Federal Reserve policymakers expect to hike 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 along with an expected half-point rate hike. The S&P 500 initially reversed sharply lower. Stocks came off 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 stepped down its pace of tightening after four straight 75-basis-point moves.
Ahead of today's Fed announcements, markets were pricing in 60% odds of just a quarter-point hike on Feb. 1. That fell to about 47% shortly after the Fed announcement, but rebounded all the way to 76% on Powell's comments.
The Fed chair downplayed the importance of the size of the next hike, saying what matters is how high rates go and how long they stay high. But he said it's too early to make a call whether the next move will be 50 basis points or 25 basis points and Powell repeated a few times that inflation risks remain weighted to the upside.
But the pace does matter to investors, because it provides more time for further soft inflation readings or weaker employment data to convince the Fed to pause rate hikes before passing 5%.
Powell added that wants to see "substantially more evidence" that inflation is getting under control. But he noted that "our policy is getting into a pretty good place."
Fed Meeting Clarifies Rate-Hike Outlook
The new batch of quarterly projections from Fed policymakers shows the key overnight lending rate rising to 5.1% in 2023 and easing 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., chair Powell has stressed that the Fed will have to keep interest rates higher for longer, in order to minimize risk of a protracted bout with elevated inflation, like in the 1970s.
Projections issued after the Sept. 21 meeting indicated the federal funds rate could rise to 4.6% in 2023, before easing to 3.9% in 2024. Powell has subsequently said that the Fed's peak rate of the cycle, or terminal rate, would likely have to rise above 4.6%.
In fact, markets had been pricing in a terminal rate of about 5.05% just ahead of Tuesday's softer-than-expected CPI inflation data.
But in the wake of the CPI data, which showed core inflation rising just 0.2% last month, markets were pricing in a 4.9% peak rate ahead of today's Fed meeting.
Yet there was good reason to doubt that Powell will be swayed by the tamer readings for the consumer price index and core CPI inflation. In fact, Powell gave a speech on Nov. 30 explaining why those are the wrong inflation rates for the Fed to consider.
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S&P 500 Near Key Level
The S&P 500 fell 0.6% in volatile stock market action after the Fed meeting news and Powell's comments. That reversed Tuesday's 0.7% gain, which dwindled to that fraction after the S&P 500 had climbed nearly 3% at Tuesday morning highs following the tame CPI.
The Dow Jones Industrial Average fell 0.4% after the Fed meeting, while the Nasdaq composite lost 0.8%.
The S&P 500 pushed above its 200-day line intraday on Wednesday for the second straight day, before slipping below the key technical level after the Fed meeting policy statement. The past several rally attempts back to April have stalled out at the 200-day moving average.
All the major indexes hit resistance at their Dec. 1 highs on Tuesday.
Through Tuesday's close, the S&P 500 has rallied 10% from its Oct. 12 bear-market closing low. Still, the S&P 500 remains 18% below its record high on Jan. 3. The Dow Jones has climbed 16.5% since hitting bottom, leaving it just 9% off its all-time high. The Nasdaq has bounced 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.
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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 favorite new inflation rate happens to be the most problematic one for the S&P 500. The gauge factors out goods inflation, which is rapidly falling. It also excludes housing inflation, which appears set to fall in 2023 as government data catches up to the stalling growth of market rents.
That leaves only core services other than housing, such as health care, education, hospitality and haircuts. Because price changes for such services are closely linked to wage growth, they provide the best signal of where core inflation is heading, Powell said.
The Fed's new key inflation rate isn't great for the S&P 500 because it puts the focus on the strongest part of the economy: the tight labor market. Until the job market cracks, wage growth is likely to remain stubbornly high, and the Fed may hike its benchmark interest rate higher and for longer than markets anticipate.
The CPI report showed that core services prices excluding shelter were flat in November vs. the prior month. But the similar PCE index won't be quite that tame. That's partly because the two indexes measure health care services inflation in much different ways, with the PCE measure more reflective of wage pressures. The CPI medical care services index fell 0.7% in November, the largest-ever monthly decline.
