How do interest rate changes affect stock prices?

Interest rate changes influence stock prices primarily by altering the discount rate applied to future corporate cash flows and by changing the cost of borrowing and risk perceptions. Research by John Y. Campbell of Harvard University and Robert J. Shiller of Yale University has long emphasized that valuation ratios respond to shifts in expected returns and discount rates, meaning that when central banks raise policy rates, the present value of expected dividends and earnings typically falls. That mechanical effect is reinforced by broader effects on corporate investment, consumer spending, and investor risk appetite.

Transmission channels

One clear transmission channel is the discounting of future cash flows. Higher interest rates raise the safe rate investors can earn elsewhere, so equities must offer higher expected returns to remain attractive. Empirical work by Bulent Gürkaynak, Brian Sack, and Eric Swanson of the Federal Reserve shows that monetary policy surprises and changes in expected short-term rates move long-term yields and asset prices quickly. Changes in yields therefore shift valuation multiples across the market, especially for firms whose profits are weighted toward the distant future.

A second channel is the cost of capital for businesses. Higher borrowing costs reduce net present value of new projects, slowing capital expenditure and potentially lowering future earnings growth. This effect is uneven across the economy. Firms with high leverage or long-lived investments such as utilities, real estate developers, and infrastructure companies are generally more sensitive to rate increases. Conversely, banks can initially benefit from steeper yield curves because interest margins often widen, though credit losses can offset that benefit if economic activity weakens.

Risk premia and liquidity also respond. Tightening policy can increase equity risk premia as investors demand greater compensation for uncertainty, amplifying price declines beyond discount-rate mechanics. Gürkaynak, Sack, and Swanson document that unexpected policy moves alter market liquidity and risk perceptions, contributing to volatility in equity markets.

Sectoral and global differences

Sector composition matters for territorial and cultural outcomes. Economies with a high share of interest-rate sensitive sectors experience larger wealth effects when rates move. Emerging market equities are often hit harder during U.S. rate hikes because capital flows can reverse and local currencies depreciate, making foreign-currency denominated debt costlier. The International Monetary Fund and central bank analyses have noted how higher advanced-economy rates can constrain public investment in lower-income countries, with long-term consequences for development priorities and regional inequality.

Environmental and human consequences are important but sometimes overlooked. Elevated cost of capital can delay or cancel low-return long-term investments in renewable energy and public transport, affecting decarbonization trajectories. Households carrying variable-rate mortgages face income strain when rates rise, reducing consumption and shifting political pressures on policymakers.

For investors and policymakers the consequences are clear: interest rate policy affects not only headline stock indices but the distribution of returns across sectors, the pace of investment, and cross-border capital flows. Empirical evidence from Campbell and Shiller and from Gürkaynak, Sack, and Swanson underscores that both the mechanical discounting effect and broader macro-financial channels must be considered when assessing how rate changes will influence equity valuations and real economic outcomes.