The Fed Is Raising Rates the Slow Way. History Says the Pace Matters More Than the Hike.

Inflation is heating up, and the Federal Reserve is preparing its response.

The central bank already raised the federal funds rate a quarter point at its September meeting before holding steady in October. According to the fed funds futures market, there's a 100% chance that the Fed will hike at least another quarter-percentage point next month.

We know that stock prices usually react negatively to higher interest rates. But how the Fed chooses to change rates can have a big impact on how stocks react. If it can raise rates slowly and steadily, the potential downside might not be as severe.

Image source: Official Federal Reserve Photo.

What happens to stocks when the Fed starts raising rates?

A recent study by Charles Schwab looked at more than a dozen rate-hiking cycles since World War II. It categorized six of them as "slow" hiking cycles and eight of them as "fast."

Among its findings:

• On average, the S&P 500 (SNPINDEX:^GSPC) gained 18% in the year prior to the first rate hike. In the year ending Sept. 16 of this year, when the Fed first hiked rates, the index gained nearly 16%, right about average. This could be due to fast economic growth fueling stock gains before the Fed needs to step in to slow things down.
• In slow hiking cycles, defined as raising rates roughly every other meeting, the S&P 500 was down about 12% on average in the subsequent 12 months.
• In fast hiking cycles, defined as raising rates roughly every meeting, the S&P 500 fell by an average of more than 16% over the next 12 months.

Those returns would clearly fall into correction territory and don't paint a positive outlook for stocks. Right now, the S&P 500 is up about 1% since the September meeting but down about 3% from its high.

Why does the pace of rate hikes matter?

The fed funds futures market is currently expecting the fed funds rate to be in the 4.50%-4.75% range by the June 2027 meeting. That would put the current market in the "slow" rate hike cycle category.

In general, the markets prefer slow changes, not sudden ones. Sudden changes cause uncertainty, and the market hates uncertainty. Rapid increases in the fed funds rate, like the cycle we saw throughout 2022, leave investors guessing about how much the economic outlook will change. And when investors have questions about what happens next, they tend to turn defensive.

The one thing that could make 2026-2027 different is an end to the Iran war. Inflation is being driven by energy prices, and it would seem logical that prices would come down if the conflict came to an end. There's no sense yet that this could happen soon, but it's a catalyst that could quickly change the Fed's plans.

History shows that U.S. stocks could be in for a rough road ahead. But given that there's no guarantee how this plays out, staying the course might be the best option.

Charles Schwab is an advertising partner of Motley Fool Money. David Dierking has no position in any of the stocks mentioned. The Motley Fool recommends Charles Schwab and recommends the following options: short September 2026 $95 calls on Charles Schwab. The Motley Fool has a disclosure policy.