Will the Federal Reserve Crush the Stock Market?

Stock market investors have had to deal with a slew of factors affecting the financial markets, and many of their concerns came to a head on Wednesday. With bond markets continuing to see yields push ever higher and turbulence in other areas like commodities, major stock indexes suffered declines. As we've seen recently, the smallest drop came for the Dow Jones Industrial Average (^DJI 0.40%), with the S&P 500 (^GSPC 1.02%) and Nasdaq Composite (^IXIC 2.02%) seeing ever-larger drops on the day.

Data source: Yahoo! Finance.

The big news of the day came from the Federal Reserve, which released the minutes from its Federal Open Market Committee meeting on monetary policy from mid-March. The minutes revealed an extensive strategy for tightening policy that took some investors by surprise, and many now seem to wonder whether the Fed is actively looking to take on the stock market and the speculative fervor that has accompanied the easy-money policies of the past several years.

What the Fed said

Fed policymakers are now in uncharted territory as they try to reverse some of the aggressive methods they've used to bolster economic activity. Investors had anticipated for quite a while that the Fed would have to reverse some of the asset purchases it had resorted to in boosting the size of its balance sheet, and much of the discussion at the March meeting concerned the details of the quantitative tightening process.

Fed participants generally agreed that it would make sense to allow the balance sheet to shrink at a rate of roughly $95 billion per month, with $60 billion of that coming from redemptions of Treasury securities and the remaining $35 billion from agency mortgage-backed securities. The balanced approach would match up well with how the Fed purchased those securities in their quantitative easing efforts. The central bank made it very clear that it wasn't holding a formal vote, although market participants saw the news as reflecting likely policy stances for the future.

Image source: Getty Images.

Meanwhile, many investors were watching closely for comments about the likely path of interest rates, and the minutes reflected a more hawkish tone. Several participants noted that they might find increases of half a percentage point in the federal funds rate to be appropriate in the near future, especially if inflationary pressures persist. Bond market participants had already anticipated those moves, as the current prices for short-term bonds reflect expectations not just for rate increases at each remaining Federal Open Market Committee meeting in 2022 but also for some of those boosts to be more than the traditional quarter-point increases the Fed has tended to prefer in the past.

All in all, the Fed's minutes seemed to confirm the views of those who have expressed fears that the central bank has gotten behind the curve in fighting inflation. Indeed, with the latest report on employment showing that one of the Fed's dual mandates appears to be taken care of, refocusing its attention more squarely on inflationary pressures seems to make sense.

Should stock investors worry?

The fact that stock indexes fell on the same day as the Fed minutes came out suggests a causal link between the two. However, investors had already gotten advance warning of the gist of what the minutes revealed, so it's hard to put the blame for the market decline squarely on the Fed release. Moreover, stocks rose on the day of the actual meeting in question in March, so it's odd to draw an opposite conclusion from the minutes of the same meeting.

Higher interest rates have restrained economic activity in the past, but it's uncertain what impact they'll have now. Household finances, on average, are in relatively good shape, and many people still have pent-up demand for goods and services they've gone without during the two years of the COVID-19 pandemic. That's likely to support economic activity at least for a while, although sustained pressure on the economy will eventually have an impact.

Indeed, if stock markets respond to rising rates by working their way lower, they'll effectively do some of the Federal Reserve's work to cool the economy for it. That might seem like a high price to pay, but if it effectively kills the latest inflationary spurt, many will judge that it will have been well worth the cost.