Absent the presence of special factors, interest rates drive the stock market. Monetary policy is the government's most versatile policy tool. Through adjustments in bank reserves, and thus loanable funds, Federal Reserve Bank policymakers can influence interest rates (the cost of money and credit). The ultimate impact of these adjustments is on economic activity. When interest rates increase, economic activity is curtailed. Conversely, when rates decrease, economic activity expands. Since stock market growth is fueled, in part, by business expansion, market analysts pay close attention to every move made by Federal Reserve Board Chairman Alan Greenspan.
The Federal Reserve policymakers target a desired rate of money growth. This targeting is reflected in the movement of the federal funds rate (the rate on reserves loaned and borrowed among banks, usually overnight). Since the funds rate represents the cost of day-to-day funds for banks and securities dealers, its movements foreshadow changes in the prime lending rate and other money market interest rates: "A central bank is a man-made institution that deliberately creates money by means of some kind of governmental prescription or license" (Timberlake, 1993, p. 411). Movement in the cost of overnight funds triggers movement in more publicly visible rates such as the prime and the Treasury bill rate. The Federal Reserve discount rate also tends to follow these other rates albeit often with a lag.
The stock market is particularly sensitive to Federal Reserve policy. For instance, if the action of the Federal Reserve results in an increase in the federal funds rate and other money market rates, upward pressure on bond yields occurs. A depressing influence on stock prices occurs shortly thereafter. A sustained increase in interest rates hurts the stock market in two ways. First, higher interest rates make bonds more attractive investments than stocks. Second, ri...