Except in setting the initial margin requirement, which limits the leverage investors can use in buying stock, the Fed has no direct control over the equity market. But the influence its actions have on that market can be substantial.
For
example, if the Fed initiates lower interest rates, investors
are likely to find bonds and other fixed-income securities less
attractive. That means they’re more likely to put money into
stocks. Conversely, in response to rising interest rates, investors
typically pull money out of the stock market and invest in
fixed-income
securities.
Similarly, the stock market is not the focus of the Fed's monetary policy decisions, but the stock market is a factor the Fed must take into account.
That’s because the health of the stock market affects the wealth of shareholders, and hence their willingness to spend on goods and services. That relationship between a sense of financial security and investors’ spending habits, sometimes known as the wealth effect, has a powerful impact on the economy.
Anthony Santomero,
Federal Reserve
Bank of Philadelphia
The risk premium
Investors are willing to take
a certain amount of risk when they expect that the
return on their investment, over time, will be greater
than the return on risk-free investments. The risk-free
benchmark,
or point of comparison, is the 13-week
U.S. Treasury bill. That's because the bill's short
term eliminates inflation risk and its status as a
U.S. government issue makes it safe from default.
The formula for calculating the annual risk premium
is to divide the total return for the investment category,
such as large company stocks, by the total return
for Treasury bills.
For
example, if the Fed initiates lower interest rates, investors
are likely to find bonds and other fixed-income securities less
attractive. That means they’re more likely to put money into
stocks. Conversely, in response to rising interest rates, investors
typically pull money out of the stock market and invest in
Similarly, the stock market is not the focus of the Fed's monetary policy decisions, but the stock market is a factor the Fed must take into account.
Anthony Santomero, 