Fed Chair Jerome Powell said earlier this week that a half-percentage-point rate increase could be in the cards as the central bank tries to cool down the economy and get soaring inflation under control. That would be the first time the central bank has done so in 20 years.
And there may be more than one big interest rate hike under consideration.
on Friday said it now expects four consecutive half-point moves this year, and possibly more if inflation remains above 5%.
Although half-point rate hikes are rare steps for the Fed, their impact on the stock market is by and large not dramatic.
How Often Does the Fed Raise Interest Rates by a Half-Point?
The federal-funds rate has been effectively zero since March 2020 when the global economy shut down to stop the spread of the Covid-19 pandemic. The rate, set by the Federal Open Market Committee, sets the target interest rate for commercial banks to borrow and lend their excess reserves to each other overnight. It’s often viewed as a benchmark that influences short-term interest rates for everything from car loans to credit cards.
The FOMC now expects to raise the rate at each of its remaining six meetings this year. If all of those moves are quarter-point hikes, the rate could reach a range of 1.75% to 2% by the end of 2022, the highest since 2019. The rate would be even higher if any of the rate changes are a half-point or more.
Over the past few decades, the Fed has tended to make small adjustments to its rate—like the quarter of a percentage point hike seen last week.
Since the 1970s, the central bank has hiked and slashed interest rates a total of 184 times. During that period, the rate was raised by a quarter-point or less 55 times and cut by a quarter-point or less 33 times. That alone accounts for half of the rate changes.
In comparison, the central bank raised rates by half a percentage point or more 44 times in total, but mostly in the ’70s and early ’80s when officials were chasing skyrocketing inflation. Since the early ’80s, such big moves occurred only 12 times.
It’s been decades since the U.S. has seen a period of swift tightening. The last time the Fed hiked interest rates by half a percentage point was May 2000 during the dot-com bubble. And the last time the Fed hiked rates by a half-point or more multiple times in one year was 1994 in a move to stave off inflation.
What Do Rate Hikes Mean For The Economy?
The Fed often raises its target interest rate when the economy is overheated––often shown in rising inflation.
Higher rates make borrowing money more expensive, and therefore encourage companies and people to borrow less and save more. As a result, less money would be circulating in the economy, which leads to slower growth and less inflation.
But it can be tricky to pace those moves. If the Fed doesn’t raise rates fast enough to rein in inflation, the economy could suffer from the double whammy of rapidly rising prices and slow growth, or stagflation, as the U.S. saw in the 1970s.
At the time, the Fed was pursuing the so-called stop-go monetary policy, which alternated between fighting high unemployment and high inflation, with rates seesawing up and down. That made both problems worse.
On the other hand, if the central bank raises rates too quickly, it could damp the economy and cause a recession, like what happened in the early 1980s when rates jumped from 10% to 20% in four months.
How Do Stocks Perform When the Fed Raises Rates?
Many investors believe higher interest rates might lead to lower stock prices because they discount the future cash flows of companies, making them worth less today. As bond yields rise, investors also tend to sell their equity holdings and move to the more attractive fixed-income investments instead.
But in reality, the relationship between rates and stocks is more complicated than textbooks suggest, says Russ Koesterich, portfolio manager for BlackRock’s Global Allocation Fund. “It very much depends on where the rates are starting from and how fast they are moving in up.”
In the ’70s and early ’80s, higher rates often coincided with poor stock returns. But when rates are rising from low levels like today’s, stock valuations have been more likely to rise than fall, according to Koesterich.
Barron’s analyzed the
average performance six and 12 months after the Fed adjusts its interest rate. Whether it’s a cut or hike and regardless of the size of the rate moves, in nearly every case, the stock market is higher one year after the change.
When the central bank raised or cut rates by a quarter-point or less, the S&P 500 returned an average of about 4% six months later and around 7% a year later. Returns also tend to be good one year after big moves of more than 1 percentage point, with the S&P 500 advancing 9% for hikes and 19% for cuts of that magnitude, on average.
One exception was when the Fed raised rates between half of a percentage point and 1 full point. Stocks performed poorly, on average, both six months and a year after the change.
Stocks tend to not react much on the day that rate changes are announced. That’s because the news is often already priced into the market. “It’s not just the Fed’s announcement, but what investors expect it to do,” says Koesterich, “The Fed has been more intent on telegraphing their intentions, and that will affect investors’ reactions.”
Koesterich notes that higher rates often come during times with faster economic and earnings growth, which can make up for companies’ discounted future cash flows and support their stock prices.
Stocks are also less likely to collapse because investors don’t have many reasons to move their money into bonds and cash when rates are as low as they are today––even when they are rising. The fed-funds’ nominal rate has remained effectively zero since March 2020, and the mounting inflation means the real rate has long fallen into the negative territory.
“In the early 2000s when real rate was very positive, if people wanted to step away from equities, they can just park their money in cash and it’d be good returns. That’s not available today,” says Koesterich. “There are not a lot of alternatives producing real returns.”
Write to Evie Liu at [email protected]