The Federal Open Markets Committee (FOMC), the policy-making arm of the Federal Reserve, raised the benchmark federal funds rate by a quarter of a percentage point on Wednesday to a target range of 4.75% to 5%. Even though this was the more aggressive of the two most likely outcomes of the Fed meeting, the S&P 500 briefly spiked higher after the move was announced -- only to fall from there and end the day down 1.65%.
Here's a look at why the market reacted as it did and what might happen with interest rates going forward.
Why did investors have mixed feelings after the rate hike?
Over the past year or so, the Fed has made a series of aggressive rate hikes to attempt to slow down inflation, and it apparently feels that continued rate increases are necessary. All other things being equal, higher interest rates are generally a negative catalyst for stocks, so it's not surprising that the market ultimately declined.
However, there are a few potential catalysts that could have led to the initial positive reaction to a higher federal funds rate. For one thing, the Fed indicated for the first time in the current rate hike cycle that we may be approaching the top. Previous versions of the statement accompanying the FOMC's decision used the phrase "ongoing increases" when discussing the outlook, but this one removed that language, instead saying that "some additional policy firming may be appropriate" to bring inflation to the 2% target level. Plus, the Fed kept its "terminal rate" unchanged from its December estimate at 5.1%, which implies only one more rate hike. Although this is the same as the previous forecast, it was just a few weeks ago that Fed Chair Jerome Powell said that the FOMC may need to raise rates higher than it previously anticipated.
Furthermore, the Fed makes it clear that it foresees rates declining in both 2024 and 2025, with a median projection of 3.1% by the end of 2025, with inflation approaching the 2% target at that point. For now, the FOMC said in a statement that unemployment remains low and inflation remains elevated, thereby justifying the latest rate hike.
On the other hand, investors may be perceiving this rate hike as an unnecessarily aggressive move considering the banking crisis that is still playing out. The FOMC acknowledged that the recent bank failures and ongoing uncertainty in that industry are likely to tighten credit conditions, slow down hiring, and put downward pressure on inflation. In a nutshell, these are the goals of the Fed's rate hikes, so investors may be wondering why the Fed decided to continue its tightening cycle.
Where will interest rates go from here?
One other interesting development is that the FOMC's projections of interest rates going forward and the market's expectations are two very different things, and this uncertainty likely isn't helping (markets do not like uncertainty).
The FOMC sees rates at 5.1% at the end of 2023, indicating one more 25-basis-point increase before pausing. The committee sees this falling to 4.1% at the end of next year and 3.1% at the end of next year, as previously mentioned.
On the other hand, according to the CME's FedWatch tool, the stock market is expecting the federal funds rate to fall this year by 50 basis points from the current level, and that the most probable outcome by the end of 2024 is a range of 3% to 3.25%, which the Fed doesn't think it will reach until the end of 2025.
In a nutshell, there's quite a bit of disconnect between the Fed's projections and where investors think interest rates will actually go. But whatever happens going forward, investors seem to be taking the outcome of this week's FOMC meeting as a sign that we're at or near the top of the rate hike cycle, although it appears the market was hoping for a pause in rate hikes or a softer tone from the committee.
