The Federal Reserve will hold its first policy meeting of the year on Jan. 28 and 29, where it is widely expected to keep interest rates right where they are after cutting three times since September.
The Fed has a dual mandate: First, it aims to keep prices stable, which means maintaining a rate of inflation of around 2% per year as measured by the Consumer Price Index (CPI). Second, it wants to keep the economy operating at full employment, although it doesn’t have a formal target for the unemployment rate.
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The Fed has mostly tamed the inflation surge from 2022, which is why it was cutting the federal funds rate (the overnight interest rate it charges banks) at the end of 2024. However, there are some concerns about stickiness in the CPI, meaning it could remain above the 2% target for longer than expected. As a result, the Fed recently reduced its forecast for interest rate cuts in 2025.
Here’s when investors can expect the next drop in rates, and also what it could mean for the S&P 500 (SNPINDEX: ^GSPC) stock market index.
Image source: Getty Images.
The COVID-19 pandemic was a once-in-a-generation event. The U.S. government responded accordingly by injecting trillions of dollars into the economy during 2020 and 2021 to prevent a deep recession (or worse). The Fed also slashed the federal funds rate to a historic low of almost 0% and pumped trillions of dollars into the financial system using quantitative easing (QE).
Such a sharp increase in money supply was bound to trigger an increase in inflation. But the pandemic also triggered supply chain issues because factories were closing all over the world to stop the spread of the virus, which sent the price of many consumer goods skyrocketing. It added to the cocktail of inflationary pressures, resulting in a 40-year high of 8% in the CPI in 2022.
Once again, the Fed was forced to respond quickly. Between March 2022 and August 2023, it raised the federal funds rate from 0.1% to 5.33%. It was one of the fastest increases in history, but thankfully it worked because the CPI fell to 4.1% in 2023, and continued to decline in 2024.
The downward trend was enough for the Fed to cut rates in September, November, and December 2024. But after falling to an annualized rate of 2.4% in September, the CPI has now increased for three straight months, coming in at an annualized rate of 2.9% in December.
US Consumer Price Index YoY data by YCharts
Four times per year — in March, June, September, and December — the Fed releases a report called the Summary of Economic Projections (SEP). It tells the public where each member of the Federal Open Market Committee (FOMC) thinks economic growth, inflation, and the federal funds rate will be over the next few years.
Since the FOMC is responsible for setting interest rate policy at the Fed, Wall Street watches each SEP very closely. In the September SEP, the FOMC forecast five potential interest rate cuts in 2025, but that forecast was reduced to just two cuts in the December SEP.
The reasons? First, the consensus projection for 2025 gross domestic product (GDP) growth rose from 1.8% in September to 2.2% in December. Second, the consensus projection for 2025 personal consumption expenditures (PCE) inflation rose from 2.1% to 2.5%.
In other words, the FOMC members are bracing for a stronger economy in 2025 than previously expected, accompanied by higher inflation. That means fewer interest rate cuts.
Wall Street is even more cautious. According to the CME Group‘s FedWatch tool, traders expect just one rate cut for the whole of 2025. It’s projected to happen in June, which means the Fed might pause and do nothing for the next five months.
The Fed has a very difficult task ahead. Throughout history, the central bank made a habit of keeping interest rates high for too long, often contributing to a slowdown in the economy that led to a recession:
Data by YCharts.
For that reason, I think Fed Chairman Jerome Powell deserves credit for cutting the federal funds rate three times already, even though the CPI is still above the 2% target.
Lower rates are good for stocks for a few reasons. They allow companies to borrow more money to fuel their growth while reducing their interest expense. Both of those things can boost corporate earnings, and earnings drive stock prices.
Plus, falling rates will reduce the yield on risk-free assets like cash and Treasury securities, pushing investors into growth assets like stocks and driving prices higher in the process.
With that said, every rate-cutting cycle since the year 2000 was followed by a temporary dip in the S&P 500:
Data by YCharts.
The three cutting cycles in the above chart were triggered by significant economic shocks: the bursting of the dot-com internet bubble in the early 2000s, the global financial crisis in 2008, and the pandemic in 2020. Therefore, it’s likely the S&P dipped on each occasion because of those negative events, not because interest rates were falling.
That brings me to my final point: Investors don’t want to see the Fed cutting rates because the economy is weak. That would coincide with sluggish corporate earnings, which is a recipe for a decline in the S&P 500 even if rates are falling. There is no reason to be alarmed right now, but the unemployment rate ticked higher in 2024 (from 3.7% to 4.1%), which could be an early sign of trouble ahead.
If something worse does materialize and it triggers a correction in the S&P 500, investors should consider it a buying opportunity for the long term. After all, history proves that the index always climbs to new highs given enough time.
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Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool recommends CME Group. The Motley Fool has a disclosure policy.
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