FALLING INTEREST RATES AND THE STOCK MARKET

The Federal Reserve cut its funds rate by 50 basis points (bps) this week, on top of last week's unannounced 75 bps reduction. A good article on The Economist last week pointed out that on the 15 occasions since 1970 when the US Federal Reserve has cut interest rates by 75 bps or more, European stock markets have risen by an average of 10.3% over the next 6 months.

The same article has a great graph displaying the performance of some major world indices since January of 2007 (see below). Note that Japan's main index, the Nikkei 225 average, is down about 25%. This explains why my EAFE fund is down a devastating 15% at the moment (about 1/4 of EAFE is allocated to Japanese stocks).

DO CENTRAL BANKS LOWER RATES IN RESPONSE TO FALLING MARKETS?

The Bank of Canada cut its overnight rate by 25 bps (0.25%) on Monday to 4.00%. According to The Bank, the main reasons for this decrease were lower than expected inflation figures for the fourth quarter and increased risk to Canadian exports from a more pronounced housing slump in the US.

The US Federal reserve also announced a surprise, more aggressive, 75 bps cut to their Federal funds rate on Monday. With markets taking a beating (year to date the TSX is down 6.7% and the S&P 8.1%) several blogs have questioned the wisdom of lowering interest rates in response to falling markets.

Given these interest rate cuts, are central banks bailing out investors? Although lower rates will surely help stock markets, the main impetus for providing monetary stimulus is the risk that falling asset prices pose to consumption - as asset prices fall, individuals will feel less well off, reduce consumption to increase savings, lowering aggregate demand and leading to a possible recession.

In short, the Bank of Canada and The Federal Reserve react to falling asset prices (both housing and the stock market in the US case) in order to manage the broader economy.