The era of high interest rates may be over, according to the Federal Reserve.
The Federal Reserve has two goals mandated by law. First, the goal is to increase the consumer price index (CPI), which measures inflation, by about 2% annually. Second, although it does not set a specific target for the unemployment rate, it seeks to maintain full employment in the U.S. economy.
The CPI rose to a 40-year high of 8% in 2022, sparking one of the most aggressive interest rate hike campaigns in the Fed’s history. Thankfully, the economy has cooled significantly since then, allowing the Fed to lower the federal funds rate in September for the first time since March 2020.
The central bank’s forecasts indicate further rate cuts are on the horizon, and history suggests that big swings in the S&P 500 (^GSPC 0.61%) stock index could follow, but not as much as you would expect. Not the direction.
Interest rates could fall further in 2024, 2025 and 2026
The combination of inflationary pressures from the pandemic led to a sharp rise in the CPI in 2022.
Governments spent trillions of dollars in 2020-2021 to combat the economic impact of COVID-19, including cash payments to Americans in the form of stimulus checks. The Fed cut interest rates to a historic low of 0.13% and also used quantitative easing to inject trillions of dollars into the financial system. Periodic factory closures around the world to prevent the spread of the coronavirus have led to shortages of everything from computers to televisions to cars. That drove up prices.
The Fed began raising the federal funds rate in March 2022, and by the final hike in August 2023, the federal funds rate was 5.33%, the highest level in 20 years. The goal was to cool the economy to curb inflation after highly stimulative policies during the pandemic.
It seems to have worked. The CPI ended 2023 at 4.1%, and by August 2024, the most recent reading, it had grown at just 2.5% annually. That means we are just a few steps away from reaching the Fed’s 2% target.
For this reason, the Federal Open Market Committee (FOMC) chose to cut the federal funds rate by 50 basis points at the September Fed meeting. According to the FOMC’s own forecasts, further rate cuts are expected, including:
Additional rate cut of 50 basis points by the end of 2024; Rate cut of 125 basis points in 2025; Rate cut of 25 basis points in 2026.
This would push the federal funds rate to 2.8% in 2026, down almost half from its recent peak. These forecasts are a good indicator of what the Fed is thinking right now, but they could change as new economic data is released.
Stock markets don’t necessarily like short-term interest rate cuts
Lower interest rates can be a big boon for the stock market. This increases a company’s borrowing power, boosting its growth, and reduces interest costs, potentially providing a tailwind to corporate profits. Additionally, yields on risk-free assets such as cash and government bonds often fall in tandem with interest rates, forcing investors to turn to growth assets such as stocks instead.
However, the graph below tells a different story. It’s an overlay of the federal funds rate and the S&P 500 index going back to 2000, and shows that lower interest rates often herald temporary declines in the stock market.
^SPX data by YCharts.
However, the S&P 500 index has always trended upward over time, so investors need not be discouraged by the possibility of a short-term decline. The Fed typically begins cutting rates when the economy slows or suffers an unexpected shock, but this (and not the rate cut itself) is likely the real reason for the temporary drop in stocks on the chart.
In the early 2000s, the bursting of the dot-com technology bubble sent the economy into recession, and the Fed cut interest rates. Then, in 2008, the Fed cut interest rates due to the global financial crisis. Finally, the 2020 cuts were caused by the pandemic.
In other words, the Fed’s recent interest rate cuts may actually be a tailwind for the S&P 500, as there are currently no signs of an impending economic crisis. In fact, the index hit a new all-time high a few days ago.
However, there are some signs of an economic downturn.
The unemployment rate was 3.7% at the beginning of 2024, but rose steadily throughout the year to its latest reading (September) at 4.1%. Further deterioration in the job market could cause a slowdown in consumer spending, which could have a negative impact on the overall economy.
In that scenario, Wall Street analysts would likely lower their expectations for future earnings for U.S. companies, which would almost certainly lead to a decline in the S&P 500 index, which is currently historically expensive. This is because it trades on valuation. In other words, the stock market will fall as soon as the Fed cuts interest rates again.
But that’s no reason for investors to sell stocks. In fact, if the S&P 500 were to decline in the near future, it would probably be a great buying opportunity given its long-term uptrend.
