The Federal Reserve will hold its first policy meeting of the year on January 28 and 29, where it is widely expected to keep interest rates at previous levels after cutting three times since September.
The Fed has a twofold mandate: First, it aims to keep prices stable, which means keeping inflation at about 2% per year, as measured by the Consumer Price Index (CPI). Second, the country wants to keep the economy running at full employment, even though the country has no formal target for the unemployment rate.
The Fed has largely tamed the rise in inflation from 2022 and therefore cut the federal funds rate (the daily interest rate it charges banks) at the end of 2024. However, there are some concerns about the stability of the CPI, meaning it could remain above the 2% target for longer than expected. As a result, the Fed recently lowered its forecast for rate cuts in 2025.
This is when investors can expect the next interest rate drop, as well as what it could mean for the economy S&P500(SNPINDEX: ^GSPC) stock market index.
Image source: Getty Images.
The COVID-19 pandemic was a once-in-a-generation event. The US government responded accordingly by injecting trillions of dollars into the economy in 2020 and 2021 to avoid a deep recession (or worse). The Fed also cut the Fed Funds rate to an all-time low of nearly 0% and pumped trillions of dollars into the financial system using quantitative easing (QE).
Such a sharp increase in the money supply would undoubtedly trigger a rise in inflation. But the pandemic also caused supply chain problems as factories around the world closed to stop the spread of the virus, sending the price of many consumer goods soaring. 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 had to respond quickly. Between March 2022 and August 2023, it increased the Federal Funds Rate from 0.1% to 5.33%. It was one of the fastest increases in history, but luckily it worked as the CPI fell to 4.1% in 2023 and continued to fall 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 risen for three months in a row, with an annualized rate of 2.4%. 2.9% in December.
Annualized US Consumer Price Index according to YCharts
Four times a year – in March, June, September and December – the Fed releases a report called 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 in the coming years.
Because the FOMC is responsible for setting interest rate policy at the Fed, Wall Street keeps a close eye on each SEP. In the September SEP, the FOMC forecast five potential rate cuts in 2025, but that forecast was reduced to just two cuts in the December SEP.
The reasons? First, the consensus projection for gross domestic product (GDP) growth in 2025 rose to 2.2% in December from 1.8% in September. Second, the consensus projection for personal consumption expenditure (PCE) inflation in 2025 rose from 2.1% to 2.5%.
In other words, 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 fair An interest rate cut for all of 2025. This is expected to happen in June, meaning the Fed may pause and do nothing for the next five months.
The Fed faces a very difficult task. Throughout history, the central bank has 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 per 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 interest rates are good for stocks for a number of reasons. They allow companies to borrow more money to fuel their growth while lowering their interest costs. Both of these things can boost corporate profits, while profits boost stock prices.
In addition, falling interest rates will reduce returns on risk-free assets such as cash and government bonds, pushing investors toward growth assets such as stocks and raising prices in the process.
That said, every rate cut cycle since the year 2000 has been followed by a temporary dip in the S&P 500:
Data per YCharts.
The three austerity cycles in the chart above were caused by significant economic shocks: the bursting of the dotcom bubble in the early 2000s, the global financial crisis in 2008, and the pandemic in 2020. Therefore, it is likely that the S&P took a dip each time because of that negative events, not because interest rates fell.
Which brings me to my final point: Investors don’t want the Fed to cut 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 as interest rates fall. There is no reason to worry at this point, but the unemployment rate rose in 2024 (from 3.7% to 4.1%), which could be an early sign of trouble ahead.
If something worse comes along and triggers a correction in the S&P 500, investors should view this as a long-term buying opportunity. After all, history proves that given enough time, the index always climbs to new highs.
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Anthony Di Pizio has no positions in the stocks mentioned. The Motley Fool recommends CME Group. The Motley Fool has a disclosure policy.
Here’s when the Fed is likely to cut rates again, and what it means for stocks was originally published by The Motley Fool
