Question

Fed just raised the discount rate yesterday. Would anyone like to explain the relationship between Fed's discount rate or interbank loan rates and the market short-term or M1 interest rate as well as the long-term mortgage rate, bond rate and stock prices?

Answer 1

US economy performing well, and inflation is likely to rise in near future. Thus, Fed has increased the discount rate to ease down potential inflationary pressures.

Discount rate and market short term interest rate:

• Rise in discount rate implies that now commercial banks are less likely to borrow from Federal Reserve. Fall in borrowing from Federal Reserve will invariably lead to fall in capacity of banks to lend out money.
• Thus, money supply shrinks and it results into rise in interest rate. Since interest rate is determined where demand and supply for money are equal.

Further, bond price and interest rate inversely related. Rise in interest leads to fall in price of bond. Thus, when discount rate rises, the interest rate also moves similar line and bond price witnesses fall.

Stock market is also inversely related to rise in interest rate. high interest rate suggests that now borrowing shall be costly in market. Thus, cost of production would rise and demand is also likely to see fall. Hence, rise in interest rate is bad news for stock market. Stock market will react negatively to rise in discount rate.