The Fed’s Biggest Interest Rate Hike in 28 Years Could Be Coming

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Markets are tumbling because investors fear the Federal Reserve will raise rates quicker and faster than previously expected—opting for the first three-quarter-point increase in the fed-funds rate since 1994.

While a rapid rise in rates usually results in a sharp stock selloff, there have been exceptions.

The Federal Open Market Committee is set to meet this Tuesday to set its course for future monetary policy. The central bank raised the target for the fed-funds rate by a quarter of a percentage point in March—the first increase in three years—and then by another half-point in May. It now sits between the range of 0.75% and 1.00%.

Investors had been expecting another half-point raise at this week’s meeting. But as inflation keeps rampaging, the market is now betting on a 94% chance that the Fed’s impending move would be even more aggressive, raising the benchmark rate by three-quarters of a point, according to CME’s FedWatch tracker. As recently as Monday morning, it was only seen as a 30% chance.

What’s more, the market is expecting the fed funds’ target rates to reach at least between 2.25% and 2.50% by September. That means yet another 75-basis-points hike could be on the table. 

Such moves are rare for the central bank. Over the past few decades, the Fed has tended to make small adjustments to its rate. 

From the 1970s until last year, 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.

A rate hike of 75 basis points or more occurs even less often—only 28 times since the 1970s. The last time it happened was in November 1994, when the Fed hiked rates multiple times in one year in a move to stave off inflation.

Higher rates make borrowing money more expensive, and 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. The monetary tightening comes with the risk of recession if the central bank raises rates too much and too fast. 

A recession could cut into company earnings, while higher rates make their future cash flows worth less today. Meanwhile, as bond yields rise, investors are more inclined to sell their equity holdings and move into the more attractive fixed-income assets instead. All this means aggressive rate hikes could lead to selloff in stocks, such as what happened in the ’70s and early ’80s, when the S&P 500 fell deep into the bear market. 

But this s isn’t always true. When the Federal Reserve raised interest rates by three full points from February 1994 to February 1995——including three half-point hikes and one three-quarter-point hike——the

S&P 500

only dipped 8% in between and soon bounced back to record highs after the rate-raising cycle. The stock index was actually 27% higher 12 months after the three-quarter-point interest-rate hike.

When rates are rising from low levels like today’s, stocks are also less likely to see a runaway selloff because investors aren’t very motivated to move their money into bonds or cash. Despite the recent rate hikes, real rates remain negative because of rampant inflation. That means fixed-income investments still aren’t an attractive option.

Write to Evie Liu at evie.liu@barrons.com