The Fed Could Crush the Stock Market Tomorrow, But Don't Panic

Since inflation data for August came in hotter than expected last week, investors have been on edge. The market sent the Dow Jones Industrial Average tumbling by more than 1,100 points last week. Despite the pain, the worst still may be to come, with the Federal Reserve's September meeting kicking off today and wrapping up tomorrow. Here's how the Fed could crush the stock market tomorrow and also why you shouldn't panic.

What kind of rate hike is coming?

In August, the Consumer Price Index (CPI), which tracks the prices of a range of daily consumer goods and services, rose 0.1% from July and was up 8.3% year over year. Economists had been penciling in a 0.1% decline from July and the CPI being up 8% year over year. The bigger increase spooked investors because many had assumed that inflation had peaked and could be headed south, but the CPI report did not show this.

Fed Chairman Jerome Powell.

Image source: Federal Reserve on Flickr.

The longer inflation persists, the longer the Fed has to stay hawkish and raise interest rates, which has roiled markets this year because investors are worried that intense rate hikes will push the economy into a severe recession.

Prior to the August inflation data, the market expected the Fed to raise interest rates by 0.50% or 0.75% following two 0.75% rate hikes at both of the Fed's June and July meetings. After the disappointing inflation data, the market is all but certain there will be at least a 0.75% rate hike, but now some investors think the Fed could even surprise with a full 1% hike.

According to the CME Group's FedWatch Tool, there was an 82% chance on Monday that the Fed would hike its benchmark overnight lending rate, or the federal funds rate, by 0.75% and a 18% chance the Fed would implement a full 1% hike on Wednesday. However, that number had been as high as 20% on Monday morning.

I do think a 1% hike would seriously crush the stock market tomorrow. It would be the largest single move by the Fed since the Fed began using the federal funds rate in the 1990s, according to Bloomberg. I also think it would send a message to the market that the U.S. economy has a more serious inflation issue than anyone could have imagined -- even at this point -- if the Fed has to do the full 1% hike.

At a conference earlier this month, Federal Reserve Chairman Jerome Powell said he is worried that a similar situation that happened in the 1970s when "the public had really come to think of higher inflation as the norm" could play out now. Powell blamed the Fed in the 1970s for not staying hawkish enough to rein in inflation.

Don't rule it out

I agree with the market that a 1% hike is unlikely tomorrow. After all, most of the Fed's big rate hikes this year weren't done until June and therefore have still not likely had enough time to fully work their way through the economy.

But I'm also not willing to rule out a 1% hike completely given Powell's recent comments and the fact that prices for things like rent have stayed high. Rent is a big expense in a consumer's life, and ever-increasing levels could lead to lingering inflation.

Regardless, be prepared for the market to take a hit if the Fed hikes rates by a full point tomorrow. But also don't panic! I do think the Fed will eventually rein in inflation, and that any bear market and recession will eventually be followed by a bull market, a thesis that has held true in market history. Investors that choose stocks with strong business fundamentals and invest with a long-term outlook in mind will be able to ride out this rough patch and succeed.

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Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool recommends CME Group. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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