Fed Cuts Rates Again: S&P 500 and Nasdaq Respond with Losses
On Dec. 18, the U.S. Federal Reserve wrapped up its final policy meeting for 2024. Experts largely anticipated a reduction in the federal funds rate (the overnight interest rate), and indeed, the Fed cut it by 25 basis points. This marks the third rate reduction since September, attributed to easing inflation and softening job market indicators.
The reaction from investors was unexpected; instead of rallying, the markets experienced notable declines. On the day the rate cut was announced, the S&P 500 (SNPINDEX: ^GSPC) dropped 2.9%, while the technology-centered Nasdaq-100 fell by 3.6%. Here’s the underlying reason.
Image source: Getty Images.
Market Focus Shifts to the Fed’s Future Projections
The stock market primarily looks ahead. Investors are less worried about current events, as they are already known; they are more interested in future possibilities.
Each quarter, the Fed releases its “summary of economic projections” (SEP), which outlines the Federal Open Market Committee’s (FOMC) outlook on inflation, economic growth, and interest rates.
The December SEP brought surprising news. The FOMC now anticipates only two interest rate cuts (25 basis points each) in 2025, down from five projected in September. This implies a potential federal funds rate range of 3.88% to 4.12% by the end of 2025, compared to an earlier forecast of 3.13% to 3.62%.
What accounts for this shift in perspective? The FOMC increased its median estimate for U.S. Gross Domestic Product (GDP) growth for 2025 from 2.0% to 2.1%. A more robust economy indicates less need for rate cuts.
Additionally, the projected Personal Consumption Expenditures (PCE) inflation rate rose from 2.1% to 2.5% for 2025. The Fed is tasked by Congress with maintaining price stability, targeting 2% inflation annually. As inflation is now expected to accelerate, fewer rate cuts are anticipated.
Why Rate Cuts Usually Favor the Stock Market
Declining interest rates usually lead to lower yields on low-risk investments like cash and Treasury bonds. This attracts investors to stocks, pushing prices higher.
Lower rates also enable companies to borrow more affordably, boosting profits, which generally supports rising stock prices.
However, a pattern exists: investors disapprove of rate cuts that signal a weak economy. Currently, while no crises loom, the unemployment rate has risen from 3.7% to 4.2% during 2024. Continued job market decline could deter consumer spending, negatively affecting corporate earnings and dragging stock indexes lower, even with Fed rate cuts.
Since 2000, the S&P 500 has temporarily retreated each time the economy faced an unexpected setback, despite the Fed cutting rates. For instance, the Fed slashed rates following the dot-com bubble burst in 2001, during the 2008 financial crisis, and again in response to the COVID-19 pandemic:
Data by YCharts.
The Risks of Prolonged Rate Cuts
Changes in interest rates don’t affect the economy immediately; estimates suggest a lag of up to two years before the full impact is felt. Consequently, the economy may not have experienced the complete effects of the Fed’s earlier hikes, the last being in August 2023.
This lag partly explains why the Fed began cutting rates in September even though inflation hadn’t yet reached the target. Fed Chairman Jerome Powell noted, “The upside risks to inflation have diminished, and the downside risks to employment have increased.”
Powell’s choice reflects a cautious approach, aiming to prevent economic downturns linked to high interest rates. Historical trends reveal that rate hikes often precede recessions:
Data by YCharts.
The complexities of the U.S. economy highlight the Fed’s historical challenges in gauging these lagged effects. It is commendable that Powell is mindful of these risks and has acted preemptively.
Yet, investors appear skeptical that the two proposed rate cuts in 2025 will suffice to mitigate these risks completely, adding to market volatility following the announcement.
The shift in the Fed’s forecasts from September to December illustrates that economic predictions are uncertain. More than two rate cuts in 2025 could happen, or perhaps none at all. Investors should refrain from making hasty decisions during every FOMC update and instead focus on long-term stock quality.
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Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.
