The first month of 2023 was relatively favorable for the stock market, at least compared to 2022. S&P 500 is about 4.6% more than the beginning of the year.
The meeting of the Federal Open Market Committee, or FOMC, could add to that positive momentum — or derail it. That depends on how much the commission raises interest rates.
What is the FOMC and why does it raise interest rates?
The FOMC is a group of Federal Reserve officials responsible for setting benchmark interest rates. The committee meets at least eight times a year and after each meeting announces a new interest rate in an attempt to keep inflation and employment stable.
The next FOMC meeting begins on Tuesday, January 31 and ends on Wednesday, February 1. The committee is expected to continue raising interest rates after seven consecutive increases last year.
The Federal Reserve is raising interest rates to try to control inflation, according to Mark Gibson, an associate professor of economics at Washington State University.
“By raising interest rates, the Federal Reserve seeks to limit borrowing by businesses and consumers — thereby causing a decline in overall economic activity,” says Gibson. The idea is to reduce inflation by reducing demand throughout the economy.
The catch, though, is that stock markets don’t like declines in overall economic activity — so they’re sensitive to interest rate increases.
What do markets expect from this FOMC meeting?
Stock prices can indicate the markets’ expectations of future interest rates, Gibson says. A big drop ahead of the FOMC meeting, for example, indicates that markets expect a higher-than-average rate hike.
The S&P 500 traded up about 2.5% in the week ahead of the January-February FOMC meeting. The market expects a 25 basis point, or 0.25 percentage point, increase in the Fed’s target rate, Gibson said.
There is a possibility the Fed could raise rates by 50 basis points, as it did after the last FOMC meeting, but a 50 basis point increase seems unlikely, he says.
“We’ve seen some progress in terms of falling inflation, so we think the Fed may now start easing rate hikes.” That’s why the market thinks 25 basis points is more likely at this meeting,” says Gibson.
However, these expectations are not always correct – and markets can become volatile when proven wrong.
“If the markets were expecting a 25 basis point increase and it turns out to be a 50 basis point increase, that would be somewhat of a surprise.” So the markets would react negatively to that,” says Gibson.
How do rising interest rates affect the economy?
The increase in interest rates over the past year is intended to reduce inflation, and there is some evidence that it is working.
According to the Bureau of Labor Statistics, the consumer price index — a key measure of inflation — rose 6.5% year-over-year in December 2022. That’s lower than the 9.1% year-over-year increase recorded by the Bureau in June 2022, although it is well above the Fed’s 2% target.
But when the Fed raises interest rates, it risks shrinking the economy too much and triggering a recession—which is possible in today’s fragile economic climate.
“Most forecasters expect a recession sometime next year. This could be caused by a variety of factors, not just Federal Reserve policy,” says Gibson.
How should you prepare for higher interest rates?
People can take a few steps now to prepare for higher interest rates, Margherita Cheng, a certified financial planner and founder of Gaithersburg, Md.-based financial advisory firm Blue Ocean Global Wealth, said in an email interview.
“Continue to contribute to your employer-sponsored retirement plans,” she said.
“Dollar cost averaging and diversification can mitigate the impact of short-term volatility in equity markets.”
Dollar cost averaging means making small, frequent investments over time to ensure you’re not only buying at high prices.
Cheng also recommended reducing debt if possible.
“Payment [down] credit card debt and variable rate lines of credit to avoid incurring higher finance charges and interest,” she said.
She also noted that “cash reserves are important” in times of economic instability.
“Think high-yield savings accounts, money market [accounts] and CD ladders. If it’s a good fit, consider buying it I-bondsCheng said.
Much depends on the outcome of the FOMC meeting, which ends on Wednesday. The extent to which the Fed raises interest rates has important implications for the stock market, inflation and the chances of a recession this year. Regardless of what the Fed does, Cheng and other advisers say consistent investing, careful debt management and moving savings to high yield accounts can help people stay ahead of rising rates.