The Federal Reserve has had the stock market in the palm of its hand all year, and that was abundantly clear this past Wednesday, Dec. 14.

The central bank raised the benchmark federal funds rate by 50 basis points (1 basis point = 0.01 percentage point), as was largely expected. However, commentary from Fed chair Jerome Powell and the updated forecast for 2023 helped lead to a sharp sell-off in stocks on Thursday and into Friday.

The S&P 500 lost 2.5% on Thursday and finished Friday down another 1.1% as investors seem to now think a recession is more likely in 2023, especially after a weak November retail sales report on Thursday. 

Just like the average investor, though, the Fed doesn't have a crystal ball, and its forecasts for a year or more into the future can change quickly.

Last year, for example, Powell was playing down the threat of inflation, saying that rising prices were "transitory." After price increases continued to get worse over several months, exacerbated by Russia's invasion of Ukraine, the Fed finally began raising interest rates in March to bring inflation to heel. The string of 75-basis-point hikes, its most aggressive hikes since 1994, is a reminder that the Fed got inflation wrong, and it had to make up for its delayed response with unusually fast increases in the fed funds rate.

The facade of the Federal Reserve

Image source: Getty Images.

How the Fed sees 2023

The central bank now expects to finish next year with the federal funds rate between 5% and 5.25%, implying 75 basis points in hikes in 2023. That forecast is also 50 basis points higher than its last one in September, showing that the economy hasn't responded to prior hikes as much as the central bank had expected. Indeed, the unemployment rate has remained low, and Powell has previously said that there would likely need to be some pain in the labor market in order to bring inflation down to the Fed's target of 2%.

The Fed's other forecasts also indicate it sees greater challenges to the economy as it calls for inflation, based on personal consumption expenditures, to rise 3.1% at the end of 2023, up from its September forecast of 2.8%. It sees an unemployment rate of 4.6%, compared to its earlier prediction of 4.4%, and it cut its end-of-year GDP forecast from 1.2% growth to 0.5%. All those signs indicate a recession could be worse than it previously thought.

A moving target

The Fed freely admits that its forecasts are subject to change based on a range of factors, including public health, the labor market, inflation, and financial and geopolitical events.

Going into 2022, for example, it would have been hard to foresee Russia's invasion of Ukraine, which has had a significant impact on global commodity prices, in particular for food and energy.

The Fed also gives a historical error range for its predictions, essentially telling investors not to take them at face value. In the case of the 5.1% forecast for the fed funds rate at the end of 2023, the central bank said it's historically had a margin of error of plus or minus 1.2 percentage points when making an interest rate prediction that far out. In other words, the fed funds rate a year from now could be anywhere from 3.9% to 6.3%.

What's an investor to do?

While the Fed's behavior is likely to dictate the market's direction in 2023 as well, it's a waste of time to try to read its tea leaves. Even the Fed itself makes clear that there's a wide range of outcomes for next year, and that's based on what's currently known.

Going into next year, investors should be aware that a recession is a real likelihood, and investors shouldn't be surprised to see stocks dip further.

The best thing to do in this type of environment is to buy shares of high-quality companies and keep some dry powder available in case stocks fall even further. 

It's impossible to predict the Fed's every move or when the bottom will be reached, but investors can be assured of one thing: The economy will eventually turn, and a bull market will start again. Focusing on owning high-quality stocks rather than anticipating the Fed's every move is the best strategy you can have.