The Federal Reserve went on a rampage this year, hiking its benchmark federal funds rate from practically zero to now inside a range of 4.25% and 4.5%, as the agency has moved quickly to try to get a handle on inflation.

The Fed's campaign isn't done yet, either, with members of the Federal Reserve projecting that the federal funds rate will go as high as 5.1% in 2023.

But investors have been hoping that once the Fed gets inflation under control, it might be able to actually start cutting interest rates, which would likely set up a better environment for the stock market. Will it happen next year? Let's take a look.

What would need to happen for rate cuts?

If you think about what ultimately leads the Fed to cut its federal funds rate, it's usually a recession. It happened during the Great Recession, and right after the pandemic as well.

That's because growth slows during a recession, and the Fed wants to stimulate the economy. By lowering the federal funds rate, the Fed is making borrowing costs cheaper, which tends to increase the purchasing power of consumer and business cash flows.

Person looking at big stock chart.

Image source: Getty Images.

But there's still wide debate about what next year's economy will bring. Many expect there to be a recession, as the Fed's intense rate hikes continue to slow the economy. But some, including members of the Fed, still see the possibility of a soft landing for the economy. The labor market is still quite strong, with an unemployment rate of only 3.7% in November.

There are also signs of inflation cooling after October, and November inflation data showed that prices in many categories were either rising at a slower pace or outright declining on a monthly basis. If unemployment only rises modestly (a big if) and inflation continues to cool at a good pace, then the Fed would succeed in engineering a soft landing. But the effect of the bulk of the Fed's rate hikes on the broader economy has yet to really be felt, so it's still a big question.

What's the market saying?

There are a lot of market participants and experts who believe a rate cut by the Fed is well within the realm of possibility.

Recently, economists at the government-sponsored entity Fannie Mae said that the Fed could begin cutting rates as soon as mid-2023, which is one of the more accelerated timelines I've seen for such a move. Fannie Mae said that due to the lagging nature of labor markets and expected weakening in manufacturing and consumer spending next year, it expects the economy to contract by 0.5% in 2023.

The agency also cited the most inverted yield curve in four decades as a reason that most expect a rate cut next year. One part of the yield curve that is looked at closely as a flashing sign of a recession is the difference between the yields on the two-year U.S. Treasury bill and the 10-year U.S. Treasury bill.

Chart showing the 2-year U.S. Treasury rate beating the 10-year Treasury rate since mid-2022.

10-Year Treasury Rate data by YCharts

With shorter-term treasury yields higher than longer-term ones, that's one indication that the market thinks the Fed will cut rates at some point. If you look at the CME Group's FedWatch tool, which analyzes futures data for the federal funds rate to see how investors think the Fed will move, it tells a similar story.

For the Fed's future meeting in March of 2023, the majority of investors expect the Fed to raise the federal funds rate to inside a range of 4.75% to 5%. But more than 33% of market participants (the largest portion) expect the federal funds rate to be back inside a range of 4.5% to 4.75% by November. Still, the percentages in the FedWatch tool change frequently, and there are still plenty of investors not pricing in a rate cut.

Far from certain

Unfortunately, the theme of the year -- and likely one of the main factors hurting the market in 2022 -- is the constant state of uncertainty, which remains today.

The Fed has not done rate hikes like this in decades. The effect it will have on consumers, businesses, and the economy is a big unknown, especially with the Fed also starting to unwind its balance sheet and essentially pull liquidity out of the economy.

So, while a rate cut is still in play, it certainly may not end up coming to fruition. We may not see a recession, or see one severe enough to merit a rate cut. That could also end up being good news, depending on how you look at it.