Wall Street’s Newfound Optimism Faces a Test as the Fed Meets

Wall Street has welcomed a change of tone at the start of 2023: Fears of a severe economic downturn are receding as slowing inflation raises hopes that the Federal Reserve will soon be done raising interest rates.

In the first four weeks of the year, this optimism has resulted in a 6.2 percent jump in the S&P 500 and an even bigger rally among big technology stocks. Tech stocks were among the worst performers in 2022 because of their sensitivity to rising interest rates, and their rally now is helping to drive the broad market higher.

The gains have been led by a steady flow of data that shows the economy continues to grow, while inflationary pressure is easing. On Tuesday, for example, a key measure of pay and benefits — the Employment Cost Index — rose less than economists had expected, and the S&P 500 jumped 1.5 percent.

But this upbeat outlook faces a big test on Wednesday.

The Fed is widely expected to raise interest rates by just a quarter of a percentage point later in the day, the smallest jump since March. Higher interest rates raise costs for companies and consumers, and weigh on profits and spending, so investors are welcoming the prospect that the central bank could start to ease off.

In some quarters of the financial markets, the optimism has gone even further. Even though the Fed has signaled that it will raise its benchmark rate above 5 percent, a growing number of investors are betting that the rate won’t ever get that high.

That view has set the stage for a battle between the Fed and the financial markets.

The stock market gains — which enrich investors and make it easier for them to borrow — actually undercut the Fed’s efforts to slow the economy enough and pull down inflation. The last time stocks began to rise markedly, over the summer, the Fed’s chair, Jerome H. Powell, had to publicly warn that the fight against inflation was far from over. That was enough to send stock prices lower again.

Mr. Powell will have a chance to do this again on Wednesday when he speaks to the press after the Fed announces its decision.

“Powell is expected to be hawkish in his press conference to counteract the trends he still fears towards a resurgence of inflation,” noted Andrew Brenner, head of international fixed income at National Alliance Securities.

That could trigger a pullback in the market — and if last summer’s slump is any guide, it could be steep. Back then, after Mr. Powell warned investors during a late-August speech that the Fed’s effort to get inflation under control was “unconditional,” the S&P 500 fell 15 percent before the selling stopped in October.