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What is the fed funds rate, and how does it affect stocks? Thanks, E.R.
That's a great question, since so many people refer to the fed funds rate in relation to the
interest rate-hike campaign without truly understanding it.
The federal funds rate is the interest rate at which U.S. banks lend to each other overnight. The loans are mostly used to satisfy the banks' reserve requirements; nevertheless, the rate influences market interest rates throughout the world.
The fed funds rate is actually a market-driven rate, but its target is set by the Fed's monetary policy committee, called the Federal Open Market Committee, or FOMC. In order to keep the rate close to the target set by the FOMC, the Fed employs something called
open market operations
whereby it buys and sells Treasury bonds and other debt securities to increase or decrease liquidity in the market.
For example, if the FOMC wants to soak up liquidity from the market to combat inflation, it sells U.S. debt to dealers in return for their cash. On the other hand, if the FOMC wants to spur growth in the economy, it buys back Treasuries and pumps cash back into the banking system.
Take a Hike
The FOMC, which has 12 voting members and five alternates, meets eight times a year in Washington to set the target. Announcements of changes in monetary policy arrive at about 2:15 p.m. Eastern Time on the second day if it's a two-day meeting.
At each meeting, the FOMC examines a number of economic indicators to determine its course of action. In the end, what the members really want to achieve is a so-called goldilocks economy (or "just right!") of strong economic growth without the nasty side effect of inflation.
For example, as a result of the Internet crash and the subsequent collapse of confidence after the 9/11 terrorist attacks, the FOMC reduced the fed funds rate from 6% in January 2001 to 1% in June 2004. The lowered rates encouraged businesses to borrow from banks in order to expand. In time, the economy regained its footing and the stock market soared along with it.
Since then, the Fed has slowly tried to remove the liquidity it provided in hopes of preventing the economy from overheating. The Fed has raised the rate 15 times in a row, each time by a quarter point. The latest hike took the target to 4.75%. In general, the market is hoping for an end to the rate hikes, because higher interest rates make it more expensive for both investors and businesses to borrow money.
How many rate hikes are left? Only the members of the FOMC know.
Could you explain what "short a stock" means? Why would you borrow somebody else's stock to make money? -- R.M.
Sometimes the lingo on Wall Street can get tricky. The best way to keep things straight when it comes to being "short a stock" or "selling-short" is to remember that it is generally a negative view on a stock.
Selling short is a way for investors to make money on stocks they believe are going to decline in price in the near future. It's important to remember that shorting, while offering a smart way to make bearish bets, carries significant downside risks.
To sell a stock short, you borrow the shares from your broker, then sell the shares and hold the money and wait for the stock to fall. If it does fall, you buy the shares at the lower price and give them back to your broker, who gets a commission and interest for his troubles. You, meanwhile, pocket the difference between the price you sold and the lower price you bought the shares back for from the broker.
The risk in selling a stock short is that if the stock's price rises, things can get hairy very quickly. You can wait to see if the stock will decline, or you buy the shares back at a higher price than you sold them and give them back to your broker (along with the other fees), and take the loss.
So when someone tells you that he literally is "short a stock," he means that he sold it high with the intent of buying it back at a lower price. In a figurative manner, it means he doesn't like the stock, meaning if he had to choose between buying it and selling, he would sell it because he thinks it's going down!
For more grist on short selling, take a look at an
earlier column I wrote explaining the matter. I hope that will clear things up for you!