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The Historic February 2018 Dow Plunge and Interest rates

Katie Bearup and Aspen Moraif

You may have heard about the historic Dow plunge on February 8, 2018. This over 1,000-point drop was largely due to concerns about the bond market and inflation.

This graph shows the Effective Federal Funds Rate in the last 16 years, up to February 8, 2018. It is not seasonally adjusted. The Federal Funds Rate is the rate at which banks lend reserve balances to other banks on an overnight basis. The Federal Funds Rate is one of the most important interest rates in the U.S. economy because it reflects monetary and financial changes, which have an effect on the broader economy, in the sense of employment, growth, and inflation. The Federal Funds Rate captures the overall trend in interest rates across the entirety of the U.S. economy.

Since the 2008 recession, interest rates have been close to zero, however as seen in the graph, this is not historically common. The upward trend in interest rates that took place at the beginning of this month may be the end of “cheap money”, as Americans will have to pay more for mortgages and loans, and companies will have to pay more for their loans, cutting corporate profits.

In order to understand the volatility, we must understand interest rates, inflation and the bond market. Interest rates are the monetary sum a borrower pays a loaner as payment for borrowing their money. Interest rates and the price of bonds are synonymous, and many times interest rates are calculated by the price of bonds. However, interest rates and the price of bonds have an inverse relationship: if price of government bonds increases, then interest rates decrease, and vice versa, meaning increasing interest rates make bonds less valuable. Additionally, the more bonds issued, the price of bonds falls and interest rates rise.

Further, there are concerns about inflation. Inflation rates are unusually low given the overall growth of the economy. The federal reserve regulates inflation by raising interest rates. Many people bet on inflation rising, but if they are wrong and inflation decreases, then interest rates rise and the price of bonds decrease.

If interest rates rise then the cost of borrowing money will increase, meaning companies will have to pay more to borrow less. This will negatively impact company profits, as they will have to compensate for the increase in interest rates. Because of this, a rise in interest rates often means a fall in stocks, as stock prices will reflect this loss in profit by companies.

6 thoughts on “The Historic February 2018 Dow Plunge and Interest rates

  1. Lauren Fredericks

    Thank you for addressing the recent DOW plunge; I definitely had questions regarding this recent issue. The graph you attached is far more dramatic than I would have expected, as the rises and falls are fairly sharp and very large. What was the reasoning for the huge increase in interest rates from 2004 to 2007?

    Reply
  2. clintong20

    This is a very thoughtful analysis of the current economic state! I was not that the cause of this was directly linked to bonds and interest rates. Since interest rates are directly linked to the companies issuing higher borrowing prices does this reflect within GDP as investment or consumption? I'd assume consumption because of its lack of physical capital.

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  3. johnsonjm20

    This is a very interesting and relevant topic. Thank you for explaining the plunge, I think I have a good grasp on what happened now. It is so interesting to see how everything in economics is related. On the surface you would not think that interest rates and stocks would be related but this post explains why they are. Its fascinating to see how there are so many small cogs in the huge machine of an economy.

    Reply
  4. spencerc20

    The correlation between interest rates and the stock market is very interesting. Instead of all the apocalyptic sounding talk that seems to come from a lot of stock market analysts, this explanation is a little less frightening and explains how it's normal for the stock market to see a decrease when there is an increase in interest rates.

    Reply
  5. radcliffec20

    I never would've guess the downfall would be so striking! I wonder if the end of cheap money will be a good thing? While it does mean we have to pay more for mortgages and loans, you pointed out that it also means corporate profits will suffer. I'm interested to see what the increase in the Federal Funds Rate has in the long run for consumers and corporations.

    Reply
  6. warej20

    After the occurrence of such a dramatic fall in the Dow, this was a relevant and well connected post. I had previously understood that stock value had severely declined, but I was not sure why this had happened amidst such a previous rise. This explanation with interest rates makes sense and the ability to borrow for cheap/with low interest rates seems very important. I am curious to see if the rise in interest rates will continue in the future and witness the extended effect of rising interest rates on the stock market.

    Reply

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