On Wednesday, January 26th, the US Federal Reserve hinted at a probable increase in interest rates in March. This is due to the country experiencing inflation levels well above the 2% target and a strong labour market, according to a statement published by the Central Bank. Jerome Powell, the Fed’s chairman, announced that asset purchase by the latter will most likely cease in March. The Central Bank also expects to significantly reduce its bond, even though no specific time frame has been announced. As a result, stock investors hastened to sell their shares.
Even before Powell’s announcement, the stock market dreaded the possibility of an increase in the Central Bank’s benchmark interest rate as inflation continued to steep. The main consequence would be an increase in the borrowing costs for businesses and consumers for the first time since the beginning of the pandemic, as rates were close to zero.
These assumptions caused stocks to fall in the first weeks of January with the S&P falling down at 9% for the year. It has gone down as low as 10% at one point before the announcement for the first time since the turmoil caused by the pandemic in March 2020. On January 26th, the S&P closed down at 0.2% following Fed’s chair announcements and thus erasing gains.
The Stock Market’s reaction to the Central Bank’s decision to tighten monetary policy is mainly because it will slow the economy down. Other financial instruments like bonds or certificates of deposits will become more attractive to investors in comparison to stocks. Since the 2008 financial crisis, the return on those assets have been small, with interest rates being quite low to encourage the economic recovery. That is why investors turned to the stock market to ensure higher returns even though the risk is higher. This may not hold anymore if bonds yield and other instruments move in the same direction as the Fed’s rate.
By raising the benchmark interest rates, traditional banks will have no other choice than to raise costs of borrowing. This means that consumer demand and spending will decrease. It will also affect private businesses, which will have to pay more for loans.
Another factor worrying investors is the pace at which and how much the Fed will actually increase interest rates. Rapid and unpredictable changes in the monetary landscape usually leads to panic.
When the inflation’s spurt began in 2021, the Fed assumed it was a side effect of the economic recovery plan, as people consumed more during and after the lockdown. As time passed, inflation continued to exceed the 2% target because demand surpassed the actual supply of goods, which was and still is disrupted by the pandemic.
As the situation worsens, the Fed announced further deterioration will lead to tighter monetary policies to limit the damages.
On the other hand, some see the Stock Market’s variations as a good thing. The only reason behind higher interest rates is because the economy and labour markets are strong enough. Stock price decrease may help company valuations to reflect their real value as opposed to being overvalued because of bubbles.