The First Interest Rate Cut of 2025 Could Happen Next Week. Here's What It Means for the Stock Market.

Key Points

• The Federal Reserve will hold its next two-day policy meeting on Sept. 16 and 17.

• The Fed has yet to cut interest rates in 2025, but a deteriorating jobs market could force its hand next week.

• Further weakness in the economy could trigger a downturn in the stock market, even with the Fed cutting interest rates.

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By law, the U.S. Federal Reserve is tasked with supporting a healthy jobs market, and keeping inflation under control. The central bank adjusts the federal funds rate (overnight interest rate) to influence economic activity when the unemployment rate or the Consumer Price Index (CPI) measure of inflation deviates too far from its target levels.

The Fed is facing a conundrum right now: The U.S. economy is creating far fewer jobs than expected, which would normally warrant an interest rate cut, but the CPI is still hovering significantly above its 2% target. Those conflicting data points put policymakers in a very difficult position.

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Nevertheless, Wall Street thinks an interest rate cut is a near certainty at the Fed's upcoming two-day meeting, which will be held next Tuesday and Wednesday (Sept. 16 and 17). Here's what it could mean for the benchmark S&P 500 (SNPINDEX: ^GSPC) stock market index.

Image source: Getty Images.

How we got here

The CPI increased at a rate of 8% during 2022, which was a 40-year high, driven by a combination of pandemic-era stimulus and supply chain disruptions that sent prices soaring. Surging inflation can be very damaging to the economy, because it erodes consumers' spending power and squeezes corporate profit margins.

As a result, the Fed aggressively raised the effective federal funds rate from its pandemic low of 0.1% to a two-decade high of 5.33% over an 18-month period between March 2022 and August 2023. The goal was to slow economic activity in order to cool prices, and it appears to have worked.

The CPI increased at a rate of 4.1% in 2023, and then 2.9% in 2024. As I write this, it's currently rising at an annualized rate of 2.7% in 2025, so it's clearly trending toward the Fed's 2% target.

This progress gave the Fed enough confidence to cut interest rates three times between September and December 2024, but the central bank has yet to make a move this year.

Wall Street is certain of a September interest rate cut

Since the CPI is still above 2%, the Fed would normally keep interest rates on hold. However, the jobs market is showing clear signs of weakness, which the central bank must take into consideration.

According to the monthly non-farm payrolls report compiled by the Bureau of Labor Statistics (BLS), the U.S. economy created 73,000 jobs in July, which was below economists' consensus estimate of 110,000. That isn't a catastrophic result at face value, but the BLS also revised the May and June numbers down by a combined 258,000 jobs, which suggests the economy is performing far worse than economists expected.

The weakness continued in the latest non-farm payrolls report. The U.S. added just 22,000 new jobs in August, far below the 75,000 jobs expected. The unemployment rate also continued to edge up, reaching a four-year high of 4.3%.

Fed Chair Jerome Powell expressed concerns about the health of the jobs market during his speech at the Jackson Hole Economic Policy Symposium on Aug. 22, saying, "With policy in restrictive territory, the baseline outlook and the shifting balance of risks may warrant adjusting our policy stance."

Wall Street believed Powell opened the door to a September interest rate cut, and in fact, CME Group's FedWatch tool now places the odds at 100%. It predicts a 90% chance of a 25-basis-point cut, and a 10% chance of a more aggressive 50-basis-point cut.

The Fed might be too late

According to guidance from the Reserve Bank of Australia, it can take up to two years for an economy to feel the full effects of an interest rate adjustment. Therefore, given the rapid slowdown in the jobs market, the Fed might be behind the curve already. This is a consequence of making data-driven policy decisions -- employment and inflation reports are backward-looking, so the numbers are often stale by the time they hit the wires.

That's why shifts in the economy often catch the Fed by surprise. Dating back to the 1960s, periods of high interest rates have often preceded recessions (represented by the grey shaded areas in the below chart), which suggests the central bank takes far too long to cut interest rates. In other words, by the time the economic data looks weak enough to warrant rate cuts, it's already too late to avoid a downturn:

Data by YCharts.

What a September rate cut means for the stock market

Conventional wisdom suggests lower interest rates are great for the stock market. They allow businesses to borrow more money to fuel growth, and the reduced interest cost is a direct tailwind for corporate earnings. Plus, lower rates reduce the yield in risk-free assets like cash and government Treasury bonds, pushing more investors into stocks.

However, an economic downturn can negatively impact corporate earnings, which can be a trigger for a temporary decline in the stock market even if the Fed is slashing interest rates. There have been several examples of this over the last 25 years, including the dot-com tech crash in 2000, the great recession in 2008, and the COVID-19 pandemic in 2020.

On each of those occasions, the S&P 500 headed south even with interest rates falling sharply:

^SPX data by YCharts

As a result, if the economic data continues to deteriorate, a September rate cut probably won't be a tailwind for stocks in the short term.

But that doesn't mean investors should sell stocks. History proves the S&P 500 always trends higher over the long term, so any weakness is likely to be a buying opportunity rather than a reason to exit the market.

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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.