Fed Meeting: Key Interest Rate May Hit 5.1% In Mildly Hawkish Surprise; S&P 500 Falls

The Fed meeting signaled that policymakers plan to hike their key interest rate higher than expected in a test for the S&P 500 rally. Stocks dived, then slashed losses.

The Federal Reserve expects to raise its key interest rate by a higher amount than Wall Street expected, to 5.1% in 2019. New projections were released by the Fed at its meeting on Wednesday, along with an anticipated half-point increase in interest rates. S&P 500 began by reversing sharply downward. Stocks recovered from their lows, but they failed to maintain a rally. Fed chief Jerome Powell did not rule out limiting the next rate increase to a quarter point.

The Fed has slowed its tightening pace after four consecutive 75-basis point moves.

Before today's Fed announcements the markets had placed 60% odds on a mere quarter-point increase in February 1. This fell to 47% after the Fed's announcement but jumped back up to 76% with Powell's remarks.

The Fed Chair downplayed how big the next rate hike will be, saying that what is important is how high the rates are and how long they remain high. Powell said that it is too early to decide whether the next hike will be 25 or 50 basis points. He also reiterated several times that the inflation risks are still skewed to the upside.

Investors are interested in the rate of increase, as it gives the Fed more time to slow down if inflation or employment numbers continue to be weak.

Powell said that he wants "substantially greater evidence" of inflation being brought under control. He did note that "our policies are getting in a good place."

In the new set of quarterly projections by Fed policymakers, they show that overnight lending rates will rise to 5.1% by 2023 before easing down to 4.1% at 2024.

The Fed expects unemployment to increase to 4.6% in the next year, as growth is expected to slow to 0.5%.

Since his August Jackson Hole speech, Powell has stressed the Fed's need to maintain higher interest rates for longer in order to reduce the risk of prolonged bouts with high inflation like the 1970s.

After the meeting on Sept. 21, projections indicated that the federal funds rate would rise to 4,6% in 2023 before falling to 3.9% by 2024. Powell said that, in the future, the Fed's terminal rate or peak rate would have to be higher than 4.6%.

Markets had already priced in a terminal interest rate of 5.05%, just before Tuesday's CPI inflation data came out softer than expected.

In the wake of CPI data showing core inflation rose just 0.2% in January, the markets had priced in a peak rate of 4.9% ahead of today’s Fed meeting.

Powell's stance on inflation is unlikely to be affected by the lower readings of the CPI core and consumer price index. Powell actually gave a speech Nov. 30, explaining why these are not the right inflation rates to be considered by the Fed.

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After the Fed meeting and Powell's remarks, the S&P 500 dropped 0.6%. This reversed Tuesday's gain of 0.7%, which had been reduced to a fraction following a tame CPI. The S&P 500 was up nearly 3% on Tuesday morning.

After the Fed meeting, the Dow Jones Industrial Average dropped 0.4% while the Nasdaq Composite fell 0.8%.

S&P 500 pushed over its 200-day line for the second consecutive day intraday, but then fell below the important technical level following the Fed's policy statement. Since April, the past few attempts to rally have been stalled at the 200 day moving average.

On Tuesday, all the major indices reached resistance at their December 1 highs.

The S&P 500 closed Tuesday up 10% from the low of October 12, when it was in a bear market. The S&P 500 is still 18% below the record high of Jan. 3; however, it has made a significant recovery. Since its bottom, the Dow Jones has gained 16.5%. It is now only 9% away from its record high. The Nasdaq is up 6.6%, but still 31.5% off its peak.

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The U.S. economy faces a hard landing unless the Federal Reserve does this

Powell's specific inflation rate, on which he says that the Fed and Wall Street must focus, comes from the Commerce Department’s monthly Personal Income and Spending Report, which tracks PCE, or personal consumption expenditures.

Powell's preferred new inflation rate is the one that poses the greatest problem for the S&P 500. The index factors out the rapidly declining goods inflation. The housing inflation is also excluded, as the government data will catch up with the slowing market rent growth in 2023.

This leaves core services such as education, health care, hospitality, and haircuts. Powell explained that because the price changes of these services are closely related to wage growth they give the best indication as to where core inflation will be heading.

The Fed's new inflation rate, which is the key to the S&P 500's performance, doesn't do much for the S&P 500 as it focuses on the most important part of the economy - the tight labor markets. The Fed's benchmark interest rate may be raised higher than expected by the markets until the job market cracks.

In November, the CPI report revealed that prices for core services, excluding housing, were unchanged compared to the previous month. The PCE index, which is similar to the CPI, won't be as tame. This is partly because both indexes are different in how they measure inflation for health care services, the PCE being more indicative of wage pressures. The CPI medical services index dropped 0.7% in November. This was the largest monthly drop ever.

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