Investors responded with great enthusiasm on Wednesday when Federal Reserve Chair Jerome Powell offered his latest comments on the current status of U.S. monetary policy. In particular, Powell's assertion that the Fed could choose as soon as its December meeting to slow down the pace at which it has increased interest rates so far in 2022 came as welcome news for those who had feared that the central bank was determined to tighten too far.
Even though stock markets soared in the hours following Powell's comments, the true impact of a slower pace of tightening is far less certain. Determining the optimal course of monetary policy to balance price stability and economic growth is nearly impossible to accomplish. It's entirely possible that slowing the pace of rate increases in the near future could achieve the best long-term results, but investors shouldn't rule out the possibility that prematurely backing off of its aggressive stance toward policy tightening could make inflation more persistent.
For long-term investors, preventing entrenched inflation is arguably the most important goal for the central bank. Therefore, that's the perspective from which market participants should evaluate any policy move from the Fed.
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The impact on bond investors
Fed policy has a direct impact on borrowing costs, which in turn moves bond prices. However, the Fed's influence affects one portion of the bond market much more than the other, and the results of successful Fed policy can look very different, particularly in the short term.
The Federal Reserve sets monetary policy primarily by establishing a target range for the federal funds rate, which is an overnight interest rate between financial institutions. Short-term fixed-income investments like Treasury bills typically move in line with the fed funds rate. The rates that consumers pay on credit card finance charges also often rise and fall along with the Fed's actions.
A slowing pace of Fed rate hikes will keep any further increases in borrowing costs for these borrowers somewhat in check, but it won't stop those increases entirely. Moreover, short-term bond investors could see rates continue to rise, boosting their potential investment income.
Yet longer-term bonds are already seeing steep declines in light of the Fed's apparent plans to slow the pace of short-term rate increases, with 10-year Treasury note yields having fallen from 4.25% in early November to below 3.6%. That indicates investor confidence that the Fed's moves could control inflation while allowing for a faster return to less restrictive monetary policy.
However, the drop in longer-term rates will have immediate impacts, including boosting total returns for bondholders and reducing borrowing costs in areas like mortgage lending, where loan rates are typically tied to longer-term bond benchmarks.
The impact on stock markets
Monetary policy's impact on stocks is even less direct than on bond markets. Investors often consider short-term impacts while neglecting longer-term effects. The bear market in 2022 has largely centered on the idea that rising rates will create recessionary conditions, which will be detrimental for consumers and cause financial stress for the businesses that serve consumers. Conversely, if the Fed doesn't raise rates as much, it arguably preserves a stronger economy.
Just about every argument favoring higher stock prices, however, has an also-compelling counterargument for lower stock prices. Signs that the Fed will defeat inflationary pressures could drive valuation levels higher once again, particularly for growth stocks, where prospects for profits lie well in the future. Yet the Fed also sees excessive speculation as potentially dangerous to financial markets, so its commitment to keep policy restrictive for an extended period could keep stocks from rebounding as quickly as they otherwise might.
If the Fed gets inflation moving lower again, stock investors can expect rate increases to slow and eventually stop. Yet some are hoping for a quick return to much lower rates, and that seems less likely to happen.
Be ready for anything
Of course, the best predictions of what the Fed will do are always subject to surprise events. An end to the Russian invasion of Ukraine or COVID-19-related lockdowns in China could have dramatic positive impacts on world markets, while new unforeseen threats could hurt investor sentiment.
Absent those outlier events, however, investors should keep their eyes on the Fed and the state of the global economy to see if central bank policy is working the way everyone wants. Success or failure on that front will be the primary mover for financial markets in 2023.
