The Stock Market May Be Wrong about Federal Reserve and Interest Rates. Here’s Why

On big exchanges like TD Ameritrade and others, the stock market rallied aggressively at the start of this week even though one Wall Street firm feared that investors were overlooking something important. They worried investors are yet to appreciate how swiftly the Federal Reserve might react to hiking rates.

Wall Street has bounced back after it endured unfavorable conditions in the last three trading days of the previous week. The bounce-back saw the Dow Jones Industrial Average move up by over 1.5%.

Just last week, the Federal Open Market Committee’s (FOMC) meeting with officials revealed they now see two rate increases coming in 2023. This is happening faster than the market’s anticipation.

The analysis observed the committee was just two member projections away from pulling the first-rate increase into 2022. The Committee’s sentiment about policy implementation has shown changes from the historical easy Fed stance

Mohamed El-Erian, the Chief Economic Advisor at Allianz, told CNBC that “the market is getting back to its comfortable mode.” He said the market growth is strong, investors have continued to believe the inflation is temporary, and the Fed will be slow to react.

Hans Mikkelsen, credit strategist for Bank of America has said the prevalent investors’ optimistic view of Fed policy is wrong. According to him, the credit market is misjudging the Central Bank’s direction with beliefs that a tighter monetary policy may come before 2023. However, the market predicts just a 41% chance that the Fed hikes rates by July 2022.

Mikkelsen advised investors to “expect the Fed to soon begin tapering its purchases, and to start hiking interest rates earlier than expected – and most importantly much faster than currently priced in markets.” He says the Fed’s unprecedented sales of the portfolio of corporate bonds it purchased during the pandemic is a move towards tapering.

There are conflicting opinions from the Federal Reserve itself

The dot-plot projections released Wednesday are evidence that the Fed stance is indeed changing. John Williams, New York Fed President, said on Monday, that he sees inflation as transitory. He was assured that the Fed policy is right, looking at the current and expected conditions.

However, St. Louis Fed President, James Bullard, shocked the market on Friday. He revealed he is one of the FOMC members who support a rate hike in 2022. But the case isn’t the same for Robert Kaplan, Dallas Fed President, who mentioned, on Monday, that he is more concerned with slowing down the rate of bond purchases. He thinks that is the most pressing issue and believes the question on rate should be left for later.

Bullard and Kaplan acknowledged the progress the economy has made. They also admit that the inflation that cropped up in the past few months may be more difficult than the Fed had anticipated.

Kaplan believes the supply-demand imbalances will be resolved within the next 6 to 12 months. He cautions however that inflationary pressures may be prolonged by some structural changes in the US economy. He also gave an example of the progression of the energy sector towards sustainable power, saying that such changes will contribute to longer periods of inflationary pressures.

Bullard mentioned the changing labor market as an essential factor for future Fed policy. He observed that the labor market is very tight. “We have to be ready for the idea that there are upside risks to inflation,” he said.

Natixis’ Chief Economist for the Americas, Joe LaVorgna, has hinted on why the Fed is seemingly moving slowly. “Right now, inflation is transitory. But if you overlay that with significant further stimulus, then you run the risk of making something transitory permanent,” he said.

If inflationary pressures become higher than the Fed expects, it would be compelled to tighten policy quicker than usual. A policy move of that nature will shock the stock market and broader economy, as they are both dependent on lower rates.