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A common belief among investors is that central banks – the institutions responsible for monetary policy in most major countries – have material influence over the economy and, therefore, equity markets. Any time a central bank acts or comments, investors dissect minor details for clues about the economy and what it means for markets. But do central banks really have the outsized influence many believe?
In Fisher Investments Canada’s view, central banks have much less influence on markets than many think. In this article, Fisher Investments Canada will review the tools central banks use to enact monetary policy, the real-world impact of their decisions and why long-term investors should look beyond central banks’ actions when reviewing their investment strategy.
Understanding how central banks utilize monetary policy
Before we can understand how central banks influence markets, it’s important to know how these institutions operate. Some central banks, such as the U.S. Federal Reserve, have a dual mandate that includes maintaining optimal employment levels, but the primary mandate of most central banks is to promote a stable price environment (i.e. control inflation). To accomplish their goals, central banks implement various forms of monetary policy to attempt to influence the amount of money in circulation. Let’s take a closer look at some of these tools.
Short-term interest rates
Fisher Investments Canada knows that perhaps the most well-known and commonly used tool by central banks is adjusting interest rates – sometimes referred to as the “policy rate” or “overnight rate.” If a bank needs additional funds to cover short-term cash fluctuations – or meet reserve requirements from regulators, where applicable – it can borrow from the central bank, or fellow banks, at or near the overnight rate.
When central banks lower overnight rates, it makes money cheaper to borrow between institutions and the central bank, potentially increasing a bank’s desire to lend money because of lower borrowing costs. Some believe this “loosening” of monetary policy can help to spur economic growth. Conversely, when central banks increase overnight rates, this could disincentivize banks to lend.
However, Fisher Investments Canada believes it’s important to remember that interbank borrowing is not the only factor that can affect the lending environment. Central banks only set overnight rates, which most directly impact short-term interest rates. Long-term interest rates – which consumers and businesses actually borrow at – are not directly controlled by central banks and are primarily influenced by free-market forces (i.e. supply and demand).
Open market operations
Another tool central banks may use to influence the money supply are open market operations. This is when a central bank becomes an active market participant to attempt to influence parts of the market it has less direct control over. A notable example of this was when the U.S. Federal Reserve, European Central Bank (ECB), Bank of England (BoE) and others engaged in a program called “quantitative easing”(QE) following the great financial crisis in 2008-2009. The theory behind QE was that a central bank could become a major buyer of its own country’s debt to artificially keep long-term interest rates low. The belief was low rates would stoke demand for loans and boost the economy.
Fisher Investments Canada could write a book on all the flaws in this logic and whether QE was effective (in our view, it wasn’t), but most of these programs are being slowly unwound – sometimes called “quantitative tightening.” However, that’s a topic for another day and central banks continue to see various forms of open market operations as viable options, if needed.
Reserve requirements
In some nations, central banks set reserve requirements, which are meant to help ensure banks have enough money to pay out customer withdrawals and absorb unexpected losses. If a central bank raises reserve requirements, banks may have less money to lend, constricting the money supply. On the contrary, lowering or removing reserve requirements could be seen as supportive of lending and loosening the money supply.
A real-world look at the impact of central bank decisions
Now that we’ve discussed some of the tools central banks have, Fisher Investments Canada will take a look at some of the recent real-world impact of their policies. Often, monetary policy decisions don’t live up to investors’ initial fears or hopes. One example of this occurred when central banks around the globe quickly hiked short-term interest rates from mid-2022 through 2023 in response to high inflation. Many investors feared these rate hikes would be negative for equity markets. Yet, among the rapid rate hikes, global equity markets bottomed in October 2022, forming a new bull market that grew through several additional rate hikes in 2023 – counter to financial media narratives, in Fisher Investment Canada’s review.
Rate cuts on the other hand are reputed by many to be good for equities, with cheaper lending thought to spur economic growth. Yet, as seen in Exhibit 1, equities have a high frequency of positive returns 12 months after both rate hike and cut cycles. Though the chart depicts S&P 500 returns – a U.S. equity index – and Fed policy turning points, it demonstrates how developed equity markets tend to react to central bank decisions.
Exhibit 1: U.S. Equity Returns 12 Months Following Rate Hikes & Cuts
Source: FactSet, as of 1/7/2025. S&P 500 Price Index Return and Initial rate cute dates of each interest rate cycle, 1/1/1950 – 12/31/2024. 12-month rolling returns are calculated on a monthly basis, while the forward returns are from the date of the cut/hike.Supplied
Monetary policy – just one of many factors driving markets
Central banks and monetary policy changes will continue to make news cycles, and many investors will continue to overstate their impact to equity markets. It is true that central banks can make policy errors that have derailed bull markets in the past, often involving reacting too late or leaving monetary policy too restrictive, for too long. But, in our view, there are many more economic, political and sentiment factors investors should consider when assessing whether a central bank decision is positive or negative for markets. Fisher Investments Canada believes long-term investors should focus on fundamental market drivers instead of allowing central bank speculation to drive their equity investing decision-making processes.
Read Fisher Investments Canada's additional reviews of markets and financial topics.
Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates. This document constitutes the general views of Fisher Investments Canada and should not be regarded as personalised investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments Canada will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
Fisher Investments Management, LLC does business under this name in Ontario and Newfoundland & Labrador. In all other provinces, Fisher Asset Management, LLC does business as Fisher Investments Canada and as Fisher Investments.
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