A friend of mine was asking about the stock market and why its been so lousy lately. A large part of it has to do with the Federal Reserve raising Interest Rates. So why does this make the stock market go down? Why should you care?

Basically the Federal Reserve is trying to keep people working, while keeping inflation low. Its a sort of balancing act. They do this by raising and lowering Interest Rates.

When interest rates are low (think 2001-2004), money is easy to get. We (as a nation) typically go out and buy big homes, big screen TVs, and new cars. We spend the money. But, if this goes on too much, companies figure out they can start charging a lot more for that home or car. This happened in the housing market recently as interest rates were historically low. Home prices were rising at historical rates. This is called inflation. When it kicks in, soon you find your dollar doesnt go very far. After all, who wants their paycheck to only buy of what it did a year ago?

The Stock Market hates higher interest rates because lets face it. If I can get a 6% rate of return in a savings account why would I risk investing in a company? The company has to pay me a much higher return on my money because there is risk, and money is more expensive for them to borrow. The Federal Reserve has one heck of a tool for putting the squeeze on Wall Street.

In the past year and half the Federal Reserve has been relentless on raising interest rates. They believe the economy is very strong and want to slow it down to stop inflation. Thats why when you turn on the TV, the stock market has been going down down down. As more good news of the strong economy comes up in government reports, investors know it builds the case for another increase in Interest Rates. This creates stock market panic. Were seeing a lot that today.

Beware: The Federal Reserve is far from perfect. Sometimes they over raise interest rates and things backfire sending the economy into a recession. Try this simple inflation test. Look at items at your local home depot or grocery store. Are their prices noticeably higher than they were a year ago? If so, youre seeing inflation first hand.