Federal Reserve policymakers expect to raise their key interest rate to 5.1% next year, higher than Wall Street was counting on. The new projections, released at the end of Wednesday’s Fed meeting, were revealed alongside an expected half-point rate hike. The S&P 500 initially reversed sharply lower. Stocks fell off their lows but failed to sustain a rally after Fed chief Jerome Powell didn’t rule out holding the next rate hike to a quarter point.
Today’s hike to a range of 4.25% to 4.5% came as the Fed slowed its pace of tightening after four straight moves by 75 basis points.
Ahead of today’s Fed announcements, markets were pricing in a 60% probability of a quarter-point hike on February 1. Shortly after the Fed’s announcement, the share fell to around 47%, but rebounded as high as 76% on Powell’s comments.
The Fed chair played down the importance of the size of the next hike, saying what matters is how much rates rise and how long they stay high. But he said it’s too early to tell whether the next move will be 50 basis points or 25 basis points and Powell has reiterated a few times that inflation risks remain weighted to the upside.
But pace is important to investors, because it offers more time for more weak inflation readings or weaker jobs data to convince the Fed to halt rate hikes before breaking above 5%.
Powell added that he wants to see “substantially more evidence” that inflation is getting under control. But he noted that “our politics is getting into a good place.”
The Fed meeting clarifies the prospects for rate hikes
The new set of quarterly projections from Fed policymakers show the key overnight lending rate rising to 5.1% in 2023 and falling to 4.1% in 2024.
The Fed now expects the unemployment rate to rise to 4.6% next year as growth slows to 0.5%.
Since his August speech in Jackson Hole, Wyo., President Powell has stressed that the Fed will need to keep interest rates higher for longer, in order to minimize the risk of a prolonged period of high inflation , as in the 70s.
Projections issued after the Sept. 21 meeting indicated that the federal funds rate could rise to 4.6% in 2023, before declining to 3.9% in 2024. Powell later said that the cycle’s peak rate Fed, or terminal rate, is likely to exceed 4.6%.
Indeed, markets were pricing in a terminal rate of around 5.05% just before Tuesday’s weaker-than-expected CPI inflation data.
But on the back of CPI data, which showed core inflation rose just 0.2% last month, markets were pricing in a 4.9% cap rate ahead of today’s Fed meeting.
Yet there was good reason to doubt that Powell would be swayed by the tamer readings for the consumer price index and core CPI inflation. Indeed, Powell gave a speech on Nov. 30 explaining why these are the wrong inflation rates for the Fed to consider.
S&P 500 near key level
The S&P 500 fell 0.6% in volatile stock market action on news of the Fed meeting and Powell’s comments. That reversed Tuesday’s 0.7% gain, which fell to that fraction after the S&P 500 jumped nearly 3% to Tuesday morning’s highs following the docile CPI.
The Dow Jones Industrial Average fell 0.4% after the Fed meeting, while the Nasdaq Composite lost 0.8%.
The S&P 500 broke above its 200-day intraday line on Wednesday for the second day in a row, before slipping below the key technical level following the Fed meeting’s policy statement. The latest rally attempts until April are stopped at the 200-day moving average.
All major indices ran into resistance at their December 1st highs on Tuesday.
Through Tuesday’s close, the S&P 500 was up 10% from its October 12 bear market closing low. However, the S&P 500 remains 18% below its January 3 all-time high. The Dow Jones is up 16.5% since it bottomed, leaving it just 9% short of its all-time high. The Nasdaq rebounded 6.6% but remains 31.5% below its peak.
Be sure to read IBD’s The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.
The US economy faces a hard landing unless the Federal Reserve does
The Fed’s new key inflation rate
The specific inflation rate that Powell says the Fed and Wall Street should focus on comes from the Commerce Department’s Monthly Personal Income and Spending Report, which tracks personal consumption expenditures, or PCE.
Powell’s new preferred inflation rate appears to be the most problematic for the S&P 500. The gauge takes into account commodity inflation, which is rapidly declining. It also excludes housing inflation, which looks set to ease in 2023 as government data catches up with stalled market rental growth.
That leaves only basic services other than housing, such as health care, education, hospitality, and haircuts. Because price changes for such services are closely tied to wage growth, they provide the best signal of where core inflation is headed, Powell said.
The Fed’s new key inflation rate isn’t great for the S&P 500 because it puts stress on the strongest part of the economy: the tight job market. Until the job market collapses, wage growth is likely to remain stubbornly high and the Fed could hike its key interest rate higher and for longer than markets expect.
The CPI report showed that prices for basic services excluding hospitalizations were unchanged in November from the previous month. But the similar PCE index will not be so tame. This is partly because the two indices measure health services inflation in very different ways, with the PCE measure more reflecting wage pressures. The CPI medical care services index fell 0.7% in November, the largest monthly drop on record.
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