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March 2023 has been a harrowing month in finance: Two bank failures and a global sell-off in bank stocks.
So what will make headlines next? It might be the Federal Reserve meeting set to conclude Wednesday. After that meeting, the Fed will announce changes to the federal funds rate and release a summary of economic projections, or SEP, for the next several years.
Here’s what economists say the new federal funds rate and SEP could mean for stocks, the economy and the banking crisis.
What is the federal funds rate?
“The federal funds rate is a target rate set by the Federal Open Market Committee — it’s the rate that banks lend their reserve balances to other banks on an overnight basis,” Collin Martin, a director at the Schwab Center for Financial Research, said in an email interview.
“Many short-term borrowing costs are referenced to the federal funds rate, so any increase or decrease can impact the cost of borrowing for consumers or the interest earned by savers,” he said.
The Federal Reserve has been raising the federal funds rate over the last year in an effort to bring down inflation by increasing the cost of borrowing throughout the economy. The latest consumer price index report showed a 6% year-over-year inflation rate in February — lower than the 9.1% rate from July 2022, but still well above the Fed’s 2% target.
“One way to describe inflation is 'too much money chasing too few goods.' But if there isn’t too much money chasing those goods anymore, because the cost of that money has risen so much, then the rate of inflation should decline,” Martin said.
What’s the deal with the Fed’s summary of economic projections?
The Fed meets eight times a year, and every other meeting, the Federal Open Market Committee releases a SEP in which its economists try to predict the unemployment rate, inflation rate and economic growth rate over the next three years.
But according to Eric Swanson, a professor of economics at the University of California, Irvine, the main thing investors will be looking at in the upcoming SEP is the "dot plot" — a chart showing Fed officials’ projections for interest rates in the years ahead.
“Everybody’s interested in what the peak federal funds rate is going to be,” Swanson says. “There’s going to be a lot of attention on that dot plot, and how high the FOMC members see the federal funds rate going,” he says.
The last dot plot, released in December 2022, projected that the federal funds rate would peak at slightly over 5% later this year. Swanson says he expects the next one to project a peak at 5.5%, but it’s unclear how the recent banking crisis might affect these long-term predictions.
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How is the federal funds rate expected to change in March?
Before the failure of Silicon Valley Bank on March 10, investors were strongly expecting either a 25- or 50-basis-point increase in the federal funds rate — that is, a 0.25 or 0.50 percentage-point increase — due to high inflation and a tight labor market.
The Chicago Mercantile Exchange’s FedWatch tool, which uses data from options and futures markets to predict changes to the federal funds rate, indicated that there was a 79% chance of a 50-basis-point increase as of March 8, and a 21% chance of a 25-basis-point increase.
But the bank runs over the following days changed everything. Current FedWatch data shows that investors are now expecting either a 25-basis-point increase or no increase at all.
Swanson made a similar prediction in emailed comments. “I just can’t imagine that they would raise interest rates by 50bp at the next meeting, it’s almost certainly going to be 25bp,” he said.
How might all of this affect stocks?
In theory, higher interest rates should push down stocks.
“Since higher borrowing costs can slow down consumer spending, corporate revenue growth could slow, or could even turn negative. Higher borrowing costs can eat into profit margins, resulting in lower corporate earnings,” Martin said.
But in practice, the market’s reaction to Fed meetings is a bit more complicated — and depends on whether or not the market’s expectations for future interest rates are correct.
The market currently expects either an unchanged federal funds rate or a 25-basis-point increase, and a peak dot-plot rate between 5% and 5.5%. The S&P 500 index rose 2.1% in the week before the meeting, based in part on those expectations.
Bigger moves might happen if those expectations turn out to be wrong.
Swanson says that if the Fed raises interest rates more than the markets expect, or if the dot plot shows a higher-than-expected peak rate, stocks would fall, interest rates would rise and expectations for economic growth would weaken.
On the other hand, if the rate increase or peak dot-plot rate is lower than expected, Swanson says the stock market would rise, interest rates would fall, and people would increase their expectations for economic growth.
How might it affect the banking crisis?
Swanson said in emailed comments that interest rate risk played a role in the collapse of Silicon Valley Bank. When the Fed raises interest rates, bond prices generally fall.
“Part of the reason SVB collapsed was because the Fed’s tightening reduced the value of their long-term bond assets. There are many other banks in the U.S. with substantial long-term bond assets as well, so the failure of SVB is kind of a warning shot that these banks’ financial positions have weakened substantially,” Swanson said.
He added that the Fed will want to be “as smooth and steady as possible” for the next several months in order to avoid putting any more stress on the banking system.
The banking crisis has given the Fed a difficult choice. Either it sticks with aggressive rate increases to control inflation and risks more bank failures or it pauses the increases to protect the banks and risks an even longer fight against excessive inflation.
We’ll all find out which option they chose on Wednesday.