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The Federal Reserve concluded its December meeting by announcing a 0.5% hike in its benchmark interest rate on Wednesday. This is less than a 0.75% increase from the previous four meetings in 2022, but it still sent stocks fluctuating throughout the day.
Why did the Fed announce a 0.5% interest rate hike?
“The Fed is raising rates because it wants to slow inflation,” says Gabriela Best, an assistant professor of economics at California State University in Fullerton and a former fellow at the Federal Reserve Bank of St. Louis.
Best says that higher interest rates increase the cost of borrowing, meaning that people and businesses have less money to spend. This slows down the rise in prices, which we call inflation, but it is a double-edged sword.
“When they raise interest rates, they reduce the demand for goods and services. But then when the demand for goods and services goes down, so does the gross domestic product,” says Best.
In other words, she says, raising interest rates could shrink the economy and trigger a recession. This means higher unemployment.
“They want to slow down inflation, but they don’t want soaring unemployment,” Best says.
The last two monthly consumer price index or CPI reports from the US Bureau of Labor Statistics showed lower inflation figures than economists had expected, and much lower inflation figures than summer ones.
The Fed is tasked with keeping inflation and unemployment low and stable. Given the unexpected decline in inflation, the central bank decided to increase the base interest rate by 0.5% instead of the previous 0.75% in order to continue to contain inflation and minimize the rise in unemployment.
“Inflation data available so far for October and November shows a welcome decline in monthly price growth rates, but much more evidence will be needed to make sure inflation is on a sustained downward path,” said Federal Reserve Chairman Jerome Powell. at the post-match press conference.
“In light of the cumulative tightening of monetary policy and the lag in which monetary policy affects economic activity and inflation, the committee decided today to raise interest rates by 50 bps, a step down from the 75 bps pace seen earlier. . previous four meetings,” Powell said.
What does a 0.5% rate hike mean for stocks?
In the weeks leading up to the Fed’s December meeting, stocks rose on anticipation of a modest rate hike. The Dow Jones Industrial Average rose modestly a month before the meeting. It rose 2.18% on November 30 after Powell said in a speech he was ready for a 0.5% increase in December.
Best says the market is generally reacting positively to the Fed’s actions, which are less aggressive than previously expected.
“When interest rates rise, it affects investment. Therefore, if the increase is lower, it will have less effect on investments, including the purchase of shares,” she says.
However, the market reacted negatively to Wednesday’s meeting. Along with the interest rate decision, the Fed released a summary of economic forecasts that expect further rate hikes in 2023 and forecast a base rate of 5.1% at the end of next year. The Dow closed up about 0.4%.
“Aggressive [rate increase] politics will have a huge impact on demand, GDP and investment, which is not good for the stock market,” says Best.
What does this mean for inflation?
In theory, raising interest rates should help bring down inflation. But in practice, experts are not sure how effective this will be.
“Inflation, in terms of what has the biggest impact on the CPI, has been in the vast majority of sectors — and there are a few sectors that are not significantly impacted by rate hikes,” says Nathan Tankus, director of research at Modern Money Network, analyst center of monetary policy.
Tankus says these sectors include consumer goods and energy.
Best agrees that part of inflation is due to “supply factors”, i.e. shortages of goods and services rather than excess money to spend on them.
As an example, Best points to the fact that the rise in energy prices is largely due to geopolitics.
“The war between Russia and Ukraine affects the price of oil, and the price of oil affects transportation costs and production costs everywhere,” she says.
How does this affect the likelihood of a recession?
“Economists are predicting a recession for 2023, no matter what happens to interest rates,” Best says. However, she says that a slower increase in interest rates could make the situation less serious than previously expected.
“Does the Fed want two years to bring inflation down, or do they want one year to bring inflation down? Do they want to bring inflation down quickly or do they want to bring inflation down slowly? That’s the difference,” says Best.
She explains that the fast approach — continuing the 0.75% gain — is likely to lead to a steeper recession than the slow approach the Fed is now taking with 0.5% growth.
“If they increase [rates] more, it will be a more severe recession, and if they increase them less, then the recession will be softer, but it will still be,” she says.
What’s in store for the next Fed meeting?
Investors should look forward to further rate hikes in 2023, Tankus said.
“Based on the way things are now, it looks like the Fed is going to slow down the pace of the recovery, but not too much,” Tankus says.
“If economic data stays the same as before, I think there will be very strong pressure to continue,” he says.
Powell made similar remarks at a press conference after the meeting.
“We still have ways. As shown in the Economic Forecasts Summary, the median forecast for the corresponding level of the federal funds rate is 5.1% by the end of next year, half a percentage point higher than forecast in September,” he said.
Powell went on to say that the federal funds rate is projected to remain “above the average estimate of its long-term cost” through at least the end of 2025.
So while the Fed is slowing down the pace of interest rate hikes, it may take some time before growth stops completely, and it could take even longer for rates to come down.
It’s hard to predict with certainty what all this means for the stock market. As Powell said in a press conference after the meeting, “financial conditions in the short term fluctuate depending on many factors.”
And ultimately, for long-term buy-and-hold investors, these fluctuations may not be all that important. The S&P 500 has averaged about 10% annual returns over the past century, during which the Fed has raised and lowered interest rates many times.