• Wealth Management

Keep an Eye on Shifting Fed Policy

Markets have stabilized recently in part because the Fed has gotten more dovish. It may not stay that way.

The U.S. stock market is up 8% so far this year, down from the highs of 2018, but recovering from the selloff in December, in part because of the Federal Reserve’s more benign policy outlook.

In December, as the market sold off, the Fed indicated that it would likely continue to raise interest rates, a position it started to temper in January.

Now, the Fed not only has paused rate hikes, but may also scale back its plan to shrink its balance sheet (which also had the potential to nudge rates higher).

Rising interest rates raise the cost of borrowing, which tends to tighten financial conditions for companies—often translating into more volatility in the stock market. While the Fed’s two main goals are to keep prices stable and employment high, it is increasingly clear to me that it seems to have a third (unofficial) mandate to maintain financial stability.

What’s Next?

The key point for investors is that, while the Fed said it was going to “pause” on rate hikes, the market heard “stop.” Most investors don’t expect the Fed to hike again this year. Expectations for further rate increases, as measured in the futures market, have fallen to near zero through the middle of 2020.

However, the Fed could easily shift back to a more hawkish policy tilt later this year. I expect decent U.S. economic growth to continue, and inflation may even perk up—thanks to the strong job market. That would give policymakers a reason to raise rates, potentially as early as their June meeting and again in December. The Fed doesn’t necessarily want to slow growth, but it would like to get interest rates, still historically low, to a more normal level before we reach the end of the current business cycle.

Bottom Line: Investors should be prepared for market volatility to return if the Fed starts to signal that it may resume raising interest rates.