Will the Fed Cut Interest Rates Next Week? Here's What Wall Street Thinks.

The U.S. Federal Reserve has two main objectives: Maintaining an annualized inflation rate of around 2%, as measured by the Consumer Price Index (CPI), and keeping the economy operating at full employment (although it doesn't have a specific target for the unemployment rate).

The Fed hiked the federal funds rate (overnight interest rates) to a two-decade high of 5.33% between Mar. 2022 and Aug. 2023, in order to tame an inflation surge that resulted from pandemic-related stimulus measures and disruptions to the economy.

But with the CPI finally trending back down, the Fed cut rates in September and November this year. The central bank will issue its final rate decision for 2024 on Dec. 18. Here's what Wall Street predicts will happen.

Image source: Getty Images.

Here's why the Fed cut rates in September and November

The U.S. government injected trillions of dollars into the economy during 2020 and 2021, while at the same time, the Fed slashed the federal funds rate to a historic low of near 0%. The moves were designed to counteract the effects of the pandemic by encouraging consumer spending to support the economy.

A rapid increase in money supply combined with ultra-loose monetary policy can be very inflationary. However, supply chain disruptions also sent prices soaring because factories closed around the world in order to stop the spread of COVID-19. That cocktail of forces sent the CPI rocketing to a 40-year high of 8.0% in 2022.

As I mentioned earlier, the Fed reacted with a series of aggressive rate hikes. Thankfully, the policy worked because the most recent CPI reading (Nov. 2024) came in at an annualized rate of 2.7%, which is very close to the Fed's target.

Plus, the unemployment rate gradually ticked higher throughout this year. It currently sits at 4.2% after starting 2024 at 3.7%, which could be a sign the jobs market is softening.

The Fed doesn't want to cause a recession by leaving rates too high for too long, which is why it cut the federal funds rate by 50 basis points in September, followed by another 25 basis points in November.

A cut is almost certain in December, according to Wall Street

Several Wall Street banks are forecasting another 25-basis-point cut from the Fed next week. Morgan Stanley, Goldman Sachs, Wells Fargo, and Citigroup are just some of the banking giants on that list.

The CME Group's FedWatch tool also suggests there is a 98% chance of a cut in December. It uses data from the Fed Funds Futures market to calculate that probability -- in other words, it's a good reflection of what traders and investors think the Fed will do at its next meeting.

However, expectations for further cuts in 2025 have fallen dramatically. The FedWatch tool predicts two 25 basis-point cuts next year, which is significantly less than the five cuts forecast by the Fed itself when it issued its summary of economic projections in September.

The CPI still hasn't hit 2%, and gross domestic product (GDP) is still growing at an annualized rate of 2.8%, which is way above its average of 2.3% over the last 10 years. Those might be two reasons why traders have trimmed their expectations for rate cuts.

The Fed issues a new summary of economic projections every quarter, so investors will have a fresh set of data to digest following the December meeting next week. It will be important to see whether the central bank still believes five cuts will be necessary in 2025 or if it revised its forecast down the same way the market did.

Rate cuts are typically good for stocks in the long run

Falling interest rates can benefit stock market investors in a few ways. They allow companies to borrow more money to fuel their growth while reducing their debt servicing costs. Both factors can boost their earnings. Plus, lower rates will reduce the yield on risk-free assets like cash and government Treasury bonds, which pushes more investors into stocks, thus leading to higher prices.

But investors don't want to see the Fed slashing interest rates because of a weak economy. If the jobs market deteriorates further, for example, that could lead to a drop in consumer spending, which would dent corporate earnings. Since earnings drive stock prices, that might result in a drop in benchmark indexes like the S&P 500 (SNPINDEX: ^GSPC) even while the Fed is cutting rates.

There is no concrete sign of an economic downturn in the U.S. right now, but since the 1960s, almost every rate hiking cycle has been followed by a recession. Periods of high interest rates can have a lagging effect on the economy, so it's possible we haven't seen all of the negative impacts of the Fed's rate-hiking cycle from 2022 and 2023 just yet.

Below is a chart of the federal funds rate with recessionary periods highlighted in grey. It clearly illustrates how often periods of high rates precede an economic downturn:

Data by YCharts.

That said, if the U.S. does experience a recession that leads to a drop in the stock market, that would almost certainly be a buying opportunity. History shows the S&P 500 has always gone on to reach highs over the long term, so investors shouldn't be deterred by periods of short-term weakness.

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Citigroup is an advertising partner of Motley Fool Money. Wells Fargo is an advertising partner of Motley Fool Money. Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Goldman Sachs Group. The Motley Fool recommends CME Group. The Motley Fool has a disclosure policy.