The Fed's Interest Rate Cuts Foreshadowed the Recent Stock Market Correction. Here's What Might Happen Next.

The U.S. Federal Reserve has two main objectives. First, it aims to keep the Consumer Price Index (CPI) measure of inflation increasing at a rate of around 2% per year, and second, it wants to keep the economy running at full employment.

When the CPI soared to a 40-year high of 8% in 2022, the Fed rapidly increased the federal funds rate (overnight interest rates) to cool the economy down. But with inflation now under control, interest rates are finally heading lower.

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Falling interest rates normally drive an increase in economic activity, which is great for the S&P 500 (SNPINDEX: ^GSPC) stock market index. However, history shows that the first few cuts are often met with a temporary decline in the stock market, and this time was no exception. Investors might be wondering where we go from here, so let's dive in.

Image source: Getty Images.

On the path to lower interest rates

The inflation surge in 2022 was triggered by a cocktail of factors, most of which related to the once-in-a-century COVID-19 pandemic. The U.S. government injected trillions of dollars into the economy to offset the impacts of lockdowns and social restrictions, and the Fed slashed interest rates to a historic low of 0.13% while also ramping up its stimulative quantitative easing (QE) program.

On top of the massive increase in money supply, factories all over the world were grinding to a halt to prevent the spread of the virus. And this sent the price of manufactured goods -- from televisions to cars -- soaring.

Fortunately, the Fed's decision to raise the federal funds rate from 0.13% to 5.33% during the 18-month period between March 2022 and August 2023 successfully cooled the CPI down from its four-decade high. The CPI increased at a much slower rate of 2.9% in 2024, so the Fed actually started cutting interest rates in September and lopped a full percentage point off the federal funds rate by year-end.

Now, with the most recent CPI reading (for May 2025) coming in at an annualized rate of just 2.4%, the Fed has penciled in two further cuts this year. Wall Street agrees, as the CME Group's FedWatch tool also predicts two cuts by the end of 2025.

Interest rate cuts often foreshadow a temporary decline in stocks

Lower interest rates are typically a tailwind for the stock market because businesses can borrow more money to fuel their growth, and their financing costs are also reduced, which can boost their earnings. Plus, lower rates push investors to move away from risk-free assets, such as cash, and into growth assets, like stocks and real estate, in search of an acceptable return.

However, the start of every rate-cutting cycle over the last 25 years foreshadowed a decline in the S&P 500, and the trend continued following the Fed's most recent cuts:

^SPX data by YCharts.

But this correlation isn't as simple as saying the stock market declines every time the Fed cuts rates. Instead, we need to consider why the Fed is cutting interest rates. Since the year 2000, every major drop in interest rates has been triggered by an extraordinary economic shock -- the dot-com internet bubble burst in 2000, the global financial crisis struck in 2008, and the pandemic forced the Fed's hand in 2020.

As I highlighted earlier, the Fed's cuts in 2024 were prompted by a decline in inflation. However, policymakers also expressed concern about the health of the jobs market because the unemployment rate rose from 3.7% to 4.1% last year. Of course, the bulk of the recent 19% peak-to-trough plunge in the S&P 500 was triggered by President Donald Trump's "Liberation Day" tariffs, but the index had already peaked in February, which was two full months before they were announced. Plus, the index hadn't really made any upward progress since November.

Simply put, while interest rate cuts are great for the stock market in the long run, investors sometimes become jittery about cuts in the short term because they may signal potential economic weakness, which would dent corporate earnings.

Where to from here?

The S&P 500 is closing in on a record high yet again as of this writing (June 20), so investors seem to be moving past the Fed's initial rate cuts and the more recent tariff turmoil. Two more rate cuts this year would probably be viewed positively, but if there were a sudden increase in that forecast, it might raise concerns about the strength of the economy.

After all, the Fed appears to have left interest rates too high for too long on a number of occasions over the last few decades, contributing to recessions (indicated by the grey shaded areas):

Effective Federal Funds Rate data by YCharts.

There is currently no indication that a recession is on the horizon, but investors should keep a close eye on the unemployment rate. If it continues to rise, consumer spending may slow down, which would be a precursor to weakness in the economy.

But the S&P 500 should continue marching higher in the absence of an economic downturn, and some prominent Wall Street analysts have recently raised their price targets. In May, David Kostin from Goldman Sachs raised his 12-month target for the index to 6,500. Ed Yardeni from Yardeni Research is even more bullish, predicting that 6,500 could arrive by the end of 2025 instead.

With all that said, history proves investors are better off focusing on the long term. The S&P 500 has delivered a compound annual return of 10.5% since its establishment in 1957, even after factoring in every Fed cycle, recession, and bear market. No matter what happens in the balance of 2025, don't lose sight of the big picture.

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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.