How the Fed Impacts the Market
The Fed’s actions can have a significant impact on the economy and financial markets, both positively and negatively. The Fed’s monetary policy decisions, such as raising or lowering interest rates, can have far-reaching effects. Normally, when the Fed decides to increase interest rates, it is typically viewed as a positive sign for the economy.
Higher interest rates can slow economic growth by making it more expensive for businesses and individuals to borrow money. In the short term, an increase in interest rates will cause stock prices to fall because higher interest rates translate into lower corporate profits and a drag on economic growth. In the recent market cycle, interest rates were raised aggressively primarily to control inflation.
The Fed’s Influence on Inflation
The Fed’s influence on inflation is one of the most hotly debated topics related to the Fed. Most economists agree that the Fed’s ability to control inflation is limited. The Fed’s ability to control inflation is severely limited because it does not have direct control over the cost of goods and services.
When the Fed increases the money supply, it does not add to the supply of goods and services. Instead, it increases the amount of money available for lending. When the Fed lowers interest rates, it makes borrowing money less expensive. More people can now afford to buy houses, cars, and other goods and services, which creates demand for those products and puts upward pressure on their prices. So the Fed only has an indirect influence on inflation with its two main levers; (1) the money supply and (2) interest rates.
The Fed’s Influence on the U.S. Dollar
When the Fed raises interest rates, it is normally viewed as a negative sign for the U.S. dollar. Investors will often flock to other currencies, such as the Euro or the Japanese yen, instead of the U.S. dollar when interest rates are rising, which puts downward pressure on the dollar. The Fed’s actions can also have a longer-term impact on the value of a country’s currency.
When the Fed raises interest rates, it is a sign that the economy is doing well, which may prompt investors to “pull their money out” of the country. However, in our current market cycle, the U.S. Dollar has remained strong and performed quite well compared to other currencies. If I ever figure out why I’ll write an article on that. At the moment, I’m stumped on that front.
How Markets React to Fed Decisions
The market’s reaction to Fed decisions is often referred to as “Fedspeak.” Fedspeak leads investors to constantly monitor the Fed’s upcoming monetary policy decisions, speeches, and other public comments. Analysts and economists pore over each word, tone, and gesture in an attempt to divine the Fed’s next move.
As we’ve seen this year, the Fed’s decision to increase interest rates has had an immense impact on the economy, especially the financial markets and the housing market. The Fed’s decision to change monetary policy can send investors scurrying to buy or sell stocks and other financial assets. When the Fed’s decision is announced, it may also cause investors to rush to sell stocks and purchase “safe” investments, such as U.S. Treasury bills, in order to avoid being caught with losses in the stock market.
Tech stocks are particularly hit hard when interest rates are increased. And as we’ve seen recently cryptocurrencies behave like tech stocks. Refer to previous newsletters on the impact on the housing market.
What Investors Need to Know
The Fed’s decisions and actions can profoundly impact the economy and financial markets. It is essential for investors to understand how the Fed’s decisions can affect the economy and their portfolios.
The Fed’s ability to control the economy and financial markets is limited. No one can predict with absolute certainty what the economy will do tomorrow, let alone next week or next month. But, as we’ve seen this year, the Fed’s actions can set the tone for the economy over the long term.
We’re in a season of elevated interest rates (compared to the last 14 years). I’ve seen no indication that will change anytime soon. The latest data from December 2020 is inflation is 7.1%, down from 7.7% last month. And the Fed raised interest rates by another 50 basis points as compared to 75 basis points last month. So we’ll wait and see what impact that has on the housing market, the jobs market, and the stock market.
The trend so far is that the hike in interest rates is resulting in lower inflation. I’m sticking to my prediction that the Fed will raise interest rates 2 more times in 2023 and they will be successful in getting inflation down to 3% by December 2023. Where do you think it will be?
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