What is Fed rate?
In a simple language the Fed rate is the rate at which the borrower bank borrows money from the lending bank. The Fed rate is the abbreviation of the Federal Funds rate. It is the rate which is prescribed by the Federal Reserve Bank i.e. the Central Bank of USA, also considered to be the most powerful financial institution in the world. The Fed rate is the cost that banks are charged for borrowing money from the Federal Reserve Banks.
The Fed rate can be called as a rate that determines the level of all other interest rates in the US economy. Also, the Fed rate has its effect on the global markets.
Fed rate explains inflation?
To understand how the Fed rate controls inflation, firstly we need to understand what exactly inflation is?
Inflation is spending too much money for chasing too few goods i.e. when there is too much demand for too less supply.
Fed rate usually hikes when there is a need to control inflation. When explained in a simple language, if you increase the lending rate borrowing decreases. This means that when there is inflation, the Fed rate hike which makes less rotation of free money in the market. Less borrowing, less purchasing power, decrease in the price of the goods. This is because when the lending rate is less people seem to purchase more on credit but when the lending rate is more people would borrow less and naturally the privilege for credit purchase vanishes due to higher lending rate. This is how the inflation is controlled.
One can conclude that there is a negative relationship between inflation rate and fed rate, i.e. when the Fed rate decreases inflation rate increases and vice versa.
Let us understand how the interest rate affects an individual and how does an individual affects a business?
When we borrow a sum of money from bank to buy a house, they know that they have to use a bank’s money through a mortgage to purchase a house and in return they have to pay the bank for the privilege. Similarly, the credit card users understand that they borrow money for a short time in order to buy something just at the swipe of the card.
When the Fed rate hikes, the banks also increase the interest rate at which they charge the customers to borrow money. This has the effect on the individuals. They tend to decrease the amount they spend. The disposable income of an individual decreases because of its interest expense they pay for the borrowed money from the bank. Individuals have to pay the bills and when those bills become expensive they tend to spend less discretionary income. Now this affects business of the companies i.e. their revenue.
When individuals stop buying or decrease their purchases, company’s revenue and profit flow in a downward direction. This tend to decrease their business. This slow down the growth of the business and naturally the profit is reduced.
How the stock market is affected?
There is a method of valuing a company that is to sum up the future discounted cashflow and divide it by the number of shares available. So by dividing the future discounted cashflows of a company by its available number of shares one can arrive at the company’s share price. As discussed above when the business of the company drops down, so will the future cashflows, and this way the stock price goes down. When enough companies experience decline in their stock prices and especially when they are A- graded companies, the indexes are bound to go down and hence will the stock market.
Also we must note that the stock price of the company fluctuates as a result of different expectations that people have about the company at different times. Because of those differences some wishes to buy the shares and some sell the shares.
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