a faithful reader (my wife no less) asking what the relationship between the government lending rate and the markets. Not being an economist or having much economic training of any type I thought this would be an interesting one to tackle.
My answer
The government lending rates are used to try to control the economy and inflation (not the stock market).
The idea is that if lending rates go higher, that will put a damper on economic activity ie business spending, expansion etc. So if the economy was going “too well” and inflation was creeping up then the government will raise lending rates to slow the economy down and keep inflation in check.
The opposite is also true – if the economy is slowing down and a recession looks like it might occur then the government will lower rates to try to stimulate the economy by encouraging businesses to spend more.
How this affects the stock market is sometimes not all that clear, but generally speaking if lending rates get lowered then that provides an upward push on the markets because the risk of a recession is less (in theory). An increase in the lending rate should create a downward pressure on the market for the opposite reason.
The stock market is supposed to be valued according to the future earnings of the companies in said market, so if there is a recession then future earnings will be lower and the market will go down. If the economy is ‘hot’ then future earnings should be good so the market will go up.
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I’m no economist either but thought I’d point out the Bank of Canada (like the Fed and other central banks) is an arms-length agency, not influenced by the government of the day. While the Bank of Canada holds the monetary lever, the government holds the fiscal lever. The government of the day can decide to boost economic activity by cutting taxes (like President Bush is trying to do now), ramping up spending etc.
There is a saying on Wall Street: “Don’t fight the Fed”. It means that when the Fed is easing monetary policy, stock prices will generally go higher and vice versa.
It will be interesting to see if there will be further moves by either government to stimulate fiscal policy.
Mike
I agree with many of the points in this post about how lower interest rates prop up the economy by encouraging spending by businesses (and I would argue consumers) who are willing to borrow to purchase goods and services. Here’s my theory on why the markets go up when interest rates are lowered.
Equities become more attractive to investors that are looking for a place to park their money. In the last year or two, interest rates have been favorable enough for people to park their money in short term vehicles and still obtain rates of return above inflation to allow their capital to grow with very little (if any) risk. For evidence of this, look at the trillions of dollars that people have been putting into money market funds as fears of risk in the markets increase.
However, as interest rates come down and people aren’t able to obtain returns above inflation, then they seek other growth opportunities. Typical examples of where this money goes are into things like gold, real estate and equities.
The results is that the basic economic law of supply and demand kicks in, thus raising prices for gold, real estate and equities as more money floods into these investment vehicles and the supply can’t keep up with demand.
We saw evidence of this in the last 5 years or so with significantly lower than average interest rates and as a result real estate went on a tear and equities had a good run too.
That’s my $0.02 worth – note I am not an economist either so feel free to discount my $0.02.
SI
SI – I agree with your analysis. I think that’s why dividend stocks like the banks tend to get nailed by interest rate increases – if an investor can get the same yield (ignoring taxes) in a short term fixed income security as they can get with a yahoo company like CIBC then why take the extra risk?
One affect that has’t really been discussed is the fact that lower borrowing rates encourage business development and risk taking. More loans will be taken out, more risks taken, etc. Risk is the backbone of the U.S economy and small business drives much of the economy.
Daddio…very true!
Mike
The Fed cut was very surprising. I just read somewhere that the last time it was this aggressive was during the tech crash and the low interest rates was what fueled the credit mess. Lower interest rates encourages business spending but also reckless behavior…
That’s true Mariam. Lately the government seems pretty determined to keep economic downturns to a minimum but some economists think that it might be better in the long run to have a “good” recession and get rid of weaker companies.
Mike
I think you might be right Mike. It feels unnatural to not let recessions happen and artificially prop up the economy and markets with cheap money. I think the U.S. might need a good recession to clense the system; athough I am no economist so I could be dead wrong
MG – I don’t think anybody knows for sure.
It would kind of suck to be working at one of those “weaker” companies if it went under in a recession.
Mike
Central banks might decide to lower interest rates out of concern that a drop in asset prices will spill over to the “real” economy through something economists label the wealth effect. As the stock market falls individuals will feel less well off and decide to curtail consumption to increase savings. This, in turn lowers demand and yaddah, yaddah, yaddha… the economy finds itself in a recession.
In short, the Fed is reacting to falling asset prices (both housing and the stockmarket) in order to manage the broader economy.
The shocking thing about the cut was not just that it was so much, but that it happened between regularly scheduled meetings. In fact, it was decided on a holiday. The last time a large cut came in between meetings was after 9/11.
In my mind, this is why I would be concerned about a recession.