The U.S. Federal Reserve is mandated to take necessary actions that keep the Consumer Price Index (CPI) measure of inflation growing at an annualized rate of 2%. When the rate deviates too far from that target, the Fed adjusts the federal funds rate (overnight interest rates) to influence economic activity.
The CPI started rising in 2021 and reached 8% in 2022 (the fastest growth pace in 40 years). In response, the central bank embarked on the most aggressive campaign to hike interest rates in its history. Fortunately, that policy response worked and the CPI has cooled significantly since then.
Newer economic data is showing signs now that the Fed needs to make further adjustments, this time in the other direction. As a result, the Fed has signaled that it plans to cut interest rates at the conclusion of its next two-day gathering, which is scheduled for Sept. 17 and 18.
If the cut happens, it will be the first since March 2020. If history is any guide, such a cut could foreshadow a big move in the S&P 500 (SNPINDEX: ^GSPC) stock market index, but maybe not in the direction one would expect.
How we got here
Factors that can trigger a significant rise in inflation include:
- A period of heightened government spending.
- Loose monetary policy in the form of ultra-low interest rates.
- A rapid increase in money supply.
- Product shortages creating a supply-demand imbalance, resulting in much higher prices.
All four of these factors existed at some level at the height of the COVID-19 pandemic in 2020 and 2021. The U.S. government flooded the economy with stimulus dollars to shore up consumer spending, while the Fed slashed the federal funds rate to a historic low range of 0% to 0.25% while injecting trillions of dollars into the financial system through quantitative easing (QE). Factories were also shutting down all over the world to stop the spread of the virus, which led to shortages of many different products.
To combat the inflation surge that resulted, the Fed raised the federal funds rate over the course of 18 months to a range of 5.25% to 5.50%, which was the highest level in 23 years.
It remains there today, but the CPI cooled to an annualized increase of just 2.5% in the most recent reading (released Tuesday) and it's clearly trending toward the Fed's 2% target. Therefore, an interest rate cut is the consensus outcome of next week's monetary policy meeting.
The Fed normally adjusts the federal funds rate in increments of 25 basis points, but according to the CME Group 's FedWatch tool, there is a 27% chance the Fed will cut rates by 50 basis points next week. Whatever the official outcome, FedWatch suggests there will be additional cuts in both November and December.
Lower rates will benefit stocks, but maybe not immediately
Falling interest rates tend to be good for stocks in the long term. They allow companies to borrow more money to fuel their growth , and the smaller interest payments can be a direct tailwind for their earnings. Plus, lower rates will reduce the yield on risk-free assets like cash and Treasury bonds , encouraging investors to invest in growth assets like stocks instead.
With that said, the start of a rate-cutting cycle foreshadowed a drop in the S&P 500 on each of the last three occasions:
^SPX data by YCharts
As displayed by the chart, the S&P 500 has trended higher over time, so investors shouldn't panic at the thought of some short-term weakness . Besides, the Fed slashed rates on the last three occasions due to significant economic shocks, which were likely the main cause of the stock market declines as opposed to the rate cuts themselves.
The rate-cutting cycle in the early 2000s was spurred by the bursting of the dot-com tech bubble, which triggered a recession in the economy. Then, the Fed was forced to cut rates in 2008 because of the global financial crisis. Finally, on the most recent occasion, the central bank slashed rates in 2020 to soften the economic blow from the pandemic.
No sign of a crisis this time
While there are no signs of an imminent crisis at the moment, the U.S. economy does appear to be slowing. The unemployment rate has climbed to 4.2% after starting the year at 3.7%, and if that trend continues, it could impact consumer spending, which will increase the chances of a recession. Along with its mandate to keep inflation in check, the Federal Reserve is also mandated with the task of keeping unemployment manageable.
A recession could trigger a decline in the S&P 500, because investors would have to revise their future corporate earnings estimates downward. In that scenario, the stock market might be falling at the same time the Fed is slashing rates, creating the perception that, once again, rate cuts are sending stocks lower.
But considering the S&P 500 has always climbed to new highs given enough time, any weakness is likely to be a buying opportunity for long-term investors .
At the Jackson Hole Economic Symposium last month, Fed chair Powell said "the time has come for policy to adjust." He commented on the declining risk posed by inflation, but also the growing risk to the employment market. Next week's meeting will be the first opportunity for Powell to act on that statement, and by all accounts, he's going to announce the first rate cut since March 2020.
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