Fed Cuts To Prop Up Markets?

by Mike Holman

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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