Question

-Hypothetical situation: A couple of years ago, the Federal Reserve expressed concerns that the economy was heating up. The fear was that this would initiate inflationary pressure. To keep this from happening too rapidly, they began raising interest rates. They raised the Fed funds rate four times during 2018.

Theoretically, what should be the impact on the economy and the stock market?

Has this been the reaction we have seen from the market? Why or why not?

Answer 1

Theoretically the impact on economy, when the interest rates are increased by the Federal Reserve, is that the economy starts slowing down. The slowdown is not immediate but happens gradually after several months usually after 12 months from the announcement of the rate increase. This happens because the U.S. economy is mainly a consumption driven economy and with rate hikes the consumption and purchase of different items like houses, automobiles etc. becomes expensive and so the overall consumption level declines. The impact of rate hike on the stock market is immediate, in contrast to the gradual impact on the economy. Banking stocks rise when interest rates are increased while stocks of other companies in other industries will exhibit a subdued behavior.

Yes, this reaction was seen from the market during the 2018 increase of Fed funds. In fact in December 2018 U.S. stock market hit a one year low after Fed increased the rates. On 20^th December 2018, after the announcement of a hike in the rates by the Fed, the S&P declined by 1.5%. The Dow Jones Industrial Average also declined by 1.5% on that day. The economy is expected to remain subdued and all this is due to recent rate hikes as well as the expectation that Fed is expected to announce another two rate hikes in 2019.