As the announcement came that interest rates would see yet another 75-basis-point hike at Wednesday’s Federal Reserve Open Market Committee (FOMC) meeting, the stock market did something predictable: it fell. It’s no secret that equity markets have been on a downward slide for most of this year. What flies under the radar, however, is the Federal Reserve’s role in the stock market’s turmoil. And it goes beyond even actual policy.
While the U.S. central bank has had a veritable stranglehold on stocks for years, lately the leash has been shortened dramatically, with even minor monetary news items substantially affecting equity markets. Just last month, when July’s Consumer Price Index (CPI) came in hotter than expected with 0.1% month-to-month price growth, the stock market suffered its worst single-day pullback in nearly three years. The S&P 500 fell by more than 4%, and the Dow Jones Industrial Average dropped an eye-popping 1,300 points.
The reason for the downturn? The 0.1% price increase signaled to investors that the Fed would raise rates again. As of Wednesday, that signal proved accurate.
This reflects a greater economic trend, one that casts the Fed as the puppet master in the stock market’s volatility the past few years.
Since Covid, the Federal Reserve Has Owned the Stock Market
In the years since Covid-19 first took root in the country, the Fed has been at the forefront of nearly every major market movement. As the central bank lowered interest rates to near zero and began its bond-buying initiative to inject cash into a stagnating quarantine economy, the stock market began what felt like a ceaseless upward rise.
This, of course, wasn’t without cause. Interest rates play a direct role in the aggregate demand of the country. When rates are low, people have more money to buy things. Add in a pent-up pandemic consumer base, and business made a triumphant return after Covid-19 initially stalled the economy.
As low interest rates pushed a growing number of Americans toward spending, industries across the board saw their earnings increase. Large corporations are often highly leveraged, meaning changes to interest rates have direct consequences on the companies’ expected profits. As a result of this friendly monetary policy, the stock market boomed. So did inflation.
In 2021, the S&P 500 climbed nearly 27%, while enjoying 70 all-time highs, a record only surpassed in 1995. While the party raged, inflation quietly climbed to 7%, the highest level in more than two decades.
The Fed’s role in the stock market shouldn’t be overlooked. Unfortunately, this year the central bank has proven to be more of a downward force on stocks than in prior years.
Stock Markets Overreact to Fed Signaling
Looking back at most of the major Fed events of this year, the stock market reacted sharply time and time again, often without even a policy precedent. Often, it seems what the Fed says has greater consequences than what the central bank actually does.
By March of this year, the stock market was already beginning to falter from 2021’s peak. Indeed, on March 11, the S&P was hovering around $4,204, down from $4,766 on Dec. 31, 2021. At this point, not only were interest rates still around their pandemic levels but also the Fed was still in the midst of quantitative easing.
The reason for the drop? Well, aside from grander macroeconomic events, like Russia’s invasion of Ukraine at the end of February, Powell had gone on a virtual media spree in the months prior, warning of rate hikes to come.
Following Powell’s recent Jackson Hole speech, in which the Fed Chair warned of “some pain” to come for American households, stocks took a similarly bearish turn. In the two weeks that followed Powell’s now infamous Aug. 26 address, the S&P lost roughly 7% of its value.
And the worst part of it? In some sense, it’s what the Fed wants. Lowering the aggregate demand of the country is one of the surefire ways to lower price levels. It’s the logic behind the rate hikes. Just as the excessive economic growth of 2021, perpetuated by dovish monetary policy, heavily contributed to the current inflation crisis in the country, the current economic slowdown, accelerated by the Fed’s hawkish agenda, is targeting a reduction in price levels. With that in mind, it wouldn’t be misleading to characterize the stock market selloffs that follow each startling Fed announcement as being right in line with the central bank’s goal.
The overblown investor response to every monetary news piece is basically the Fed manipulating a cooler economy — one with a manageable inflation rate.
The Federal Reserve’s Iron Fist Over Stocks
Events like CPI reports, comments from members of the Fed, FOMC meetings, and so on have resulted in a stock market that is constantly flirting with a pullback. In that sense, the investing environment that individuals like Powell have nurtured is unfair to the scores of people that have money in the market.
The simple fact is that in 2022, 142 million Americans have money in the stock market. That’s nearly 60% of all American adults. As such, every time someone at the Fed makes a bearish statement in passing, investors lose millions. The power the Fed wields over financial systems simply cannot be understated.
There needs to be some prudence, some diligence, some nuance in the way the central bank communicates with its constituents. Otherwise, investors will continue to feel “some pain” time and time again, while wondering when this year’s bear market will truly bottom out.
Current projections predict the Fed will push out an additional 1.25% increase in interest rates during its last two FOMC meetings this year. If history is any indicator, the stock market may be liable to sink even lower during these events, something that every investor should understand and brace for.
On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
