Federal Reserve/Interest Rates

"Don't fight the Fed." How often have you heard this expression? While seemingly innocuous, this simple phase encapsulates the relationship between the Federal Reserve's decisions on the direction of short-term interest rates and the perceived performance of the equity markets. But before we delve into the impact of interest rate cuts and hikes, we really should have some understanding of who and what body makes these decisions.

According to the Federal Open Market Committee's (FOMC) official website, the FOMC consists of 12 members--the 7 members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and 4 of the remaining 11 Reserve Bank presidents, who serve 1-year terms on a rotating basis. The monetary-policy setting group holds 8 regularly scheduled meetings during the year, and other meetings as needed. You can find a calendar of those official meetings on the FOMC's official website.

Historically, when the Federal Reserve is in the loosening process (i.e. reducing the target federal funds and discount rates), the markets have tended to react in a positive fashion. Conversely, when the Fed is in a tightening mode (i.e. raising the target federal funds and discount rates) the markets have tended to underperform.

The rationale for this theory is based on the relative supply of money in the economy. Theoretically, decreasing interest rates should encourage banks to also lower the interest rates that they charge customers on consumer and business loans, as the banks in question can now borrow from Federal Reserve member banks at the reduced rate. This relative "easy" supply of money is a tool the Federal Reserve uses in an attempt to stimulate the economy.

The opposite, however, also holds true. An increase in the federal funds rate tends to cause businesses and consumers to put off expenditures due to the higher "cost" of borrowing, thus helping to decrease economic activity.

For a graphical representation of this theory, below is a dual chart of the broad market barometer S&P 500 Index (SPX) and the federal funds rate. In general, there appears to be an inverse relationship between the respective charts (i.e., rising federal funds rate corresponds to declining SPX values and vice versa).

As you can see from the chart below, however, any change in the federal funds rate has a delayed effect on the market. The roughly 350-basis-point reduction in the interest rate in 2001 did not have an immediate impact on the SPX, with the broad-market indicator waiting until March 2003 to begin its uptrend. Furthermore, the roughly 425-basis-point increase that began in July 2004 has yet to fully impact the SPX. This delayed reaction has perpetuated the debate on the ability of the Fed to affect the desired result pertaining to the overall market.