Why did Fed announce a 0.5% increase in interest rates?
“The Fed raises rates to slow down inflation,” Gabriela Best, an associate economics professor at California State University Fullerton, and a former researcher at the Federal Reserve Bank of St. Louis, says.
According to Best, higher interest rates mean that borrowing costs are higher which in turn means that people and businesses have less money. This slows inflation, but it is a double-edged sword.
“When they increase interest rates, they lower the demand for goods or services.” Best states that when the demand for goods or services falls, gross domestic product also decreases.”
She said that raising interest rates could cause the economy to shrink and a recession. This means that there is more unemployment.
Best states that they want to slow down inflation but not for unemployment to soar.
The U.S. Bureau of Labor Statistics’ last two monthly consumer price index reports, or CPI reports, showed lower inflation than economists expected and lower than the summer.
The Fed’s task is to keep inflation and unemployment low and stable. The Fed decided to reduce the benchmark interest rate by 0.5% due to unexpectedly lower inflation. This will allow the Fed to keep inflation down and minimize any rise in unemployment.
Federal Reserve Chair Jerome Powell stated that although the October and November inflation data show a welcome decrease in price rises, it would take more evidence to support the belief that inflation is on an upward trajectory.
Powell stated that the cumulative tightening in monetary policy and the lags by which monetary policies affect economic activity and inflation, led to the committee deciding to increase interest rates by 50 basis point today. This is a decrease from the 75-basis points pace observed over the four previous meetings.
What does an increase of 0.5% in the rate for stocks mean?
Stocks rose in anticipation for a smaller increase in interest rates during the week leading to the December Fed meeting. In the month before the meeting, the Dow Jones Industrial Average grew modestly. After Powell’s speech, he said that he was open for a 0.5% increase in December. The Dow Jones Industrial Average jumped 2.18% on November 30.
Best claims that the market responds positively to Fed moves that seem less aggressive than originally expected.
Investment is affected by interest rates going up. She says that if interest rates rise less, it will affect investment less. This includes buying stocks.
The market responded negatively to Wednesday’s meeting. The Fed also released a summary economic projections, which predicted more rate hikes in 2023. They also forecasted a benchmark rate at 5.1% by the end of next fiscal year. The Dow closed at 0.4 %.
Best states that an aggressive rate-hike policy would have a significant impact on demand, GDP, and investment. This is bad news for the stock market.
What does this mean for inflation?
The theory is that the rise in interest rates will help to reduce inflation. Experts are not sure how effective it will actually be in practice.
“Inflation has been overwhelmingly dominated, in terms of how much it has on CPI has been overwhelmingly controlled by a handful of sectors — and at this point, a few sector that rate hikes have little impact on,” Nathan Tankus, research director of Modern Money Network, a think tank on monetary policy, says.
Tankus states that these sectors include consumer staples, energy, and other related products.
Best agrees with the notion that inflation can be driven by “supply side factors”, that is, a scarcity or excess of goods and services.
Best cites as an example how geopolitics is driving the rise in energy prices.
“The conflict between Russia and Ukraine has an impact on the oil price, and this is affecting transport costs and production costs all over the world,” she said.
What does this mean for the chances of a recession?
Best states that economists predict a recession in 2023 regardless of what happens to interest rates. She believes that slower interest rate increases could make it less severe than originally expected.
“Does Fed want to spend two years trying to lower inflation or one year? Are they looking to reduce inflation quickly or slowly? Best says that’s the difference.
She explained that the Fed’s fast approach of continuing 0.75% increases would likely lead to a worse recession than the slow, 0.5% increase.
She says that if they raise [rates] more it will be a severe recession. If they decrease them, the recession will be milder but it will still be there.”
What’s on the horizon for the Fed’s next meeting?
Investors should expect more rate increases in 2023 according to Tankus.
“The current situation suggests that the Fed will slow down the pace of hiking,” Tankus states.
He says that if economic data continues to improve, there will be a lot of pressure to keep it going.
Powell made similar comments in the post-meeting conference news conference.
“We have a long way to go. He said that the median projection of the appropriate federal funds rate at the end next year is 5.1%, which is half the projection in September.
Powell said that the federal funds rates are expected to remain “above its median estimate of their longer-run value” through 2025.
The Fed slows down the rate of interest rate rises, but it could take some time before they stop completely. And it might take even longer to bring rates down.
This is difficult to predict what it will mean for the stock market. Powell stated at the post-meeting conference that “financial conditions fluctuate short-term in response span>
These fluctuations might not matter for long-term, Buy-and-Hold investors. Over the past century, the average annual return for the S&P 500 index was about 10%. This is despite the Fed raising and lowering interest rates numerous times.