When the chairman of the Federal Reserve Board insinuates that monetary policy implementations are on the horizon, investors and companies are some of the first parties to react to the news. Some policies, such as high interest rates, spark fear in the hearts of investors; other policies, such as boosting the money supply, cause investors to rally. The government also implements monetary policies that could cause a sudden jolt in the stock market or, in other cases, cause the market to drop by hundreds of points.
The Federal Reserve influences the cost of borrowing money by changing interest rates. When the nominal interest rate is low, businesses have a greater incentive to take out a loan due to the lessened cost of borrowing. The expansion of capital through such a loan typically raises stock prices when this capital is allocated in an efficient manner. For instance, if the low nominal interest rate compels a business to take a cash loan for the sake of a merger or hostile takeover, the stock market will respond favorably if such a merger is deemed to bring value. In most cases, business expansion in the short term signals a jump in the market. Owen Evans, author of the book “Macroprudential Indicators of Financial System Soundness,” explains that high interest rates create stress in financial markets. However, Owens also mentions that sustained low interest rates also signal problems, such as the government trying to sustain a weak economy.
Quantitative easing is a monetary policy implemented by the Federal Reserve. The goal of a quantitative easing program is to provide greater liquidity in the market. Another byproduct of this type of policy is compelling investors to buy commercial assets, such as stocks, instead of government bonds. This is because the Fed reduces the returns of government assets such as Treasury bonds by purchasing them as part of the program. When investors switch from government assets to stocks, the market naturally rises as a result of the increased demand. Thus, in the short term, quantitative easing provides a boost to the stock market. However, William Watts explains in an April 2011 “Wall Street Journal” article how investors recognize that quantitative easing is a short-term fix, likening it to a “liquidity sugar rush.”
The government sometimes influences the stock market by unveiling certain programs. An example of a monetary policy that provided a jolt to some stocks is the 2008 “Cash for Clunkers” program. This program provided an incentive for consumers to upgrade vehicles by purchasing a new one in lieu of their old “clunker.” This program helped the stocks of automobile companies. Additionally, when investors observed a boost in consumer confidence through this program, the overall market reflected gains. Other government programs that affected the stock market include those that offered incentives to first time homebuyers and for purchases of energy-efficient appliances.
In some cases, the gains from implementing certain monetary policies are short term. The Fed implements policies in hopes of providing long-term economic value and sustained stock market levels, but the policy is not guaranteed to work. An example is lowering interest rates: Despite keeping the nominal interest rate near zero percent, stock prices stagnated. Thus, the slow economic growth compelled the Fed to engage in quantitative easing programs.