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Every bull market needs a theory. And two months can be a long time in stock markets. The Dow Jones Industrial Average, America’s premier stock market index, was at 28,726 points as of September-end. It has rallied by around 20% to close at 34,347 points as of Friday.

This is in an environment where the US Federal Reserve has been raising the federal funds rate, its key short interest rate, to rein in decadal high retail inflation in the US. In October, the inflation stood at 7.8%.

The federal funds rate, the interest rate at which commercial banks in the US lend excess reserves overnight, has been raised from the range of 0-0.25% in March to 3.75-4% currently.

Typically, as interest rates rise, investors pull their money out of stocks and invest in fixed-income investments. Nonetheless, enough of that doesn’t seem to be happening currently with US stocks having risen by close to 20% in the last two months.

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Why is that? At a simple level, interest rates are still much lower than the prevailing inflation rate, incentivizing investors to continue betting on stocks. But more importantly, the stock market is betting on the theory that as economic conditions deteriorate, the Fed will pivot, meaning it will stop raising the federal funds rate and might even cut it.

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The trouble is, this isn’t the message being sent out by the Fed. Last week, the minutes of the meeting of the Federal open market committee (FOMC), which happened in early November, were published. The FOMC decides on the monetary policy of the US.

There are two important points that came out of these minutes. First, as the minutes pointed out: “A substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate." The last four times the FOMC has met, it has raised the federal funds rate by 75 basis points each time. The minutes of the last meeting seem to suggest that the FOMC now plans to slow down the pace of the federal funds rate increase. This means that when the FOMC meets next on 13-14 December, it will probably raise the rate by 50 basis points.

The reason for this lies in the fact that the effect of monetary policy on economic activity and inflation happens with a lag, and hence, a slower pace of interest rate hikes allows the Fed “to assess progress toward its goals of maximum employment and price stability" in a much better way.

The stock market is betting on the fact that the slower pace of an increase in the federal funds rate might ultimately lead the Fed to pivot. But, the Fed in the minutes isn’t saying that. And that’s the second important point that comes out of the FOMC minutes.

The Fed’s message is that it is now important to see to what level the FOMC will increase rates to control inflation rather than be obsessed with “the pace of further increases in the target range," as the stock market is.

In September, the FOMC had projected that it saw the federal funds rate going up to as high as 4.6% in 2023. But given that the rate is already in the range of 3.75-4% currently, it is highly likely that the terminal funds’ rate will be higher than projected in the past. This is because inflation still remains at considerably higher levels than the Fed and the American economy are comfortable with.

To conclude, the key takeaway from the Fed’s meeting is that it will raise the federal funds rate at a slower pace than was the case throughout this year. Nonetheless, that doesn’t mean that it will stop raising rates. On the other hand, with so much easy money still going around, the stock market continues to bet on the Fed pivot.

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