Why Stocks Fell After the Fed Decision

The stock market lost ground on Wednesday, and all of the decline came after the Federal Reserve released its latest decision on monetary policy. The Dow Jones Industrial Average (^DJI -0.65%), S&P 500 (^GSPC -1.20%), and Nasdaq Composite (^IXIC -1.79%) had all been seeing sizable gains on the day coming into the early afternoon, but by the end of the trading session, all three were down, albeit by less than 1%.

Data source: Yahoo! Finance.

For the most part, the Fed decision went largely as the majority of investors had expected. Yet from the immediate response to the news, you might think that there was something buried in the central bank's announcement or some nuance in the subsequent press conference that gave investors a new look at the likely course of future policy. And indeed, there were some things behind the scenes that might have given market participants some pause about how 2023 is likely to go.

What the Fed said

As was largely expected, the Fed boosted its target range for the federal funds rate by half a percentage point, setting the new range at 4.25% to 4.5%. Some investors had been concerned that the central bank might do a three-quarter percentage-point increase for the fifth consecutive time, but most had anticipated a slowing of the pace of rate hikes based on changes to the Fed's post-meeting statement roughly six weeks ago.

Most aspects of the Fed's statement remained largely the same from the last meeting. The Fed said it would keep taking into account the fact that there will be a lag between its past tightening moves and when their effect will show up in measures of inflation and economic activity. Nevertheless, the Fed believes that it will take further increases in the target for the fed funds rate before its policy will be sufficiently restrictive to return inflation rates back to the central bank's long-term 2% annual target.

Image source: Getty Images.

However, there were significant changes in the accompanying materials that the Fed released along with the statement. In its economic projections, the Fed expects economic growth to remain sluggish well into the future, with real gross domestic product rising just 0.5% in 2023 and 1.6% in 2024 before returning to a long-term expectation of 1.8% annually. Those projected numbers were weaker than in the Fed's projections from September.

Unemployment is likely to rise by nearly a full percentage point next year to 4.6% according to Fed members, which is higher than previously projected. Fed members also kicked up their inflation expectations, although they still think personal consumption expenditure prices will rise just 3.1% in 2023, reflecting a quick reversal in price pressures.

Probably the biggest change came in the Fed's anticipated course of future monetary policy. The board now expects the fed funds rate to rise to 5.1% in 2023, up fully half a percentage point from its projections just three months ago. That implies more tightening than many investors had hoped to see, and it arguably raises the chances that strict monetary policy will cause a prospective recession to occur.

Market reaction to the Fed

In addition to stocks falling, bond yields immediately rose following the Fed decision. Yet both of those moves moderated somewhat over the rest of the afternoon, with investors seemingly feeling more comfortable about what the future will bring.

Within the stock market, investors seemed to get more conservative. Healthcare stocks were the only group that rose on the day, and traditionally defensive sectors like utilities and consumer staples had only minimal losses. By contrast, higher-growth areas like communication services struggled, as did financial stocks, which have gotten whipsawed by an inverted yield curve.

All in all, the market's reaction to the Fed was relatively muted, and stocks didn't give up much of their gains from earlier in the week. Even if investors are disappointed today, that should provide some reassurance that a bull market will come eventually -- even if the Fed has more surprises up its sleeve in 2023.