On January 26, the US Federal Reserve (Fed) 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 labor market, according to a statement published by the Central Bank. Jerome Powell, the Fed’s chairman, announced that asset purchase will most likely cease in March. The Central Bank also expects to significantly reduce its bond holdings, although no specific time frame has been announced. As a result of the announcement, 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 rise. The main effect of such an interest rate increase would be a rise in borrowing costs for businesses, as well as consumers. These kinds of effects haven’t been felt since the start of the pandemic, when rates fell close to zero.
The stock market’s assumptions caused stocks to fall in the first weeks of January, with S&P Global falling down to 9%. This was the first time the stock fell below 10% since the turmoil of March 2020. Following the Fed’s chair announcements on January 26, the S&P closed down at 0.2%, erasing its gains.
The stock market reacted this way mainly because the Central Bank’s decision will slow the economy down. Other financial instruments, such as bonds or certificates of deposits, will become more attractive to investors compared to stocks. Since the 2008 financial crisis, return on those assets has been small, as low interest rates stimulate economic recovery. Consequently, investors turned to the stock market to ensure higher returns, despite higher risks. If bonds yield, this may not hold anymore, and other instruments may move in the same direction as the Fed’s rate.
If the Fed raises benchmark interest rates, traditional banks will have no other choice but to raise the cost 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 the Fed will increase interest rates. Rapid and unpredictable changes in the monetary landscape usually lead to panic.
When the inflation’s spurt began in 2021, the Fed assumed it was a side effect of President Biden’s 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 is still offset by the pandemic.
As the situation worsens, the Fed announced further deterioration will bring about tighter monetary policies to limit the damage. Meanwhile, others see the stock market’s variations as a good thing. Higher interest rates symbolize strong economy and labor markets. A decrease in stock prices may help company valuations reflect their real value, as opposed to being overvalued due to bubbles.