The Impact of FOMC and the Federal Funds Rate on Stocks
This article outlines how the Federal Reserve's federal funds rate decisions transmit to stock prices through discount rates, capital flows, and exchange rates.
What are the FOMC and the Federal Funds Rate?
The FOMC (Federal Open Market Committee) is the monetary policy-making body of the U.S. central bank, the Federal Reserve (Fed). It holds eight regularly scheduled meetings per year to set the federal funds rate. The rate set here is specifically the target range for the federal funds rate, which is the interest rate at which banks lend reserve balances to other banks overnight. It is typically announced in a 0.25 percentage point range.
In South Korea, the Bank of Korea's Monetary Policy Board performs a similar role, determining the benchmark interest rate. While the interest rates of the two countries are separate, the U.S. rate serves as a benchmark for global capital, making the Korean market sensitive to FOMC outcomes.
This article is an educational resource explaining how interest rates affect stock prices and does not recommend specific stocks or trading timings.
The First Channel for Interest Rates to Affect Stock Prices: The Discount Rate
The theoretical value of a stock is the present value of its future cash flows. The rate used to discount future amounts to their present value is called the discount rate. When interest rates rise, the discount rate also increases, reducing the present value of the same future earnings.
For a simple example, let's say you expect to receive $1,050,000 one year from now. If the discount rate is 5%, the present value is $1,000,000. However, if the discount rate rises to 10%, the present value decreases to approximately $950,000. This is why growth stocks, which rely heavily on future earnings, are more sensitive to changes in the discount rate.
Therefore, during periods of rising interest rates, high-growth technology stocks, which depend more on distant future earnings than immediate profits, tend to underperform relatively.
The Second Channel: Cost of Capital and Corporate Earnings
When the federal funds rate rises, corporate borrowing costs also increase. Companies with high debt face greater interest burdens, leading to reduced net income and, consequently, a drop in EPS (earnings per share). For example, if a company has a share price of $100 and an EPS of $5, its P/E ratio is 20x. If interest expenses increase and EPS falls to $4, the P/E ratio at the same share price rises to 25x, increasing the valuation burden.
From the household perspective, rising loan interest rates reduce consumer spending power, impacting corporate revenues. Conversely, during periods of falling interest rates, the cost of capital decreases, stimulating investment and consumption, and making it easier for capital to flow into risk assets like stocks.
However, the impact varies across industries. Banks may benefit from higher interest rates due to wider net interest margins, while highly leveraged sectors like real estate and utilities tend to be disadvantaged.
Interpretation Criteria: 'Compared to Expectations' and the Dot Plot, Rather Than the Decision Itself
The market prices in interest rate decisions in advance, so what moves stock prices is not the outcome of a hike or cut itself, but how much it differs from expectations. For instance, if a 0.25 percentage point hike was widely expected and the Fed indeed raises rates by 0.25 percentage points, the stock market reaction will be small. However, if the market expected a pause and a hike occurs, the shock will be significant.
Furthermore, the Fed's quarterly dot plot, which shows individual committee members' projections for the future path of interest rates, provides clues about the future direction. The tone of the Chair's press conference remarks after the meeting—whether hawkish (favoring tighter policy) or dovish (favoring looser policy)—also increases short-term volatility.
Ultimately, what matters is not a single number, but changes in market expectations regarding whether interest rates will rise or fall, and at what pace.
Exchange Rates and Foreign Capital: What Korean Investors Should Also Consider
If U.S. interest rates become higher than South Korea's, capital tends to move into dollar-denominated assets in pursuit of higher returns. This process causes the won-dollar exchange rate to rise (meaning the Korean won weakens). A rising exchange rate can reduce the dollar-denominated value of Korean stocks for foreign investors, potentially leading to selling pressure.
For example, if the exchange rate rises from ₩1,300 to ₩1,400 per dollar, the dollar-denominated value of the KOSPI index, even if unchanged in won, decreases by approximately 7%. Therefore, the Korean stock market must consider not only the FOMC outcome but also the resulting exchange rate movements.
The Bank of Korea sometimes adjusts its benchmark interest rate, mindful of the interest rate differential with the U.S., precisely because of this capital and exchange rate linkage.
Pitfalls and Checkpoints
Interest rates and stock prices do not always move in opposite directions. In phases where interest rates are raised due to a strong economy, corporate earnings may also increase, leading to rising stock prices. In other words, the outcome depends on the 'reason' for the interest rate change—whether it's to address an overheating economy or to counter a recession.
Another pitfall is to overly focus on short-term reactions. Fluctuations on the day of a meeting are often noise stemming from the difference between expectations and reality, and the actual impact on the economy and corporate earnings unfolds slowly over several quarters.
To summarize the checkpoints: first, look at the difference compared to expectations and the dot plot rather than just the outcome; second, distinguish and consider the three channels—discount rates, cost of capital, and exchange rates; and third, ascertain whether the background of the interest rate change is economic expansion or slowdown. This article is an educational resource to help understand these principles.
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