Financial markets are going through a challenging period due to persistent inflation and discouraging economic growth numbers. In response, the FED is raising interest rates, and stocks have seen negative returns in recent months.

In this article from Hapi, we explain the relationship between the FED and the stock market and what to consider when investing in 2023.

Introduction to the FED: What is it and how does it work?

The Federal Reserve, known as the FED, is the organization responsible for setting U.S. monetary policy and is the most influential central bank globally. It also regulates financial institutions and promotes financial stability.

The main objectives of monetary policy are:

1. Price stability: The FED aims to control inflation, which is the general increase in prices. Uncontrolled inflation distorts business investment decisions and reduces family income value. For this reason, it's important to maintain controlled inflation, typically near 2% or 3%.
2. Promote employment: The FED also seeks to keep employment levels as high and sustainable as possible in the long term.

How is the interest rate related to the economy?

The main tool the FED has to influence the economy is the interest rate or federal funds rate (FFR). This is the rate at which banks lend to each other overnight.

When the FED lowers the interest rate, it encourages borrowing and investment, which can stimulate economic growth. Conversely, when they raise rates, it prevents the economy from overheating and controls inflation.

For example, before and during the 2007–2008 financial crisis, the FED drastically lowered rates to help revive a weakened economy. Eight years later, rates were still near zero. As the economy strengthened, the FED raised rates nine times between 2015 and 2018.

Another significant intervention by the FED occurred in 2020 during the COVID-19 pandemic. Financial market turmoil erupted in early March as the pandemic spread. The FED quickly acted by lowering interest rates to zero to provide liquidity and ensure market functioning. Its aggressive response likely prevented a financial crisis and helped with recovery from a severe but brief recession.

How does the FED impact your investments?

FED decisions have important consequences for the U.S. stock market.

When the FED lowers interest rates, it can lead to higher stock prices because investors are willing to pay more for companies' future cash flows. Additionally, with expectations of greater economic growth and easier access to capital, corporate profits also rise. For this reason, during periods of low interest rates, growth stocks tend to perform well.

The opposite occurs when interest rates rise. Typically, the stock market falls under these circumstances because economic growth slows and capital moves to more conservative investments.

How to invest in 2023 based on FED decisions

After starting 2022 near an all-time high, the S&P 500 ended the year with a 19.4% annual loss, the worst market performance since 2008. Although the outlook is more optimistic for 2023, significant volatility is expected due to inflation and employment news in the U.S.

Ultimately, while short-term FED rate hikes cause a dip in the U.S. stock market, it's a necessary pain to preserve economic stability in the long term.

FED policies can have a significant impact on your personal finances. Therefore, understanding its role in the economy and the stock market can help you make more informed decisions.

To stay updated with all stock market movements and FED policies, don't forget to follow Hapi's social media and blog. There, you'll find information to make informed investment decisions according to your preferences. Plus, if you don’t yet have a portfolio, download the app here to start investing without commissions or minimum amounts from Latin America.