By law, the U.S. Federal Reserve has two primary mandates. First, it aims to keep the Consumer Price Index (CPI) measure of inflation rising at a rate of around 2% per year. Second, it aims to keep the economy operating at full employment, although it doesn't have an official target for the unemployment rate.
The Fed adjusts the federal funds rate (overnight interest rates) to influence economic activity when the CPI and unemployment rate deviate too far from where they should be. In 2022, the central bank ratcheted up the federal funds rate to a two-decade high to combat soaring inflation, but with the CPI now mostly under control, it has started reversing that policy.
The Fed has cut interest rates three times since September, and although conventional wisdom suggests that is positive news for the stock market, history tells a different story. The benchmark S&P 500 (^GSPC +1.20%) index just entered correction territory after plunging by more than 10% from its recent record high, and here's what could happen next.
Image source: Getty Images.
How we got here
The CPI measure of inflation hit a 40-year high of 8% in 2022, after the U.S. government and the Fed injected trillions of dollars into the economy in 2020 and 2021 to insulate it from the effects of the COVID-19 pandemic. Prices of many consumer goods also soared due to supply chain issues, as factories all over the world closed down to stop the spread of the virus.
To cool the economy and bring inflation under control, the Fed embarked on an aggressive campaign to raise the federal funds rate during 2022 and 2023. The final hike was in August 2023, with the rate settling at a two-decade high of 5.33% -- far above its pandemic-era low point of 0.13%.
Thankfully, higher rates worked as intended, with the CPI increasing at a much slower pace of 3.2% in 2024. That gave the Fed confidence to cut the federal funds rate by 50 basis points last September, and it followed that up with two more cuts of 25 basis points each in November and December.
The CPI continues to trend lower in 2025, coming in at an annualized rate of 2.8% in the most recent report for February. As a result, the CME Group's FedWatch tool suggests there could be three more rate cuts this year.
The Fed is holding its March policy meeting this week (on Tuesday and Wednesday), where it will release a new quarterly Summary of Economic Projections report. It will tell investors how Fed members are feeling about the U.S. economy right now, which could determine the pace of future rate cuts.
Interest rate cuts aren't always good for stocks in the short term
Conventional wisdom suggests lower interest rates are great for stocks. It makes perfect sense, because rate cuts allow businesses to borrow more money to fuel their growth, while also reducing the amount of interest they pay on loans which is a direct tailwind for their earnings. Moreover, lower rates reduce the yield on risk-free assets like cash and government Treasury bonds, which pushes investors into growth assets like stocks instead (thus driving the market higher).
But the beginning of every rate-cutting cycle since the year 2000 was followed by a correction in the S&P 500:
Target Federal Funds Rate Upper Limit data by YCharts
There were some extraordinary events over that period of time which triggered the Fed to cut rates. The dotcom internet bubble burst in the year 2000, causing a recession. Then, the global financial crisis happened in 2008, and finally, the pandemic struck in 2020. Therefore, the S&P 500 declined on each occasion because of those economic shocks, not because the Fed was cutting rates.
However, the below chart undeniably shows that periods of high interest rates have often foreshadowed recessions, dating back to the 1960s:
Effective Federal Funds Rate data by YCharts
It turns out the Fed isn't very good at timing interest rate cuts, and I don't blame it because some studies show it can take up to two years for changes in monetary policy to work their way through the economy. As a result, it's possible we haven't even seen the full effects of the Fed's final rate hike from August 2023.
Here's what could happen next
While lower interest rates are great for businesses, investors don't want to see the Fed cutting them to shore up a slowing economy. Less consumer spending, for example, can translate into declining corporate earnings, and earnings are what truly drives the stock market.
SNPINDEX: ^GSPC
Key Data Points
The Federal Reserve Bank of Atlanta created a tool called GDPNow, which attempts to forecast the potential gross domestic product (GDP) growth in a given quarter. Shockingly, it's predicting the U.S. economy will shrink by 2.4% in the first quarter of 2025, partly because of disruptions to global trade. In other words, it's possible some of President Trump's tariffs on foreign products -- which have triggered reciprocal tariffs from other countries -- are starting to hurt the American economy.
But that isn't the only indicator pointing to a slowing economy. The unemployment rate came in at 4.1% in February, and while that is still quite low, it has steadily ticked higher over the past year which suggests there could be some cracks forming in the jobs market. Moreover, the University of Michigan U.S. consumer sentiment index fell to 57.9 in March, which was the lowest level since November 2022. Back then, the S&P 500 was in the throes of a bear market.
Some prominent Wall Street bulls are starting to get nervous. Ed Yardeni of Yardeni research just lowered his 2025 target for the S&P 500 from 7,000 to 6,400. Goldman Sachs also cut its year-end target from 6,500 to 6,200. Both cited the potential negative economic impacts of President Trump's tariffs as one of their key reasons.
Therefore, it's possible investors will have to navigate choppy trading conditions for the foreseeable future. But history makes one thing clear: The U.S. stock market always climbs to new highs over the long term. So, even if we do see further weakness in the S&P 500, it will almost certainly be a buying opportunity for investors who want to be in the market for the next five to 10 years (or more).
