"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 Fed's official website, "The Federal Open Market Committee (FOMC) consists of twelve members--the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis." The monetary-policy setting group holds 8 regularly scheduled meetings during the year, and other meetings as needed.
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.