Stocks finished lower on Wednesday, although the damage was fairly limited. The Dow Jones Industrial Average (^DJI 0.59%) and S&P 500 (^GSPC -1.39%) suffered somewhat steeper losses, approaching 1%, but the damage to the Nasdaq Composite (^IXIC -2.77%) was less than half a percent in the end.

Index

Daily Percentage Change

Daily Point Change

Dow

(0.80%)

(270)

S&P 500

(0.70%)

(29)

Nasdaq

(0.46%)

(55)

Data source: Yahoo! Finance.

Earnings season is approaching its peak, but most investors were squarely focused on the end of the Federal Reserve's two-day meeting to discuss interest rates. The move the central bank made was widely expected, but investors nevertheless seemed disappointed by some of the nuances of what Fed chair Jerome Powell said in the conference call following the decision.

Short-term fluctuations in stocks aren't always meaningful, but it was nevertheless surprising to some that the market reacted negatively to what many had already expected.

Federal Reserve building in Washington.

Federal Reserve. Image source: Getty Images.

What the Fed did

The Federal Open Market Committee (FOMC), which is the Fed body that deals specifically with monetary policy, voted unanimously to raise the federal funds rate by a quarter percentage point. That brought the target range for the fed funds rate to between 5% and 5.25%, its highest level in 16 years.

Much of the language in the FOMC statement was similar to what previous statements from past meetings have said. The Fed repeatedly asserted its commitment to get inflation back down to a 2% rate, saying it would continue to reduce the size of its balance sheet through its quantitative tightening measures. It reminded investors that it will consider that the actions it has already taken will have delayed impacts, and it will also continue to look at new economic data for guidance on whether its policy decisions are getting inflation under control.

Some investors were initially pleased to see a slight shift in language that suggested that the Fed might make no further increases to interest rates if new information on the economic outlook makes tightening from current levels unnecessary. Yet the Fed didn't choose to refer heavily to recent stresses in the banking sector as a possible excuse to slow the pace of its tightening.

Powell stands his ground

Fed chair Jerome Powell's press conference that began later in the afternoon prompted the stock market to decline. Powell emphasized tightness in the labor market, very low unemployment rates, and increasing labor force participation as contributing factors to inflation, and he pointed to several measures of prices that remain stubbornly high.

There were a few more dovish comments Powell made. He acknowledged that regional banks have tightened their credit standards, which should rein in leveraged economic activity from businesses and lead to less aggressive hiring among employers. Yet in the end, Powell still didn't rule out further interest rate increases.

A huge disconnect

Financial market investors remain convinced that the Fed is following the wrong course of action and will quickly have to do an about-face with monetary policy. Already, fed funds futures suggest that the Fed will have to cut rates by half a percentage point by the end of 2023, with the rate dropping to 3% by September 2024.

Indeed, market participants believe the chance of rate cuts is more likely now than before the Fed's latest statements. Yet Powell made no suggestion that the Fed is even considering cuts.

Eventually, that disconnect will resolve itself. That could happen in two ways: Either the market is right and the Fed will have to loosen monetary policy abruptly in order to bolster the economy, or the Fed is right and the market will have to accept higher interest rates for a longer period of time.

Oddly enough, today's market action seems to imply that investors would rather have a recession than see the economy muddle through -- but only the future will tell what actually happens.