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The Federal Reserve’s job hasn’t been easy amid this year’s economic volatility.
The Consumer Price Index, a key inflation gauge, rose 8.3% year over year in August — well over the Fed’s 2% target. The stock market hasn’t been well-behaved either: The S&P 500 index is down by more than 10% so far this year.
The Federal Open Market Committee is due to meet Sept. 20-21, when it will decide whether to raise interest rates for the fifth time this year — and by how much.
Here’s what economists and a financial planner have to say about what’s going into the decision, how the stock market might react, and what it means for long-term investors.
Why is the Federal Reserve raising interest rates?
In short, the Fed is considering raising interest rates again to reduce inflation. But it’s trying to do so in a way that doesn’t burden consumers and businesses.
According to Terrance Grieb, a professor of finance at the University of Idaho, the Federal Reserve’s operations follow a dual mandate. Its two responsibilities are “to provide price stability within the economy, and also to provide a healthy job market.”
“What they’re trying to do is set interest rates — which are a key component of monetary policy — in order to balance those two things against each other,” he says.
The federal funds rate, which is guided by the Federal Reserve’s Federal Open Market Committee, is the interest rate at which banks can borrow money from each other.
Banks earn profits by borrowing money at a low interest rate and then lending it out to customers at a higher rate. Changes to the federal funds rate trickle down through the banking system, influencing interest rates on a variety of things, including mortgages and bonds.
Higher interest rates decrease spending by making it more expensive to borrow money. That decreases demand for goods and services throughout the economy, then slows down the price increases that we call inflation.
But when the Fed raises interest rates, it also runs the risk of hurting the economy — and the stock market in particular — by slowing down spending too much.
“Corporations borrow a lot of money every day to run their businesses, and when it costs them more money to borrow, it means their profits go down. And if their profits go down, then their stock is not as attractive,” says Delia Fernandez, a Los Alamitos, California-based certified financial planner with Fernandez Financial Advisory.
What are markets expecting from the next meeting?
“The markets are clearly expecting a 0.75% increase in [the Fed’s] target for the federal funds rate,” says Grieb. He explains that stock market valuations can act as a predictor of future rates and that the current level of the S&P 500 and similar indexes points toward a 0.75% increase.
“If we saw a 1% rise or 1.25%, I think the markets would react very badly to that. We would see stock prices decrease. And vice versa — if it were only 0.5%, the markets would react very strongly,” he says.
Grieb says that any decision other than a 0.75% rate increase would be a surprise — but that a higher increase might be slightly less of a shock than a lower one.
“Chairman [Jerome] Powell has been pretty clear that they feel the need to be aggressive about this,” Grieb says of the Federal Reserve chair.
Keith Jakob, a professor of finance at the University of Montana, says that if rates go up by the expected 0.75%, the market reaction may be driven by what the Fed says about expectations for the next FOMC meeting in early November.
If the Fed hints that more increases are ahead, that could push markets down. But if it doesn't, markets could rise.
“If they say, ‘Yeah, we’re doing 0.75% but we think that’s enough,’ that maybe would lead to the market saying, ‘OK, let’s have a relief rally because we think they’re finished raising rates,’” Jakob says.
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How do the August inflation numbers affect the decision?
On Sept. 13, the Bureau of Labor Statistics reported inflation numbers for the month of August that were higher than economists’ expectations. In response, the S&P 500 and other major stock indexes fell by several percentage points.
“There was a grain of hope in the markets that inflation was going to start cooling more quickly,” Grieb says. That might have given the Fed the opportunity to be more gentle with its interest rate increases.
But Grieb says that the higher-than-anticipated inflation numbers show that “the Fed will have to stick to its guns,” with an aggressive course of interest rate increases in the near future — hence the negative stock market reaction.
“The markets are realizing that the aggressive path the Fed has laid out — they don’t have much room to adjust that,” he says.
Should long-term investors pay attention to Fed interest rate policy?
Fernandez says no.
“They should ignore the news, they should ignore the ups and downs, they should know that they’re in it for the long term,” she says.
Ideally, Fernandez says, investors should be making small, but frequent contributions to their investment accounts over time (for example, a set amount from each paycheck).
This approach, which is called dollar-cost averaging, can help them buy into investments at lower prices during periods of turmoil.