The U.S. Federal Reserve has a dual mandate. It aims to keep the Consumer Price Index (CPI) measure of inflation increasing by 2% per year, and it also tries to maintain full employment in the economy (although it doesn't have a specific target for the unemployment rate).
When the CPI deviates too far from 2%, or if there is a dramatic change in the jobs market, the Fed will hike or reduce the federal funds rate (also referred to as the overnight interest rate) to influence economic activity.
At its September meeting, the Federal Open Market Committee (FOMC) at the Fed decided to slash the federal funds rate by half a percentage point. The FOMC's November meeting is scheduled for next Wednesday and Thursday, so is another cut on the table?
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Here's why the Fed cut rates in September
In 2022, the CPI surged to a 40-year high of 8%. There were a number of contributing factors:
- In 2020 and 2021, the U.S. government injected trillions of dollars into the economy to offset the negative effects of the COVID-19 pandemic.
- In March 2020, the Fed slashed interest rates to a historic low of almost 0% for the same reason. Plus, it injected trillions of dollars into the financial system through quantitative easing (QE).
- COVID-19 caused factories to close all over the world, which led to shortages of consumer products and sent prices skyrocketing.
That inflationary cocktail prompted a decisive response from the Fed. It raised the federal funds rate to a two-decade high of 5.33% in the span of 18 months, with the final hike taking place in August 2023.
Thankfully, that policy adjustment worked. The CPI came in at 4.1% in 2023, and it has fallen further to an annualized rate of just 2.4% according to the most recent reading from September 2024. That's why the Fed decided it was appropriate to cut rates by 50 basis points (one basis point equals 0.01 percentage points) at its last meeting.
Will there be another cut in November?
It appears very likely another rate cut is on the way next week, because inflation is clearly trending toward the Fed's 2% target. Plus, the unemployment rate has risen from 3.7% to 4.1% this year, which signals there might be some weakness in the jobs market.
Fed chairman Jerome Powell recently said the downside risks to employment have increased, so more rate cuts are probably appropriate to support economic growth before there is any further deterioration.
According to the forecast provided by the FOMC in September, the federal funds rate could fall by another 50 basis points before the end of 2024. Since only the November and December meetings remain, the most likely outcome is two 25-basis-point cuts.
That's exactly what the CME Group's FedWatch tool predicts. It suggests there is a 95% probability of a 25-basis-point cut at next week's meeting, followed by a 78% probability of another cut in December of the same size.
Rate cuts are usually good for stocks in the long run
The FOMC's forecast suggests there could be another 125 basis points worth of cuts in 2025, with one final cut of 25 basis points in 2026. That could take the federal funds rate to 2.88%, which would be down by nearly half from its recent peak.
Lower interest rates are typically good for the stock market over the long term. Businesses can borrow more money to fuel their growth, and their interest costs are smaller, which is a direct tailwind for their earnings. Lower rates also put more money in the pockets of consumers that they can spend throughout the economy.
However, there is one caveat. Investors don't want to see interest rates fall because of an economic emergency (like a pandemic or a financial crisis), because that would be a drag on corporate earnings, which would lead to lower stock prices. That isn't a concern right now, but it's a good idea to watch the unemployment rate -- if it continues to tick higher, that might be a sign there is trouble on the horizon.
