The Federal Reserve, commonly known as the Fed, is the central bank of the United States. It is the most powerful and most influential central bank in the world. The Fed was created in 1913 in response to frequent financial shocks and the need for a stable, well-regulated banking system in the United States.
Monetary Policy
The Fed’s primary job is to maintain a healthy and stable economy by controlling monetary policy. The Fed does this primarily by setting interest rates which impacts the availability and cost of money and credit in our economy. In addition to setting interest rates, the Fed supervises and regulates financial institutions to ensure the safety of the financial system. It also provides essential financial services to banks, the federal government, and the public. The Fed is kind of like the proverbial elephant in the room, when it moves, the stock market listens. Let’s step back and look at the Fed’s dual mandate.
The Fed’s Dual Mandate: Unemployment & Inflation
The Federal Reserve has a dual mandate to accomplish its goals. First, the Fed wants to do its best to keep employment strong. Second, it wants to keep inflation near 2%. Another way of saying inflation is to call it: price stability. These goals, set by Congress, have guided the Fed’s decisions for the last century. It is important to note that strong (or maximum) employment does not mean zero unemployment. That’s not possible. Instead, what it means is keeping the unemployment rate low and at healthy sustainable levels for the economy. That typically is anything between 4-5%. Meanwhile, on the inflation front – price stability means maintaining low and steady inflation, typically around a 2% annual rate. Now that we understand the Fed’s dual mandate, let’s look at how the Fed uses interest rates to set monetary policy.
How the Fed Uses Interest Rates
We already said that setting interest rates are the Fed’s primary tool to achieve its dual mandate. The Federal Open Market Committee (FOMC) sets a target for the federal funds rate, influencing a lot of short- and long-term interest rates across the economy.
The Fed uses interest rates two primary ways: first to stimulate the economy and second to slow it down (when it gets too hot). When economic growth is too strong inflation starts to rise above the Fed’s 2% target. When that happens, the Fed will raise rates to slow the economy by slowing borrowing and spending. Higher rates make loans more expensive, discouraging both businesses and consumers from taking on new debt (which, in turn, reduces demand in the economy). This often leads to lower inflation.
On the other hand, if the economy is weak and unemployment increases, the Fed may lower interest rates to stimulate the economy. The opposite is true, lower interest rates creates cheaper borrowing which, in turn, helps stimulate consumption and investment. All that helps strengthen the economy by encouraging job creation and lifting prices toward the inflation target.
The Push and Pull of Employment and Inflation
Reaching both goals simultaneously can be difficult because the two are moving targets and rarely stay at optimal levels. The Fed is constantly analyzing a vast amount of incoming data to determine its policy path. In recent years the Fed told us it is “data dependent” meaning it will make a decision after analyzing the new “data” that shows up after its latest Fed meetings. Now that we have a good understanding of what the Fed does, its dual mandate, next let’s look at how the Fed can impact the stock market.
4 Ways The Fed Can Impact the Stock Market
1. The Stock Market Reflects The Economy
The stock market often reflects the US economy. All things being equal, when earnings are growing and the economy is strong, stocks tend to go up. The converse is also true. That said, the first way the Fed can impact the stock market is by moving interest rates (up or down) to impact the economy.
When the Fed raises rates, borrowing costs increase. That curbs demand for consumers, businesses, and investors. Again, all things being equal, when interest rates go up, economic activity slows down. Higher rates mean higher loan and mortgages which mean less consumer spending and reduced business investment. For corporations, this might mean increased interest expenses, slowing profit growth, and ultimately making their stocks less attractive. The opposite is also true. After the Great Recession in 2008 and after Covid in 2020, The Fed lowered rates to zero and took other measures (a.k.a. QE/printed money) to stimulate both the economy and the market.
2. Investor Sentiment and Risk Appetite
Another way the Fed can impact stocks is to look at investor sentiment and risk appetite. Investors are constantly looking for signals from the Fed on what it will do next. If rate increases are seen as a response to rising inflation, investors might expect slower economic growth and reduce their exposure. Conversely, if the consensus is that the Fed will lower rates that can easily boost investor appetite for equities, since bonds and other fixed-income assets offer lower returns in a low-rate environment.
3. Valuation of Stocks
Interest rates play a key role in valuing companies. Many investors use models that discount future earnings (and future cash flow) with interest rates. As rates rise, those discounted cash flows are worth less in today’s dollars, causing stock prices—especially for growth companies—to potentially fall. Conversely, falling rates can easily inflate the present value of future earnings, supporting higher stock valuations.
4. Sector Rotation and Equity Performance
Certain sectors of the market respond differently to interest rate changes. For example, tech and other high-growth sectors are more sensitive to rate increases due to their reliance on future earnings. Housing stocks are another area that are sensitive to interest rates. Financial stocks, such as banks, sometimes benefit from higher rates because they can charge more for loans. Fed moves can thus create winners and losers within the market, triggering shifts in investment strategy. That said financial stocks also do well when the economy is strong and lower rates can help strengthen the economy.
The Fed’s Communication: “Forward Guidance”
Another important point to consider is that the stock market is a forward looking mechanism. Meaning, it tends to look forward, not backward. That’s why Wall Street also pays attention to “forward guidance” from the Fed. The Fed doesn’t just move markets through its actual interest rate decisions, it has an enormous influence by signaling its future intentions based on the latest data. “Forward guidance” refers to statements about how long interest rates may remain at certain levels or under what conditions the Fed might act. For stocks, this often translates into volatile trading around Fed meetings, statements, and speeches.
Challenges and Market Implications
Keeping a steady hand on both employment and inflation is a constant challenge, especially when economic data often sends mixed signals. If inflation is stubbornly high but unemployment starts to rise, the Fed faces a dilemma: Raise rates to fight rising prices, risking job losses, or cut rates to support jobs, risking further inflation. Market volatility often increases as investors try to predict how the central bank will navigate these scenarios.
Why the Fed’s Dual Mandate Matters for Investors
Understanding the dual mandate helps investors interpret why the stock market reacts strongly to Fed decisions and even to subtle changes in language from central bank officials. The balancing act between supporting job growth and keeping inflation near 2%, directly shapes the risk and return prospects for stocks and other important asset classes.
What’s Next
Right now the Fed has told us that it wants to lower rates in 2025. Inflation is getting closer (but still above) its 2% level and the Fed believes cutting rates is the next best decision. Trump has made it clear that he wanted the Fed to already cut rates but the Fed hasn’t done that (yet). The stock market is already trading near its record high which means that if the Fed cuts rates (slowly or aggressively) we could be in for higher equity prices in the future. Stay tuned because things can change quickly in the market. As I like to say, it’s never a dull moment on Wall Street.