What the Next Fed Meeting Interest Rate Hike Effect on the Markets

According to Gabriela Best, an associate professor of economics at California State University, Fullerton, and a former researcher for the Federal Reserve Bank of St. Louis, the Federal Reserve (Fed) is raising interest rates to combat inflation. However, this action may have unintended economic consequences.

Higher interest rates raise the cost of borrowing, resulting in less disposable income for individuals and businesses. This has the potential to slow the rate of price increases, also known as inflation. It can, however, hurt the economy. As demand for goods and services falls due to higher borrowing costs, gross domestic product (GDP) may fall as well, potentially leading to a recession and higher unemployment.

As a result, the Fed must strike a balance between the desire to reduce inflation and the need to avoid negative effects on the economy and employment. "They want to slow inflation, but they don't want unemployment to skyrocket," Best observed.

Recent Consumer Price Index (CPI) reports from the United States Bureau of Labor Statistics showed lower-than-expected inflation rates, especially when compared to the high rates seen earlier in the year. As a result, the Federal Reserve (Fed) has decided to raise the benchmark interest rate by 0.5% rather than the previously planned 0.75%. This decision seeks to maintain efforts to reduce inflation while minimizing the potential impact on unemployment.

Learn more about What is Inflation and How To Fight Agaisnt It

"The inflation data received so far for October and November show a welcome reduction in the monthly pace of price increases," says Federal Reserve Chair Jerome Powell, "but it will take significantly more evidence to give confidence that inflation is on a sustained downward path." The Fed is in charge of keeping inflation and unemployment at low and stable levels.

According to Federal Reserve Chair Jerome Powell, given the previous increases in monetary policy and the time it takes for these changes to affect the economy and inflation, the Fed meeting has decided to raise interest rates by 50 basis points, a decrease from the previous pace of 75 basis points in the previous four meetings.

Stocks rose ahead of the Federal Reserve's December meeting in anticipation of a smaller interest rate increase. The Dow Jones Industrial Average rose modestly in the run-up to the meeting, rising 2.18% on November 30th after Federal Reserve Chair Jerome Powell gave a speech in which he indicated openness to a 0.5% interest rate increase in December.

According to Gabriela Best, market reactions to the Fed meeting actions that are less aggressive than expected are generally positive. She elaborates, "When interest rates rise, investment suffers. So, if the increase is lower, it will have less of an impact on investment, including stock purchases."

Despite initial positive reactions, the market reacted negatively following the December meeting of the Federal Reserve. Along with the interest rate decision, the Fed meeting released a summary of economic projections, which predicted further rate increases in 2023 and a benchmark rate of 5.1% by the end of the following year. As a result, the Dow Jones Industrial Average fell about 0.4% on Wednesday and another 2.25% on Thursday.

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An aggressive policy on interest rate increases, according to Gabriela Best, can have a significant impact on demand, GDP, and investment, which can be negative for the stock market. "An aggressive [rate increase] policy would have a huge effect on demand, GDP, and investment, which is not good for the stock market," she says.

While an increase in interest rates should help to control inflation in theory, experts are skeptical of its actual effectiveness. According to Nathan Tankus, research director of the Modern Money Network, a monetary policy think tank, certain sectors, such as consumer staples and energy, have a significant impact on the Consumer Price Index (CPI) and may be unaffected by interest rate changes.

Not only economic inflation, but there is also a type called as Lifestyle Inflation, What It Is?

Gabriela Best concurs that some inflation is caused by "supply-side factors," or scarcity of goods and services rather than an abundance of money to spend on them. She uses the rising price of energy as an example, which is frequently influenced by geopolitical events. "The war between Russia and Ukraine affects the price of oil, and the price of oil affects transportation costs and production costs everywhere," Best writes.

Economists, according to Gabriela Best, predict a recession in 2023 regardless of interest rate trajectory. She does, however, note that if interest rates rise at a slower pace, the recession may be milder than previously anticipated. Best explains that when making decisions, the Fed must consider the trade-off between the speed and severity of the recession. A faster approach, such as continuing 0.75% increases, may result in a deeper recession, whereas a slower approach, such as the current 0.5% increase, may result in a milder recession. "If they increase [rates] more, it will be a more severe recession; if they increase them less, the recession will be milder, but it will still be there," Best observes.

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Investors should expect more interest rate hikes in 2023, according to Nathan Tankus, research director of the Modern Money Network, a monetary policy think tank. Tankus believes the Fed will keep raising interest rates slowly, but not significantly. He observes that if economic data remains unchanged, there may be pressure to maintain the current trajectory.

This view is supported by Federal Reserve Chair Jerome Powell, who stated at the post-meeting news conference that the median projection for the appropriate level of the federal funds rate by the end of the following year is 5.1%, a 0.5 percentage point increase from the September projection. Powell also stated that the federal funds rate is expected to remain "above the median estimate of its longer-run value" until at least the end of 2025.

The exact impact of these interest rate changes on the stock market is difficult to predict because financial conditions can fluctuate in response to a variety of factors in the short term. Long-term investors, on the other hand, may not notice the fluctuations as much, as the S&P 500 index has had an average annual return of around 10% over the last century, despite numerous interest rate changes by the Fed meeting.