Rising levels of inflation wrecked the stock market party in 2022. Could the same happen in 2026? Federal Reserve Chair Jerome Powell certainly thinks it is a possibility. After the Federal Reserve decided to keep interest rates unchanged at its latest policy meeting, the central bank’s leader said it is taking a wait-and-see approach to policy decisions.
Specifically, Powell and the rest of the bank are worried about a spike in inflation and whether they will have to raise interest rates to bring it back down. This could shake the stock market and even bring an end to the current bull market in artificial intelligence (AI) stocks.
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Worried about inflation over all else
One of the Federal Reserve’s key concerns is managing inflation. If inflation runs too high, it will raise its benchmark interest rate to tamp down on demand. If inflation is too low, it will try to lower interest rates to stimulate the economy.
The problem with raising interest rates is that it can negatively impact parts of the economy and financial markets, even inducing a recession. Mortgage rates will be higher for homebuyers, as well as for virtually all kinds of loans people want to take out to manage their financial lives.
Powell says the Federal Reserve is currently concerned about the impact of spiking energy prices and how they could lead to more inflation. If inflation rises well above its 2% target again, it is likely that the Federal Reserve will raise its benchmark interest rate from its current range of 3.5% to 3.75%.
How does this impact the stock market? When debt is more expensive to obtain, it can reduce investor aggressiveness and make Treasury bills more attractive to buy. Right now, the market is being driven by the growing spending from AI companies. A lot of this growth is fueled by debt. Essentially, the Federal Reserve may take the punchbowl away from the party before it gets sloppy, which may be good for the economy in the long term, but that does not necessarily mean it will be good for the stock market in the short term.
Are interest rate hikes in the cards?
Predicting what the Federal Reserve will do is extremely difficult. Not even its members can agree on what it will do this year, as it has to respond to developments in the economy. Half of its members expect no changes in interest rates this year, but the actual outcomes of the Federal Reserve’s interest rate decisions relative to its historical expectations have poor predictive power.
However, if inflation rears its ugly head again and the Federal Reserve does raise interest rates, it will likely not be good for stocks.
Brett Schafer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
