Federal Reserve ‘Might’ Do Another Huge Rate Hike, But Powell Sparks Dow Jones Rally

The Federal Reserve delivered a 75-basis-point rate hike for the second straight meeting, and chair Jerome Powell indicated a third such hike “could be appropriate” in September. Still, the Dow Jones Industrial Average turned modest gains into a big rally as Powell spoke, with even more robust gains for the Nasdaq.

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While the Fed is putting its mandate to bring down inflation ahead of concerns about softening economic growth, Powell indicated the policymakers will proceed with care. His news conference offered a dash of optimism that the Fed can engineer a soft landing and a hint of dovishness that the inflation backdrop is improving.

“There’s a feeling that the labor market may be moving back into balance,” Powell said. He cited weaker data in the Labor Department’s household survey and anecdotal evidence from businesses.

Fed Chair Powell Isn’t Volcker

Here’s the key takeaway for stock market investors: The Powell Fed will cushion the landing for the economy, to the extent possible. While there’s still much uncertainty about how high the Fed will have to hike rates to bring inflation back down to 2%, Powell is signaling that he’s not going to hike more or faster than necessary. He sees his role differently than Paul Volcker, the Fed chair who killed the last inflation outbreak, engineering a recession by hiking the Fed’s key rate to 20%.

Financial Conditions And The Dow Jones

In truth, the Fed meeting didn’t change much. Before the meeting, odds of a 75-basis-point hike at the Fed’s next meeting, Sept. 20-21, were just over 50%. Toward the end of his news conference, they eased to 44%, according to CME Group’s FedWatch page.

But Powell’s news conference revealed that the Fed isn’t determined to stand in the way of a stock market rally. Given the recent rally in the Dow Jones and other indexes, largely based on hope that the Fed is almost done hiking and will start cutting rates early next year, it was far from clear that Powell would give the Dow more room to run.

Fed policy works by tightening financial conditions, which are reflected in stock prices and market-based interest rates. To some extent, higher stock prices, which can boost demand in the economy via a wealth effect, will counteract policy tightening.

Powell said that if financial conditions loosen to an extent that they’re boosting demand, contrary to Fed intentions, policy can adjust. Powell may not be especially worried about stock prices running higher because of the ongoing balance-sheet tightening. By September, the Fed balance sheet will contract by up to $95 billion per month.

The Fed’s approach does carry some risk. Here’s how Bill Ackman, founder of Pershing Square Capital Management, put it: “The more the market believes that the Fed will immediately reverse course, the less effective raising rates will be in moderating inflation, and the more the Fed will have to raise rates.”

Federal Reserve Policy Statement

Inflation finally appears to be past the peak, with the price of gas and other commodities sliding. Meanwhile, a raft of unexpectedly weak economic data has begun piling up.

Still, the Fed statement didn’t suggest any significant shift in the inflationary backdrop. “Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures.”

The statement also offered a mixed picture of the economy, even as recession red flags are accumulating. “Recent indicators of spending and production have softened. Nonetheless, job gains have been robust in recent months, and the unemployment rate has remained low. “

The 9.1% inflation reading in June’s consumer price index update and the reported 372,000 job gain last month is too fresh for a Fed pivot. But the Fed will get two more months of data before its next meeting. The real test for policy will come when it becomes clear that the job market is tanking. A slowdown in federal taxes withheld from worker paychecks suggests that may happen as soon as next Friday’s July jobs report.

Dow Jones And Treasury Yield Reaction

Shortly after release of the Federal Reserve policy statement, the Dow Jones was up 0.4%. But after Powell spoke, the Dow’s gain picked up to 1.4% at the close. The S&P 500 rose 2.4% and the Nasdaq composite leapt 4.1%.

The Dow and other major indexes hit bottom in mid-June, just after the Fed’s first 75-basis-point hike. The Fed had accelerated its tightening plans after May’s consumer price index showed the inflation rate surging to a 40-year-high 8.6%. June’s still-higher inflation data kept Fed policymakers on high alert.

But many Wall Street strategists now think that softening economic data, easing inflation and a stronger dollar mean the Fed won’t hike as much as feared. As slow growth turns to a brush with recession, the Fed is seen pausing rate hikes. By the spring of 2023, many think a rate cut may be up for consideration.

That’s why the trend since mid-June has been lower Treasury yields and higher stock prices.

The Dow has still climbed 6.3% from its June 17 closing low. That cut its loss to just 13.7% from its Jan. 4 all-time closing high. The S&P has retraced 6.9% of its losses and now stands 18.25% off its peak close. The Nasdaq has enjoyed an 8.6% bounce, but remains 28% below its peak.

The rally has come as the 10-year Treasury yield, after spiking close to 3.5%, has fallen back. On Wednesday, the 10-year yield eased 1 basis point to 2.78%. Shorter-term yields, more closely tied to Fed rate moves, fell several basis points.

The Dow Jones and other major indexes have broken above their 50-day lines for the first time since April. That reflects optimism about a Fed pivot, but the uptrends are currently under pressure. Be sure to read IBD’s daily The Big Picture column after every trading day to stay on top of the market trend and what it means for your trading decisions.

Please follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.

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