The Fed Just Cut Interest Rates for the First Time Since December 2024, and Here's What It Means for the Stock Market
Key Points
The Federal Reserve just lowered interest rates for the first time in 2025, and there could be more cuts on the way.
The U.S. jobs market is showing signs of weakness, which could become a concern for the stock market if it leads to declining consumer spending.
The Fed has a history of keeping interest rates too high for too long, contributing to economic recessions.
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Last Wednesday, Sept. 17, the U.S. Federal Reserve lowered the federal funds rate (overnight interest rate) by 25 basis points. It was the first rate cut since December last year, and there could be more to come before the end of 2025 as policymakers try to jump-start the sputtering jobs market.
Interest rate cuts are typically good for the stock market in the long run, but history suggests they can spark volatility in the short term. Here's what the latest cut could mean for the benchmark S&P 500 (SNPINDEX: ^GSPC) index.
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The Fed's dual mandate is in conflict
The Federal Reserve has two primary objectives as mandated by law:
- Maintain price stability: This means keeping inflation rising at a steady pace of around 2% per year, as measured by the Consumer Price Index (CPI).
- Maintain full employment: The Fed doesn't have a specific target for the unemployment rate, but it sets policy to maximize job creation in the economy.
A pandemic-related inflationary cocktail (which included trillions of dollars in economic stimulus, and supply chain issues) sent the CPI surging to a 40-year high of 8% in 2022, forcing the Fed to aggressively increase the federal funds rate from near-zero to 5.3% in the span of just 18 months. The goal was to slow the economy down in order to cool inflation, and it appears to have worked, because the CPI increased at much slower rates of 4.1% in 2023 and 2.9% in 2024.
This gave the Fed confidence to trim the federal funds rate three times between September and December last year. But progress has stalled in 2025, because the CPI is on track for another annualized increase of 2.9% based on the most recent data. Since it remains far above the Fed's 2% target, policymakers would normally leave interest rates on hold, but they now face a different problem: A weak jobs market.
The last couple of non-farm payrolls reports from the Bureau of Labor Statistics have been alarming. The economy created just 73,000 jobs in July, which was far below the 110,000 jobs economists expected. In that same report, the BLS revised the May and June numbers lower by a combined 258,000 jobs, suggesting the economy was far weaker beneath the surface than initially thought.
This was confirmed in the most recent non-farm payrolls report, which showed the economy created just 22,000 jobs in August, missing economists' estimate of 75,000 jobs. Plus, the unemployment rate rose to a four-year high of 4.3%.
Further interest rate cuts could spark volatility
The weak jobs market was the key reason for the Fed's interest rate cut at its September meeting last Wednesday, and there could be more to come. According to the central bank's latest quarterly Summary of Economic Projections report, policymakers on the Federal Open Market Committee (FOMC) favor two more interest rate cuts before the end of 2025.
That aligns with the CME Group's FedWatch tool, which implies Wall Street is also anticipating two more cuts.
Lower interest rates are typically great for stocks in the long run because they allow businesses to borrow more money to fuel their growth, and they reduce the cost of debt, which is a tailwind for corporate earnings. Plus, falling interest rates reduce the yield on risk-free assets like cash, pushing more investors into the stock market.
However, the beginning of every major rate-cutting cycle over the last 25 years triggered a short-term correction in the S&P 500:
Target Federal Funds Rate Upper Limit data by YCharts
Rate cuts weren't the cause of those stock market corrections -- instead, it was the underlying economic shocks. There was the dotcom internet crash in 2000, the global financial crisis in 2008, and the pandemic in 2020. However, this proves that investors will disregard the benefits of rate cuts and flock to safer assets like cash in the face of economic uncertainty, at least in the short term.
The Fed might be behind the curve already
There is no evidence of an economic calamity on the horizon right now, but the Fed is clearly worried about the jobs market. In his speech last Wednesday, chairman Jerome Powell said "labor demand has softened and the recent pace of job creation appears to be running below the 'breakeven' rate needed to hold the unemployment rate constant."
In other words, Powell thinks the unemployment rate could trend higher from here, spelling bad news for the economy. Fewer jobs will result in less consumer spending, which could deal a blow to corporate earnings. In that scenario, investors might trim their exposure to the stock market, meaning the S&P 500 could trend lower even with interest rates falling.
The Fed relies on data to make policy decisions, which is a prudent strategy, but most economic figures are stale by the time they are released. Historically, this is a key reason policymakers have often left interest rates too high for too long, contributing to economic recessions (indicated by the gray shaded areas below):
Effective Federal Funds Rate data by YCharts
Therefore, if the Fed cuts interest rates two more times in 2025 because of a spiraling economic situation, volatility will almost certainly creep into the S&P 500. However, I would remind investors to stay focused on the bigger picture because history suggests the stock market always trends higher over the long term, so any weakness is likely to be a buying opportunity.
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Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool recommends CME Group. The Motley Fool has a disclosure policy.
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