The Federal Reserve Just Delivered Incredible News for Stock Market Investors

The ongoing artificial intelligence (AI) boom is creating trillions of dollars in value for some of America's largest companies, and it has driven the S&P 500 (SNPINDEX: ^GSPC) stock market index to new record highs this year. But there is another reason for investors to feel optimistic as we head into 2026.

On Dec. 10, the U.S. Federal Reserve cut the federal funds rate (overnight interest rate) for the third time this year, amid concerns about weakness in the jobs market. The Federal Open Market Committee (FOMC) also released its latest quarterly Summary of Economic Projections (SEP) report, revealing an expectation for even lower interest rates in 2026, alongside higher economic growth.

Here's why that could be a winning combination for the stock market.

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Unemployment remains a concern

The Fed has a dual mandate:

• Maintaining price stability, which means aiming for a rate of inflation of around 2% per year, as measured by the Consumer Price Index (CPI).
• Maintaining full employment, which involves creating economic conditions that support job growth. However, the central bank doesn't have a specific target for the unemployment rate.

The latest CPI reading from September showed an annualized inflation increase of 3%, which was far above the Fed's target. To make matters worse, the CPI has trended higher since it bottomed out at an annualized rate of 2.3% in April. Interest rate cuts would normally be out of the question in this environment, but a rise in the unemployment rate has pulled the Fed off the sidelines.

The July edition of the monthly nonfarm payrolls report set off alarm bells for policymakers. The U.S. economy created 73,000 jobs for the month, which was below economists' consensus forecast of 110,000. But that wasn't the worst part, because the July report also came with significant downward revisions. The Bureau of Labor Statistics lowered the May and June numbers by a combined 258,000 jobs, signaling more weakness in the economy than initially thought.

The U.S. economy has produced a series of sluggish nonfarm payrolls reports in the months since July, pushing the unemployment rate to a four-year high of 4.4%. In his speech on Dec. 10, Fed chair Jerome Powell also said that the recent employment numbers might actually be overstated by 60,000 jobs per month due to inefficiencies in the data collection process. By his estimation, the U.S. economy might be losing around 20,000 jobs per month right now.

Concerns about the labor market were central to all three of the Fed's interest rate cuts this year (at the September, October, and December policy meetings).

Higher economic growth is expected in 2026

In the September edition of the FOMC's quarterly SEP report, policymakers were forecasting Gross Domestic Product (GDP) growth of between 1.8% and 1.9% for the U.S. economy in 2026. However, the December SEP report showed that most FOMC members are now anticipating GDP growth of between 2.2% and 2.5%, which is a noteworthy upward revision.

Lower interest rates tend to fuel economic growth by reducing the cost of credit, which gives consumers and businesses more disposable income, and increases their borrowing capacity. This leads to more hiring, which helps bring down the unemployment rate. Therefore, after three interest rate cuts in 2024 and three more in 2025, it's no surprise that the FOMC is feeling more bullish on the economy's potential.

On that note, the majority of FOMC members expect interest rates to head even lower in 2026. This is supported by the CME Group's FedWatch tool, which suggests that Wall Street is anticipating at least one rate cut next year.

However, a small number of policymakers have flagged potential rate hikes, probably because inflation is trending higher. While this might be unlikely given the state of the jobs market, it's a risk to consider.

Higher economic growth and lower rates are a winning combo for stocks

Since lower interest rates can be a tailwind for businesses, they are also great for the stock market because corporate earnings typically drive returns. Plus, as the yields on risk-free assets like cash and government bonds trend lower, more investors park their money in growth assets like stocks instead, which generally drives the market higher.

However, investors don't want to see the Fed slashing interest rates because of an impending economic recession. That would involve a further increase in the unemployment rate and a slowdown in consumer spending, which would actually be bad for corporate earnings. The S&P 500 could decline even with interest rates falling in that scenario, as investors pile into cash and other safe haven assets.

We've seen this a few times over the last couple of decades, when economic shocks like the dot-com crash, the global financial crisis, and the COVID-19 pandemic sent the stock market into bear territory despite supportive monetary policy from the Fed.

Fortunately, there is no sign of a serious economic shock on the horizon, and the recent upward revision to the FOMC's economic growth forecast for 2026 should leave investors feeling confident heading into 2026.

However, even if challenging conditions do arise, it's important to remember that the S&P 500 has always recovered to new highs even after the most dire economic events. So any weakness from here could be a great buying opportunity for long-term investors.

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.