The U.S. Federal Reserve reduced the federal funds rate (overnight interest rate) in September, November, and December last year, for a total reduction of 100 basis points. It reversed some of the aggressive rate hikes from 2022 and 2023 when the central bank was trying to tame a four-decade high in the Consumer Price Index (CPI) measure of inflation.
The CPI continues to decline toward the Fed's 2% annualized target, and since the U.S. economy faces significant uncertainty right now in the face of simmering global trade tensions, Wall Street is forecasting several more rate cuts this year.
According to the CME Group's FedWatch tool, which calculates the probability of the central bank's potential decisions based on the interest rate futures market, there could be four cuts before 2025 is over. This would have significant implications for the S&P 500 (^GSPC +0.29%) index but not in the way you might expect.
Image source: Getty Images.
Tariffs are creating a headache for the Fed
In March, the CPI increased at an annualized rate of 2.4%, the slowest pace since 2021. Given that reading was a stone's throw from the Fed's 2% inflation target, it would normally clear the way for further interest rate cuts.
However, on April 2, President Donald Trump announced plans to impose tariffs on all imported goods from America's trading partners, which threw a giant wrench into the works.
Trump enacted a sweeping 10% tariff on imports from every country, in addition to a series of much higher "reciprocal tariffs" on imports from specific countries that have large trade imbalances with the U.S. The reciprocal levies are now under a 90-day pause pending negotiations, except those placed on many Chinese imports, which currently stand at 245% for some products.
Tariffs can increase the price of goods for consumers, so Fed policymakers now have to wait for additional CPI data in the coming months before they can be sure interest rate cuts are the right move.
With that said, tariffs could also drive a sharp slowdown in economic activity, which might give the Fed a reason to cut rates even if inflation remains sticky. According to Reuters, seven top Wall Street banks raised their chances of a recession in the U.S., specifically because of the tariffs.
Goldman Sachs believes there is a 45% chance of a recession in the next 12 months (up from 35% before the tariffs), and JPMorgan Chase places the probability at 60% (up from 40% previously).
As a result, some Wall Street banks also reduced their 2025 forecast for the federal funds rate, implying more rate cuts than initially expected by the end of the year. According to the CME Group's FedWatch tool, the central bank could cut rates by 25 basis points four times: once in each of its policy meetings in June, July, September, and December.
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Key Data Points
Rate cuts often foreshadow stock market volatility
Interest rate cuts are typically good for the corporate sector because they allow companies to borrow more money to fuel their growth, and they reduce the cost of debt, which can boost profits. Plus, lower rates encourage investors to move away from risk-free assets like cash in favor of growth assets like stocks, which can drive the market higher.
However, the start of every rate-cutting cycle since the early 2000s foreshadowed a correction in the stock market, and this time is no different. The S&P 500 is currently down 12% from its recent all-time high, despite the benefit of three rate cuts at the end of 2024:
Data by YCharts.
Simmering global trade tensions (and their potential to weaken the economy) are the main reason for the recent decline in the S&P 500, not last year's interest rate cuts. But the timing is certainly interesting because the Fed tends to cut rates when the economy is showing signs of weakness, and the above chart suggests the first few rate cuts in a given cycle might be a good predictor of temporary stock market declines.
Moreover, the Fed has a documented history of being late to the party. The chart below shows how recessions (represented by the gray-shaded areas) often follow periods of rising interest rates. This indicates the Fed often hikes rates too far, or is too slow to reduce them in the face of economic weakness:
Data by YCharts.
Recessions can be bad news for stocks
Whether or not the recent correction in the S&P 500 turns into a full-blown bear market could hinge on the economic data over the next few months. If the U.S. economy slips into a technical recession -- indicated by two consecutive quarters of shrinking gross domestic product -- investors would likely trim their exposure to stocks even further.
Simply put, the long-term performance of the stock market is driven by corporate earnings, and companies make less money during recessions due to factors like higher unemployment and less consumer spending, thus sending stock prices lower.
Further interest rate cuts should help pull the economy out of any potential slump, and since the stock market is a forward-looking machine, they might even entice longer-term investors to start buying up a bargain or two. After all, despite facing the dot-com bust, the global financial crisis, and the COVID pandemic over the last 25 years alone, the S&P 500 still consistently climbed to new record highs.
This time probably won't be any different, especially since several countries are already negotiating new trade deals with the Trump administration. As a result, any further weakness in the stock market can still prove to be a great long-term buying opportunity.
