The Fed Is Expected to Raise Interest Rates Wednesday. Should You Buy the S&P 500 Before It Does?

Just one month ago, most economists expected the Federal Reserve to leave interest rates unchanged at its meeting this week. As of Monday, the futures market had priced in a 90% probability of a quarter-point rate hike.

If you're considering buying (or continuing to buy) the Vanguard S&P 500 ETF (NYSEMKT: VOO) or other U.S. large-cap equities, the question right now is, should you buy the index before the Fed announces its rate decision or wait to see what happens first?

Personally, I would continue buying. But not because I think stocks will rally on Wednesday afternoon.

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What comes after Wednesday?

Hotter-than-expected inflation data and oil prices that have pushed past $100 per barrel are fueling the expectation for rate hikes. The year-over-year inflation rate in September was 3.4% and could come in higher in September if oil prices remain elevated.

At this point, the rate hike itself probably isn't the biggest threat to stocks. Investors already expect it to happen. The real key will be the Fed's outlook and new dot plot report, showing where Federal Open Market Committee (FOMC) members expect rates to be in the future. That should give some indication of whether the central bank views this as a one-off rate hike or the beginning of an extended rate-hiking cycle.

Fed Chair Kevin Warsh has consistently been reluctant to offer any forward guidance. But the futures market thinks it's the latter. It's currently pricing in a roughly 60% chance of 75 basis points of rate hikes or more by the March 2027 meeting. That's the potentially bigger headwind for the S&P 500 (SNPINDEX: ^GSPC).

Higher interest rates make fixed income a potentially more attractive alternative to stocks. Plus, those same higher rates could help shrink valuations for equities. If that trend continues for months, U.S. stocks might have trouble moving much higher.

Higher rates don't automatically mean lower stock prices

Here are the two big factors that I think could keep the stock market rally intact. First, inflation is centered around energy prices, and a resolution to the Iran war could lower this risk relatively quickly. This isn't a guarantee by any means, and the war has already dragged on far longer than anybody originally anticipated. But a concrete de-escalation of tensions in the region could result in a sharp drop in oil prices and inflation expectations. Both would be bullish for stocks.

Second, corporate earnings growth is expected to be strong through at least 2027, and that tends to be the biggest driver of stock prices. Higher energy costs could certainly begin squeezing margins at some point. But S&P 500 earnings growth is expected to be healthy for the next several quarters. That kind of fundamental strength tends to provide strong support for higher stock prices.

One final factor that investors shouldn't discount is that we simply don't know 1) what the Fed will do, 2) what the Fed will say, or 3) how the market will react. Any buy/sell decision is really a gamble that your guess is correct.

That's why I'd personally stay the course and continue systematically buying the Vanguard S&P 500 ETF and other U.S. equity ETFs. Most of what's happening now will ultimately be short-term noise and shouldn't alter long-term investing plans.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.