The Federal Reserve Board (Fed) is the chief architect of monetary policy in the United States, and the Federal Reserve System is the closest structure that the United States has to a central bank system. The current chairman of the Fed, Alan Greenspan, has challenged tradition by indicating the types of actions that the Fed will take prior to announcing them. This results in fewer shocks to the stock and bond markets, but marks a significant departure from the way that former chairmen have behaved. This research examines recent changes in short-term interest rates and considers whether a correlation exists between the changes in rates and the stock market in general, or between changes in interest rates and four specific stocks.
The Fed changes interest rates in order to stimulate or slow down the economy. If the Fed thinks that the economy is headed for inflationary times, it will increase short-term interest rates in order to slow down economic activity and thus prevent inflation. Higher interest rates do this because they increase the cost of funds to banks, which then increase the interest rates they charge customers. This effect ripples throughout the economy with the result that borrowing (and the capital expenditures that borrowing supports) decreases and the economy is slowed.
Similarly, the Fed can decrease interest rates in order to stimulate the economy. This results in decreased interest rates from banks to their customers, which increases the amount of borrowing and thus the amount of capital invested in the economy. Changes in the interest rates also affect the investment market as investors ponder where to receive the best return for the investment. When interest rates are low, investors are attracted to stocks which may promise higher returns through growth. When interest rates begin to climb, investors may turn to the bond market (which has commensurately high interest rates) and sell some of their sto...