What Happens When the Federal Reserve Raises Interest Rates

What happens when the Federal Reserve raises interest rates? That sounds like a very complex question, but it's actually not that hard. In order for you to understand it, you're going to have to understand a couple of other things as well.

First, what is the Federal Reserve? It’s the organization that controls our money supply, and  controls how much it costs for businesses to borrow money. That's what an interest rate is. It's the cost of borrowing money. So when the Federal Reserve raises interest rates, businesses can still borrow money, but it costs them more to do it. If it costs them more to borrow money, they may not borrow as much.

So here's what happens when the Federal Reserve raises interest rates. Business tends to slow down a little bit. You might be thinking, “That's a really bad thing”. Actually, it's not. Here's the primary reason why they raise the interest rates: it helps to fight inflation.

There are a couple more things that happen as a result of raised interest rates. One is that the stock market crashes. Why? As interest rates go up, all the investors in the stock market look at what is called the bond market and they say, "Whoa! Interest rates are higher! That means if we invest in bonds, we can make money over there!" So they begin to move their investments from the stock market into the bond market. This causes the stock market to start crashing. All the amateur investors get scared because they see massive down movements in the market. So they all start selling their stocks, and calling their financial advisors and saying, "Put me in cash!" and, "I'm scared! Get me out of everything!" As a result, we go into what is called a recession. So really, raising interest rates can help cause a recession in our stock market.

 That might sound bad as well. But, guess what? Even recessions are healthy for our stock market. Recessions help to get all of what we call the illegitimate traders out of the market. These are people who are trading, but have no skill set to do so. They're more like gamblers. In a recession, they all get scared and exit. Once they're all out, the stocks go down and they get super cheap. That’s when those big investors, who had moved over to the bond market, see the stocks get super cheap and they say, "Whoa! Stocks are cheap! Maybe we should go back!" At that point, you'll often see them start to move back over to stocks.

 However, it usually takes something more for them to finally pull the trigger and go back to those stocks. It's when the Federal Reserve starts lowering the interest rates on the bond market. When they lower the interest rates, those guys can't make any money with bonds and they say, "Let's go back to stocks. They're cheap!" So the big investors go back to stocks. When that happens, you have a new bull market.

 I know it sounds super complex, but  I hope this helped make it a little easier for you to understand. If you have any more questions, or if you want to learn more about it, come check us out at tradeway.com. Go to Step One: Start Your Journey, where you'll learn a little bit more in-depth how the interests rates affect the stock market.