The Federal Reserve ended its December meeting by announcing a 0.5% increase in the benchmark interest rate Wednesday. That’s less than the 0.75% increases from four previous meetings in 2022, but it still caused stocks to whipsaw throughout the day.
Why did the Fed announce a 0.5% interest rate increase?
“The Fed is raising rates because they want to slow down inflation,” says Gabriela Best, an associate professor of economics at California State University, Fullerton and a former researcher for the Federal Reserve Bank of St. Louis.
Best says higher interest rates increase the cost of borrowing, which means people and businesses have less money to spend. That slows the price increases we call inflation — but it’s a double-edged sword.
“When they raise interest rates, they lower demand for goods and services. But then, when demand for goods and services decreases, so does gross domestic product,” Best says.
In other words, she says, raising interest rates can shrink the economy and cause a recession. That means higher unemployment.
“They want to slow down inflation, but they don’t want unemployment to skyrocket,” Best says.
The last two monthly consumer price index, or CPI, reports from the U.S. Bureau of Labor Statistics showed lower inflation numbers than economists expected — and much lower inflation numbers than those from the summer.
The Fed is tasked with keeping inflation and unemployment at low and stable levels. Given the unexpected decrease in inflation, the central bank decided to make a smaller increase to the benchmark interest rate — 0.5% instead of the previous 0.75% — to continue tamping down inflation while minimizing any increase in unemployment.
“The inflation data received so far for October and November show a welcome reduction in the monthly pace of price increases, but it will take substantially more evidence to give confidence that inflation is on a sustained downward path,” Federal Reserve Chair Jerome Powell said at the post-meeting news conference.
“In light of the cumulative tightening of monetary policy, and the lags with which monetary policy affects economic activity and inflation, the committee decided to raise interest rates by 50 basis points today — a step down from the 75-basis-point pace seen over the previous four meetings,” Powell said.
What does a 0.5% rate increase mean for stocks?
In the weeks leading up to the December Fed meeting, stocks rose in anticipation of the smaller interest rate increase. The Dow Jones Industrial Average rose modestly in the month leading up to the meeting. It surged 2.18% on Nov. 30 after Powell said in a speech that he was open to a 0.5% increase in December.
Best says the market tends to react positively to Fed moves that are less aggressive than previously expected.
“When interest rates go up, it affects investment. So if the increase is lower, that’s going to affect investment less — including buying stocks,” she says.
However, the market reacted negatively after Wednesday’s meeting. Along with the interest rate decision, the Fed released a summary of economic projections that expected more rate increases in 2023 and predicted a benchmark rate of 5.1% at the end of next year. The Dow closed down about 0.4% on Wednesday, and then fell an additional 2.25% on Thursday.
“An aggressive [rate increase] policy would have a huge effect on demand, GDP and investment, and that’s not good for the stock market,” Best says.
What does it mean for inflation?
In theory, the increase in interest rates should help tamp down inflation. But in practice, experts aren’t sure how effective it will be.
“Inflation, in terms of what has the biggest impact on CPI, has been overwhelmingly dominated by a few sectors — and at that, a few sectors that rate hikes don’t have much impact on,” says Nathan Tankus, the research director of the Modern Money Network, a monetary policy think tank.
Tankus says those sectors include consumer staples and energy.
Best agrees that some of the inflation is driven by “supply-side factors” — that is, a scarcity of goods and services rather than an excess of money to spend on them.
As an example, Best points to how the rising price of energy is largely driven by geopolitics.
“The war between Russia and Ukraine is affecting the price of oil, and the price of oil is affecting transportation costs and production costs everywhere,” she says.
How does it affect the odds of a recession?
“Economists are predicting a recession for 2023, no matter what happens with interest rates,” Best says. However, she says slower interest rate increases might make it less severe than previously expected.
“Does the Fed want to take two years to lower inflation, or do they want to take one year to lower inflation? Do they want to lower inflation quickly, or do they want to lower inflation slowly? That’s the difference,” Best says.
She explains that the fast approach — continued 0.75% increases — would likely result in a steeper recession than the slow approach the Fed is now taking with the 0.5% increase.
“If they increase [rates] more, it’s going to be a more severe recession, and if they increase them less, then the recession will be milder, but it’s going to be there anyway,” she says.
What’s in store for the next Fed meeting?
Investors should count on more rate increases in 2023, Tankus says.
“The way things look now, it seems like the Fed is going to slow the pace of hiking, but not overwhelmingly so,” Tankus says.
“If economic data keeps going the way it has been, I think there’s going to be very strong pressure to continue,” he says.
Powell made similar remarks in the post-meeting news conference.
“We still have some ways to go. As shown in the summary of economic projections, the median projection for the appropriate level of the federal funds rate is 5.1% at the end of next year — a half percentage point higher than projected in September,” he said.
Powell went on to say that the federal funds rate is projected to stay “above the median estimate of its longer-run value” until the end of 2025, at least.
So although the Fed is slowing the pace of interest rate increases, it may take a while before the increases stop altogether — and it may take even longer before rates come down.
It’s difficult to predict with certainty what this all means for the stock market. As Powell said at the post-meeting news conference, “financial conditions fluctuate in the short-term in response to many factors.”
And ultimately, for long-term, buy-and-hold investors, those fluctuations may not be that important. The S&P 500 index has had an average annual return of about 10% over the past century — during which the Fed has raised and lowered interest rates many times.