Interest rates did something they haven't done since March 2020, and that could predict a big move in the stock market. The Motley Fool

The Federal Reserve has two purposes as mandated by law. First, it aims to keep the Consumer Price Index (CPI) measure of inflation at around 2% growth per year. Second, it seeks to maintain full employment in the US economy, although it does not have a specific target for the unemployment rate.

CPI reached a 40-year high of 8% in 2022, triggering one of the most aggressive campaigns to raise interest rates in Fed history. Thankfully, it has cooled significantly since then, allowing the Fed to cut the federal funds rate in September for the first time since March 2020.

Central bank projections point to more cuts on the horizon, and history suggests a bigger move S&P 500 (^GSPC 0.77%) The stock market may follow the index — but not in the direction you might expect.

Interest rates may fall further in 2024, 2025 and 2026

A cocktail of inflationary pressures resulting from the pandemic will lead to a rise in CPI in 2022:

• The government spent trillions of dollars in 2020 and 2021 to combat the economic impacts of COVID-19, including cash payments to citizens in the form of stimulus checks.
• The Fed lowered interest rates to a historic low of 0.13% and injected trillions of dollars into the financial system using quantitative easing.
• Factories around the world have been shut down in phases to stop the spread of COVID-19, leading to shortages of everything from computers to televisions to cars. That drives the price higher.

The Fed began raising the federal funds rate in March 2022, and it was at a two-decade high of 5.33% with the last increase in August 2023. The goal was to cool the economy after highly stimulative pandemic-era policies to reduce inflation.

It seems to have worked. CPI ended 2023 at 4.1%, and it came in at just 2.5% annualized in August 2024, the most recent reading. That means it's a stone's throw from the Fed's 2% target.

That's why the Federal Open Market Committee (FOMC) cut the federal funds rate by 50 basis points at the Fed's September meeting. According to the FOMC's own estimates, more cuts are on the way, including:

• A further cut of 50 basis points by the end of 2024
• 125 basis point cut in 2025
• 25 basis point cut in 2026

That would put the federal funds rate at 2.8% in 2026 — about half its recent peak. These estimates are a good indication of what the Fed is thinking now, but they could change as new economic data comes in.

Stock markets don't always like short-term rate cuts

Lower interest rates can be great for the stock market. This increases the borrowing power of corporations, which can help accelerate their growth, and it lowers their interest costs, which can be a tailwind to their earnings. Also, yields on risk-free assets like cash or Treasury bonds often fall in lockstep with interest rates, pushing investors toward growth assets like stocks instead.

However, the chart below tells a different story. It compares the federal funds rate to the S&P 500 index going back to 2000 and shows that interest rate cuts are often a temporary predictor. decrease Stock market:

^SPX data by YCharts.

However, the S&P 500 always trends higher over time, so investors should not be discouraged by the possibility of short-term weakness. The Fed typically starts cutting interest rates when the economy slows or experiences an unexpected shock, which is probably the real cause of the temporary stock market decline on the chart (rather than the rate cuts themselves).

In the early 2000s, the Fed cut rates as the dot-com tech bubble burst, plunging the economy into recession. Then, in 2008, the Fed was cutting because of the global financial crisis. Finally, the cuts in 2020 were triggered by the pandemic.

In other words, since there are no signs of an economic crisis right now, the Fed's recent rate cuts could actually be a tailwind for the S&P 500. In fact, the index hit a new record a few days ago.

But there are some signs of economic weakness

The unemployment rate was 3.7% at the start of 2024, but it has risen steadily throughout the year (September) to 4.1%. If the job market worsens, it could cause a slowdown in consumer spending, which could have negative consequences for the broader economy.

In that scenario, Wall Street analysts would likely lower their future earnings forecasts for corporate America, which would almost certainly lead to a decline in the S&P 500 — especially since the index is now trading at historically expensive valuations. That means the stock market will fall as the Fed cuts interest rates again.

But that's not a reason for investors to sell the stock. In fact, if the S&P 500 falls in the near future, this is likely a great buying opportunity based on the long-term uptrend.