The Federal Reserve (The Fed) is the central banking system of the United States. It comprises 12 regional banks and is responsible for governing and conducting monetary policy, supervising and regulating financial institutions, and maintaining the overall stability of the banking and financial system of this country. 

Monetary policy is the approach taken by a central bank or government authority with the intent to influence economic growth by expanding or constraining the supply of money in that region. The question to be answered is how does The Fed’s monetary policy affect the Stock Market (The Market)?

On September 20, 2023, The Fed officials held the benchmark overnight interest rate in the current 5.25%-5.50% range, but sketched a stricter policy path moving forward in an inflation fight they now see lasting into 2026.  Fed Chair Jerome Powell said, a solid economy combined with strong job growth, will allow the central bank to keep additional pressure on financial conditions through 2025. 

In August, inflation fell to 3.7%, down from 7.0% when it peaked in June 2022. However, that still remains well above the Federal Open Market Committee's (FOMC) objective of 2 percent. Bringing inflation back to 2 percent will likely require a period of below-trend growth and some softening of labor market conditions. In response to high inflation, the FOMC continued to increase interest rates 11 times and reduce its securities holdings of the Treasury and mortgage-backed securities over the course of this past year. The Federal Reserve is acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials. The FOMC is strongly committed to returning inflation to its 2 percent objective. Long story -short, The Fed will continue to raise interest rates until they reach their goal for 2% inflation. 

What does this mean for the outlook of the Stock Market? The Market has endured significant volatility as investors factored in rising rates. Juan Pablo Villamarin, senior investment advisor at Intercontinental Wealth Advisors, notes that the Fed’s primary policy tool is  the Fed Fund Rate (FFR).  The FFR is the rate that banks borrow and lend to each other overnight. Changes in the FFR affect the overall economy by making money easier or more difficult to borrow. A higher FFR results in a higher cost of borrowing for businesses. This in turn means that businesses no longer have access to cheap capital for reinvestment in growth. Consumers no longer have access to low interest rates for car purchases and mortgages, causing them to spend less.

Villamarin notes that the primary result of Fed interest rate hikes on stocks is an increase in the cost of capital. “All else being equal, a higher cost of capital causes future potential profits to be worth less, and decreases investment and spending on margin by companies," he says.

Robert Johnson, chairman and CEO at Economic Index Associates, agrees, finding that during "restrictive," or rising-interest-rate, environments, stock returns tend to be more muted. Johnson notes that the average annual real return for stocks over a 55-year period was 13.8% in expansive periods, but only 1.7% in restrictive periods. However, businesses that are more cyclical in their demand tend to be disproportionately affected by a restrictive environment. This often includes stocks from technology, materials and consumer cyclical sectors and small-cap stocks. 



Tickers to consider:  IKT

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