The U.S. Federal Reserve was locked in a battle with soaring inflation throughout 2022 and 2023, which prompted the central bank to rapidly increase the federal funds rate (overnight interest rates). That triggered a steep climb in interest rates, including the 30-year fixed mortgage rate, which hit a two-decade high of 7.8% toward the end of 2023.
30 Year Mortgage Rate data by YCharts.
High rates can put the brakes on the economy. But inflation -- as measured by the Consumer Price Index (CPI) -- is now clearly trending toward the Fed's annual target of 2%, so the central bank recently started reversing its tight policy.
It cut the federal funds rate in September and November, and another cut might be on the table at its next meeting on Dec. 17 and 18. There's also a consensus on Wall Street that the Fed will cut rates at least twice in 2025. Here's what it could mean for the benchmark S&P 500 (SNPINDEX: ^GSPC) stock market index in the new year.
Why interest rates are coming down
The COVID-19 pandemic triggered a cocktail of inflationary pressures. The U.S. government injected trillions of dollars' worth of stimulus into the economy, while the Fed slashed the federal funds rate to a historic low range of 0% to 0.25%. Plus, factories were closing all over the world to stop the spread of the virus, which led to shortages of everything from televisions to cars, and sent prices rocketing higher.
The Consumer Price Index (CPI) started creeping up in 2021, but it surged to a 40-year high of 8% in 2022, which was way beyond the Fed's 2% target. As I mentioned earlier, the central bank embarked on an aggressive campaign to hike rates, which took the federal funds rate to a range of 5.25% to 5.50% -- a long way from its historic low near zero.
Pandemic-related supply chain issues were mostly resolved in 2023, and combined with higher rates, that helped the annualized increase in the CPI fall to 4.1%. As of the most recent reading (October 2024), the CPI now stands at an annualized rate of 2.6%, which is a stone's throw from the Fed's target.
That's why the central bank felt confident enough to slash the federal funds rate by 50 basis points in September, followed by another 25 basis points in November. According to data from Bloomberg, Wall Street is currently expecting two rate cuts in 2025 (25 basis points each). The CME Group's FedWatch tool is also aligned with that prediction.
Could a recession be on the way?
The U.S. economy is showing surprising resilience in the face of higher rates. In fact, gross domestic product (GDP) increased at an annualized rate of 2.8% in the third quarter of 2024 (ended Sept. 30), which is comfortably above the 10-year average of around 2%.
However, some cracks are appearing. The unemployment rate opened 2024 at 3.7%, but it has ticked higher and most recently came in at 4.1%. A further deterioration in the jobs market might spell bad news for the broader economy, because it could lead to slower consumer spending.
Plus, dating all the way back to the 1960s, a rate-hiking cycle by the Fed almost always foreshadowed a recession. Below is a chart of the federal funds rate, with the gray shaded areas representing recessionary periods.
Effective Federal Funds Rate data by YCharts.
Interest rate policy takes time to work its way through the economy, meaning the negative effects of the increases in 2022 and 2023 probably haven't fully shown up yet. That makes it very tricky for the Fed to time rate cuts. If it waits for a dramatic slowdown in GDP or a higher unemployment rate to start cutting, it would probably be too late. A recession would be far more likely by that stage.
Nothing in the economic data indicates a recession is around the corner right now. However, investors should keep an eye out for any further weakness in the jobs market next year, because that could be an early warning sign of trouble ahead.
Falling rates are great for stocks, but watch out for short-term volatility
Lower interest rates are typically good for the economy because they put more money in people's pockets by reducing their debt servicing costs. They also increase borrowing power, which leads to more spending on big-ticket items like houses and cars.
More consumer spending is a tailwind for corporate earnings, which is what drives stock prices. Plus, lower rates can reduce the yield on risk-free assets like cash and government Treasury bonds, which pushes more investors into stocks and drives prices higher.
There are a couple of caveats. First, the S&P 500 is on the cusp of delivering back-to-back annual returns of more than 20%, which has only happened a handful of times going back to 1957. Thanks to those incredible gains, its valuation is now far above historical norms. As of this writing, the index trades at a price-to-earnings (P/E) ratio of 25.1, which is a 38% premium to its long-term average of 18.1.
Second, tariffs will be a key part of the incoming Trump administration's economic policy. The President-Elect has already threatened some of America's key trading partners, like Canada and Mexico, with hefty tariffs on their exports. This may derail a stock market rally for sometime.
So even falling interest rates might struggle to sway investor sentiment in that scenario.
Given the elevated valuation in the S&P 500, any correction from here could easily morph into a bear market (a decline of 20% or more from the index's record high) if investors feel a trade war is on the horizon, because that could put a serious dent in corporate earnings.
History proves that the S&P 500 always recovers to new highs eventually, so such a decline would almost certainly be a buying opportunity for long-term investors. But falling rates might not be the tailwind for stocks in 2025 that they have been in past cutting cycles.
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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.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
