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Here’s Why the Stock Market Plunged After the Fed’s Interest-Rate Announcement

By Matthew Frankel, CFP® - Dec 20, 2018 at 6:22AM

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The rate hike was widely expected, so why did the market panic?

The Federal Open Market Committee, or FOMC (the "Fed"), decided to raise the federal funds rate by 25 basis points at the conclusion of its December meeting. The Dow Jones Industrial Average shed as much as 850 points after the move was announced, and at first glance, this might seem rather surprising. After all, the rate hike was widely expected.

The reason for the stock market sell-off goes beyond the rate hike and has to do with the policy-making FOMC's future outlook for economic growth, unemployment, inflation, and of course, for future rate hikes. Here's a rundown of what investors need to know about the Fed's decision and the subsequent plunge in the stock market.

Man scratching his head, with confused look on his face.

Image Source: Getty Images.

Outlook for GDP growth

The Fed's outlook for economic growth is a bit slower than it previously had been. It's now projecting gross domestic product (GDP) growth of 3% for the full year of 2018, down slightly from 3.1% in September. For 2019, the new 2.3% GDP growth expectation represents a 0.2% reduction.

However, it may surprise investors to learn that the Fed's long-run GDP growth estimate is now 1.9%, which is up from the previous 1.8%. In other words, the Federal Reserve seems to think that the economy is actually a bit healthier on a long-term basis than investors were expecting.

Outlook for unemployment and inflation

Unemployment and inflation projections also were disappointing to anyone who was hoping for rate hikes to stop after 2018. The FOMC's median unemployment projection for 2019 remained unchanged at a remarkably low 3.5%. And although the 2020 estimate increased by one-tenth of a percent to 3.6%, the Fed's long-run estimate actually dropped from 4.5% to 4.4%.

Additionally, the Fed's 2019 inflation projection fell by 0.1% to a core inflation rate of 2%. While this is lower, it's right in-line with the Fed's long-term target.

The Fed's statement

Along with its interest-rate decisions, the FOMC releases a statement explaining its decision and offering hints about its future outlook. The FOMC words this document very carefully, as it's one of the most dissected documents in all of finance.

In the December statement, there were a few things that could have scared investors. First and foremost, many investors expected the Fed to back off from its language stating that "further gradual increases" are on the horizon. Well, it didn't. From the statement: "The Committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective over the medium term."

Sure, the word "some" was a new addition, but this wasn't nearly as dovish as many observers had hoped for. And the FOMC indicated that it would take a more data-driven approach to rate hikes going forward by adding that the Committee "will continue to monitor global economic and financial developments and assess their implications for the economic outlook."

The most important part: The FOMC's "dot plot"

The FOMC members each make their projections of where they see interest rates going over the next few years. We can use these projections to derive a general idea of what to expect from the Fed.

Here's what the consensus is calling for. The FOMC now sees two rate hikes in 2019, down from its previous expectation of three. The Committee is definitely toning down its expectations, but the market had been pricing in just one 2019 rate hike, so this is certainly a negative surprise for observers hoping for lower rates. Furthermore, it's important to emphasize that two rate hikes is the average expectation of FOMC members -- there are six members who still say there will be three.

Beyond 2019, FOMC members project one more rate hike in 2020 and now see "neutral" at 2.8%, down from 3% previously. Still, the idea that the Fed thinks it will keep rates above neutral for much of 2019 and 2020 seems to be scaring the market.

What it all means

The key takeaway is that the policy-making FOMC clearly doesn't see nearly as much economic trouble on the horizon as many market experts do. The Fed expects interest rates to continue to rise, and many investors seem to be worried that the Fed may take rates too high, too fast.

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