Investors Just Got a Subtle Warning From the Federal Reserve. History Says the Stock Market Will Do This Next.

The U.S. stock market has delivered sizable returns this year despite economic uncertainty created by the Iran conflict. The S&P 500 (SNPINDEX: ^GSPC) and Nasdaq Composite (NASDAQINDEX: ^IXIC) have added 10% and 12%, respectively, year to date. The primary driver behind the stock market's upside has been surprisingly strong corporate earnings.

But investors recently got a subtle warning from the Federal Reserve. Earlier this week, Fed Governor Christopher Waller delivered a speech at the New York Association for Business Economics. "The FOMC has to be ready to tighten monetary policy to prevent a repeat of the 2021-to-2022 inflation episode," he said, referring to the Federal Open Market Committee. "I am committed to returning inflation to the FOMC's 2% goal."

That may not sound like a warning, but Waller's comments underscore a hawkish shift at the Fed. A few months ago, most policymakers expected to lower interest rates this year, but the median projection now implies higher rates. And new tightening cycles have often coincided with stock market corrections.

Kevin Warsh is sworn in as chairman of the Federal Reserve. Image source: Official White House Photo.

Fed Chair Kevin Warsh is committed to bringing inflation back to target

The FOMC held its benchmark federal funds rate steady in June. But Chair Kevin Warsh acknowledged a serious problem in a speech following the meeting. "We recognize that inflation has been running well ahead of the Fed's long-stated goal of 2%. That's been going on for more than five years."

Warsh made it clear that above-target inflation was unacceptable. "I am pleased to report that members of the FOMC are unambiguous and unanimous: This committee will deliver price stability," he said. "We have the capability and commitment to deliver on our price-stability objective of 2%. That's exactly what we're going to do."

Reporters tried to coerce Warsh into divulging more. "Under what circumstances would you support the Fed taking some action and raising rates?" asked Colby Smith of The New York Times. But Warsh, who has criticized the practice of providing forward guidance, did not take the bait.

Nevertheless, investors can read between the lines. Inflation has been running above target for years, so the Fed must make changes to bring inflation down. That could mean holding rates steady for an extended period, but that may be too passive, especially since oil prices are rising again amid renewed hostilities between the U.S. and Iran.

Policymakers have become much more hawkish in recent months. As of June, the median estimate among FOMC officials implies one quarter-point rate increase in 2026, but six of 18 members expect at least two rate increases. Comparatively, zero FOMC officials anticipated rate increases in March, and the consensus actually called for a quarter-point rate cut this year.

History says interest rate increases could lead to a stock market correction

Since 1999, the Federal Reserve has initiated four tightening cycles, meaning it has pivoted from rate cuts to rate increases four times in the past quarter-century. The following chart shows the maximum drawdown in the S&P 500 and Nasdaq Composite during the three-month period following the first interest rate increase in each cycle.

Data source: Federal Reserve, YCharts. The table shows the maximum drawdown in the S&P 500 and Nasdaq Composite during the three-month period following the Fed's first rate increase in a tightening cycle.

Following the first interest rate increase in a tightening cycle, the S&P 500 and Nasdaq have fallen by an average of 10% and 15%, respectively, at some point in the next three months. In other words, both major stock market indexes have historically dropped into correction territory when the Fed has pivoted from rate cuts to rate increases.

Of course, rate increases are not set in stone. Micheal Feroli, chief U.S. economist at JPMorgan Chase, thinks the Fed will stay on hold in the remaining months of 2026, before raising in the second half of 2027. David Mericle, chief U.S. economist at Goldman Sachs, also expects the Fed to hold rates steady this year, but he expects two rate cuts in 2027.

Here's the bottom line: The Federal Reserve is determined to bring inflation back to target, and the consensus among policymakers calls for a quarter-point rate increase this year. History says that rate increase could sink the stock market, so investors should be ready for a drawdown.

JPMorgan Chase is an advertising partner of Motley Fool Money. Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Goldman Sachs Group and JPMorgan Chase. The Motley Fool has a disclosure policy.