What Is the Relationship between Monetary Policy and the Stock Market?

Monetary policy and the stock market are often closely related because a government's attempts to control the monetary supply in an economy will usually have an effect on stock investors. The most common ways for a government to affect monetary supply is by either having a central bank lower interest rates or changing the amount of capital that banks must keep in reserve. In either case, the relationship between monetary policy and the stock market depends upon how investors view the news. One thing that mitigates the effect of monetary policy on the stock market is that most moves like interest rate changes are anticipated by investors well in advance and are already factored into stock prices.

There are many ways in which a government's actions to spur or sustain an economy may effect individual investors. Monetary policy is essentially the way that a government uses money supply to maintain economic forces like growth, inflation, and employment at preferred levels. The stock market often acts as a gauge for how the public perceives an economy and its potential. As a result, monetary policy and the stock market often work in tandem with one another in that the latter reacts to the former.

For an example of how monetary policy and the stock market can be linked, imagine that a government's central bank announces that it will be lowering its benchmark interest rate. This means that it will be easier for businesses to borrow money. Many of these businesses issue stock to investors, and that stock will become more valuable as a result if the lower rates spur business growth. Hence, the stock market could see an immediate rise.

It is important to note that the relationship between monetary policy and the stock market is sometimes not that simple. Psychological factors that work on the minds of investors can have a significant impact when monetary policy is taken into consideration. Using that example above, an interest rate reduction may be viewed by investors as a sign of desperation. Feeling that the government doesn't have enough confidence in the economy to right itself, investors may sell their stocks to minimize risk.

On certain occasions, the relationship between monetary policy and the stock market may be overstated. It is rare that an interest rate change arrives without some sort of advance notice. For that reason, investors may have already bought and sold stocks in anticipation of the move, meaning that the changes are already evident in stock prices. Whatever economic conditions are driving the policy may also be clear to savvy investors, so both the monetary policy and stock prices may be mere symptoms of underlying economic realities.