Bank stocks fell Tuesday on news of an aggressive 50-basis-point hike in two key interest rates by the Federal Open Market Committee, but some veteran market watchers said the Fed's action was good for banks in the long run.
"This rate hike will eventually be better for banks because it gets us quicker to the target," said James F. Mitchell of Putman, Lovell, de Guardiola & Thornton, which initiated coverage of 20 large banks Tuesday morning. "We are nearing the end of the hikes, and the economy will have to start slowing down," he said.
Mr. Mitchell said the Fed may be dissuaded from further hikes by a report that the consumer price index was unchanged in April.
The Fed said in a statement Tuesday that "against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the committee believes that the risks are weighted mainly towards conditions that may generate heightened inflation pressures in the foreseeable future."
The central bank increased the federal funds target rate to 6.5%, the highest in nine years. The federal funds rate is what banks charge each other for overnight borrowings. The Fed also raised its discount rate, which it charges banks for overnight advances, by 50 basis points, to 6.0%.
Interest rate hikes concern bank investors because rising short-term rates affect profit margins on loans. Investors also worry that it will hurt banks' customers if rate hikes tip the economy into a recession. But according to Wells Fargo & Co. chief economist Sung Won Sohn, market watchers believe the Federal Reserve "can pull off another soft landing as it did in 1994."
Back then, "interest rates rose seven times in a row, and it stretched into the first part of 1995, and that turned out to be a good year for bank stocks."
Tuesday's increase was the seventh in the federal funds rate and the sixth in the discount rate since June, when the Fed became concerned about an overheating economy. It was the largest rate increase since a 75 basis point hike in September 1994.
Prior to Tuesday's hike, the Fed had increased interest rates by a quarter-point six consecutive times. Mr. Sohn said the predictability of the monthly hike allowed the market to develop an immunity to tightening moves.
"It became like a game of tennis. If you keep lobbing the same volley, it becomes so predictable that your opponent can kill you," Mr. Sohn said. "Monetary policy needs to be varied."
"The central bank isn't looking to double the pain on the market by raising the rates," Mr. Sohn said. Rather, it is "looking to bring some surprises and uncertainties that might slow things down. There is no way we can have a meaningful economic slowdown without a sustained correction in the stock market."
Despite widespread expectation that a 50-basis-point hike might be in the offing, investors reacted negatively to the news. The Dow Jones industrial average rose as much as 152 points, to 10,971, and the Nasdaq 111 points, to 3718, before the Fed's announcement. The Dow closed at 10,934.57 and the Nasdaq at 3,717.5.
Bank stocks were off most of the day, and plunged further on news of the hike. American Banker's index of the 50 largest banks decreased 1.5% and its index of 225 banks 1.2%.
Mr. Sohn attributed that to a gut reaction on the part of traders.
"Traders tend to be very short-sighted, they look at the high interest rates and question how it will affect them today," Mr. Sohn said. "But when you look at it over a longer horizon you realize this is for the best, because the quicker climb will steady the ship faster."