Congress has charged the Federal Reserve with keeping the United States economy functioning as seamlessly as possible. If the Fed perceives the economy is behind, it can lower the federal funds rate, making borrowing money more affordable for individuals and companies. This action often raises stock values, rewarding investors with higher profits. But what happens if the Fed increases interest rates? In this article, we'll look at historical trends to try and answer that exact question.
What Are Interest Rates?
Interest is simply a fee levied against the borrower for the use of an asset. Borrowed assets might include cash, consumer items, automobiles, and real estate. Most lending and borrowing transactions are subject to interest rates. Individuals borrow money to buy houses, fund projects, start or expand businesses, or pay for college tuition. Companies take out loans to support capital projects and grow operations by acquiring fixed and long-term assets such as land, buildings, and machinery. Borrowed funds are returned in either a bulk sum or in monthly installments by a predetermined date.
Why Interest Rates Rise
When valuing investments, investors must grasp the chances for interest rate movements. Understanding why interest rates vary, on the other hand, necessitates an awareness of the reality that a variety of complicated variables contribute to these movements in interest rates. Such causes can include an economy's strength, which influences supply and demand for money; fiscal policy; monetary policy; and the level and predictions for inflation.
History of Rises in Interest Rates
1981-1990
The federal funds rate has never been higher than in the 1980s. The Fed aimed to battle inflation, which had reached its highest level on record in 1980: 14.6 %. As a result, the Federal Reserve of the United States did something that may appear contradictory for an organization that seeks to maintain the most productive economy possible: it produced a recession to bring prices back down. In January 1980, the fed funds rate was set at a target of 14 %. By the end of a conference call on December 5, 1980, authorities had raised the target range by 2 percentage points to 19-20 %, the highest level ever.
1991-2000
After a difficult few years at the helm of the Fed during the Great Inflation, Greenspan, Former Chair of the Federal Reserve of the United States, had a calmer time. However, that's not to say he didn't confront his fair share of obstacles over his almost 18-year tenure. Following an eight-month recession in August 1990, Greenspan and his team raised the fed funds rate to a target level of 6.5% in May 2000, the highest of the era. Rates fell to 3% in September 1992, the lowest level of the decade. Aside from the early 1990s, the Fed mostly modified rates during Federal Open Market Committee (FOMC) meetings, a practice that continues to this day. Officials did raise rates at an emergency meeting on April 19, 1994, in response to inflation fears, and they decreased borrowing costs in an unplanned meeting on October 15, 1998.1 Another notable achievement was the US central bank's first "insurance" rate reduction, which meant authorities dropped interest rates to give the economy a boost rather than to battle a recession. Such was the situation in 1995, 1996, and 1998, when the financial sector faced a slew of challenges ranging from Russian debt default to the failure of a large hedge fund.
2001-2010
The 2000s were the Fed's most pulsating decade ever, with defined cycles for increasing and easing rates. After a stock market bubble in the technology sector broke, kicking off a recession aggravated by the 9/11 terrorist attacks, the Fed lowered interest rates 13 times to a low of 1%. The US central bank then managed to raise interest rates 17 times between 2004 and 2006, all in quarter-point increments, reaching 5.25%. Until the 2008 financial crisis and the subsequent Great Recession slammed the brakes on the economy. The Fed then did the unthinkable: it cut interest rates by 100 basis points to near-zero levels. During this time, Chairman Ben Bernanke led the Fed through one of its most aggressive economic rescue efforts in Fed history.
2011-2020
The Fed couldn't avoid zero interest rates in the 2010s any more than it could prevent terrible recessions. Officials would eventually leave interest rates at rock-bottom levels until 2015, after which they would only raise interest rates by 25 basis points once each year. That is, until 2017, when the Fed raised rates three times, and again in 2018 when they raised rates four times. The fed funds rate reached a high of 2.25-2.5 %. Faced with weak inflation and slowing growth, the Fed planned to drop interest rates three times in 2019 to boost the economy, akin to Greenspan's "insurance" cuts in the 1990s. The fed funds rate already appeared to be on its way to zero when the coronavirus pandemic arrived, ushering in a new era of near-zero rates. As the economy came to a standstill, the Fed reduced rates to zero in two emergency meetings held within 13 days. Chair Janet Yellen took over the Fed from Bernanke in February 2014 and guided the economy through its Great Recession recovery until February 2018, when Chair Jerome Powell took control.
Do Stock Markets Fall when Interest Rates Rise?
After reviewing that rising interest rate history lesson, you may be thinking the market must have been crazy during this time. Here's the thing with the stock market in the United States and interest rate rises; If you look for evidence that shows a link between rising rates and falling markets, you could be disappointed. Dow Jones Market Data has examined the five most recent rate rise cycles to determine what history says about stock market results during these periods. Their data shows that the three major stock market indices dropped just once during a rate rise cycle across these five long-term periods. When all five cycles were included, the S&P 500 produced a median gain of 30%, the Nasdaq delivered a median gain of approximately 27%, and the Dow Jones Industrial Average (DJIA) showed a median gain of 17.4%.2 . For example, from June 29, 2004, and September 17, 2007, the federal funds rate rose from 1.0 to 5.25%, while the DJIA rose 28.7 %. Furthermore, you don't have to go back that far to uncover data that contradicts the notion that higher interest rates lead to lowering stock prices. In 2017, the Fed hiked interest rates three times, but the S&P 500 rose more than 18%.
The Short-Term Impact of Higher Rates on the Market
Now that we have an idea of how little rising interest rates affects the market long term, you may be wondering, what about the short-term effects? A review of the S&P 500's performance throughout the nine Fed rate rises between December 2015 and December 2018 reveals an uncertain picture.3 The S&P 500 fell 0.5 % the next day after the Fed announced a rate rise on December 13, 2017, but recovered 4.6 percent after one month. On the other side, the rate hike on September 26, 2018, caused the benchmark index to rise modestly the next day but then decline 8.5 % after one month. In contrast to the long-term picture, short-term market movements after the Fed rate rises produce various effects. That's not much consolation for day traders, but for buy-and-hold stock market investors with a long-term plan, the message is unmistakable: Fed rate rises aren't as harmful as they appear for your long-term financial goals.
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Foster, Sarah, Fed’s interest rate history: A look at the fed funds rate from the 1980s to the present, Bankrate, 2022
DeCambre, Mark, Here’s what history says about stock market returns during fed rate-hike period, MarketWatch, 2022
Sullivan, John & Schmidt, John, How Does Stock Market Perform When Interest Rates Rise? Forbes Advisor, 2022