Here's How Interest Rates Affect The Stock Market

Nothing, particularly when economic and financial policy is concerned, happens in a vacuum. So even if we don't follow business news too closely, we're likely to feel the impact of what happens when the government makes a decision on financial policy like interest rates, because it decides how much we need to pay the bank if we have credit card debt, student loans, car payments, or mortgages. But changes to interest rates can affect investments, too, because the move can have a positive impact on some, but a negative effect on others.

When the Federal Reserve or the "Fed" — which decides the country's monetary policy — decides to move interest rates, it's usually because something is happening within the economy that demands action. If the Fed thinks the economy is cooling off or slowing down, for example, it can cut interest rates in order to make it easier for both people and businesses to borrow money. The last time this happened was at the start of the COVID-19 pandemic, when the stock market plummeted and businesses closed while people sheltered in place. It was then that the Fed decided to cut interest rates, encouraging people to spend to boost the economy.

But the opposite can happen, too.

When an economy gets "hot" — which is what happens when people have a lot of credit, a lot of extra money, or simply want to spend — businesses end up making things more expensive, either because they don't have enough to sell, or because they feel they can get away with making more money. When this happens, we end up with inflation, a situation where our money ends up buying us less, per The New York Times. Inflation manifests in the rapid price increases of basic items like food and gas, or even in clothing and household items.

Inflation is bad because people will need more money to buy less, which, as Forbes notes, is bad for business as a whole. Speaking to the outlet, Touro University professor of business Angelo DeCandia explained that in times of inflation, "Essentials will take precedence over non-essentials as everyone tries to stretch the purchase side of their budget. Think more money spent on groceries and gasoline, and less spent on travel and entertainment."

Hope College professor of economics Todd Steen, meanwhile, says inflation also translates into less saved, because the money we have on hand isn't as valuable as it used to be. So to curb inflation, the Fed applies a different set of tools, and they raise interest rates, which should lead to less spending, and lower economic growth.

Raising interest rates doesn't just have an impact on inflation, it can hit the stock market, too. As Brenton Harrison, a Certified Financial Planner based in Tennessee, told Insider: "When interest rates are low, companies can assume debt at a low cost, which they may use to add team members or expand into new venture. When rates rise, it's harder for companies to borrow and more costly to manage what debt they already have, which impacts their ability to grow." And because higher interest rates hurt a company's ability to make money, high rates are seen as less desirable in the eyes of an investor. Common wisdom then dictates that stocks dip when rates are high, and rise when rates are low.

Still, Forbes says that's not always the case. Citing a study carried out by Dow Jones Market Data, Forbes pointed out that five of the most recent rate hikes only triggered one market decline, which made it come to the conclusion that rate hikes affect stocks differently. Once the volatility exhibited by nervous stock investors dies down, Forbes argues that high interest rates are good for financial or bank stocks, but bad for tech start-ups. The only way to make sure you can protect your portfolio is to hold a mix of different stocks and to buy bonds so your investment holds steady, and everything should come out in the wash.