The Federal Reserve and the Stock Market
by Jason Dean
The stock market went on a real roller-coaster ride today. The Dow Jones Industrial Average was hovering around +/- 0 for the day up until about 2:14 PM. Then, out of nowhere, wham!, a 120 point drop! By 2:36, the Dow had dropped another forty-eight points — 168 points in just twenty-eight minutes! But then, strangely, the market staged a mini bull rally, climbing 222 points in just over an hour! Commentators blamed the Federal Reserve for both the crash and the rally — what the heck?
‘Stocks Dive, Then Soar on Fed Decision’
The above was an Associated Press headline. But what did the Federal Reserve do to make the stock market fall? And what did they then do to make it turn around so quickly? The answer is: They did nothing. And sometimes nothing can mean a lot.
What is ‘The Fed’ and What Does it Do?
The Federal Reserve (also known as “The Fed” for short), is our nation’s central bank. Supporters characterize it as a public/private hybrid banking monopoly; critics call it a cartel. Whether or not the Fed is a good thing or an unconstitutional travesty is beyond the scope of this blog and up for individuals to decide. Regardless, every individual interested in making money should understand the basics of the Fed if they want to make money.
As the nation’s central bank, the Fed governs all member banks — and almost all banks (but not credit unions) are members. The Fed has a chairman (Ben Bernanke is the current head cheese — Alan Greenspan came before him) and a board of governors that make monetary policy decisions for the nation. For example, the Fed sets the national reserve requirement, which is the percentage of total loans each bank must keep on hand in the form of deposits. For example, the current reserve requirement is 10%, which means that your local bank can lend out $100 for every $10 it has in its vaults.
But the Fed rarely makes changes to the reserve requirement. What they do much more frequently, and what they didn’t do today, is adjust the discount rate. The discount rate is the interest rate at which the Fed loans money to its member banks. The Fed is a “lender of last resort,” which means that banks first try to borrow money from each other if they need it to meet their reserve requirements for that day. But if they’re unable to, they can come to the Fed.
The rate at which banks borrow money from each other is called the federal funds rate. If the federal funds rate is 6%, then obviously banks are going to charge more than 6% on every loan — even loans to the most credit-worthy consumers. And when the Federal Reserve changes the discount rate, this indirectly affects the federal funds rate, since it makes the “cost of money” to banks higher.
How the Fed Affected the Market Today
So what did the Fed do today? Again, the answer is nothing. At first, the stock market went down because many shareholders had been hoping for the Fed to cut the discount rate. If the Fed had, this would have meant that all interest rates would have probably gone down, and thus money would have been cheaper. Typically, when money is cheaper, more people borrow money and put it into the stock market, thus causing stock prices to go higher.
But if this is the case, then why doesn’t the Fed always cut interest rates? Obviously, that’s impractical. This is because lower interest rates usually lead to inflation. Inflation, if left unchecked, can lead to severe economic problems like we last saw in the 1970s. Most economic experts blame that era’s runaway inflation on irresponsible government spending — which is still with us today! — and equally bad monetary policy from the Federal Reserve. The fact that the Fed did not cut rates showed many inflation hawks that Ben Bernanke and his governors are not going to let inflation get out of control, and that’s why the market staged a big rally to close out the day in positive territory.