The U.S. Federal Reserve has cut the federal funds rate (overnight interest rate) six times since September 2024, as policymakers believed they had finally tamed the inflation surge from 2022. However, the Fed’s preferred measure of inflation, the core personal consumption expenditures price index (PCE), is now ticking higher once again, while the job market is showing signs of weakness at the same time.
This has put the Fed in a bind. According to its latest quarterly Summary of Economic Projections (SEP) report, policymakers are struggling to agree on the potential direction of interest rates from here. Neither consumers, businesses, nor investors like making big financial decisions in the face of uncertainty, which is bad news for the economy.
The benchmark S&P 500 (^GSPC +1.15%) stock market index is already in the throes of a sell-off, having lost more than 6% of its peak value so far. Below, I will explore the potential timing of the Fed’s next rate cut, and what it means for stocks going forward.
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The Fed’s dual mandate is in conflict
The Fed has two primary objectives: Maintain an annual inflation rate of around 2% (as measured by the PCE), and keep the economy running at full employment (although there is no official target for the unemployment rate). Right now, those goals are at odds.
Over the last four months, core PCE has ticked higher, from an annualized rate of 2.8% to an annualized rate of 3.1%. Therefore, inflation is not only above the Fed’s 2% target, it’s also trending higher — which might suggest interest rates should move up, not down.
With that said, inflation is tricky to measure right now because of the Trump administration’s tariffs on imported goods, and the ongoing geopolitical tensions that have triggered a surge in the price of oil. These headwinds make the Fed’s job very difficult, because the U.S. government can reduce tariffs at any moment, and it can also resolve the conflict in the Middle East, which would theoretically ease inflation.
Interest rate cuts would normally be off the table with the PCE increasing at the current rate. However, there is serious weakness in the job market, which might warrant action by the Fed. The U.S. economy lost a staggering 92,000 jobs during February, and it was the third monthly decline in the last six months. The unemployment rate has also ticked higher over the past 12 months. It currently stands at 4.4%, which is only fractionally below a five-year high.
No interest rate cuts until 2027?
Once per quarter, the Fed releases an updated SEP report that contains short- and long-term forecasts for economic growth, inflation, the unemployment rate, and interest rates from members of the Federal Open Market Committee (FOMC), who are responsible for setting monetary policy. In the March edition, only a small number of FOMC members indicated that more than one interest rate cut would be appropriate in 2026.
However, there was an even split among the majority of FOMC members. Half of them are forecasting just one interest rate cut this year, while the other half are forecasting one interest rate hike. In other words, there is no clear consensus among policymakers right now.
According to the CME Group‘s FedWatch tool, Wall Street is betting that the Fed will do nothing for the rest of 2026. However, traders see one potential interest rate hike in September 2027, followed immediately by two cuts in October and December. That doesn’t make sense to me personally, because the Fed aims to set policy in a stable fashion so as not to trigger volatility in the economy or the markets. Hiking rates just to cut them at the very next meeting would be unusual.
Simply put, it seems that the Street is just as unsure as the FOMC about what comes next.
Here’s what it means for the stock market
The stock market is mainly driven by corporate earnings. When companies make more money, they attract higher valuations, and the reverse is true when their profits shrink. Rising inflation with rising unemployment is bad news for corporate America, because higher prices and fewer jobs spell weaker consumer spending.
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When inflation soared to a 40-year high in 2022, the S&P 500 plunged into bear territory, losing more than 20% of its peak value. I’m not suggesting that will happen again, but the Fed is in a real conundrum. If it raises interest rates to deal with inflation (like it did in 2022), it risks making unemployment worse. If it cuts interest rates to support the job market, it risks triggering another severe spike in inflation.
The stock market typically prefers lower rates because companies can borrow more money to fuel their growth, and smaller interest costs are a direct tailwind for their earnings. However, all bets are off if the economy falls into a recession. That would almost certainly dent corporate earnings, which would send the stock market lower even if interest rates were falling.
So what should investors do? During times of uncertainty, the best strategy is to smooth out the noise by focusing on the long term. The stock market has overcome some brutal economic shocks throughout history, from the global financial crisis in 2008 to the COVID-19 pandemic in 2020, so it will move past this situation, too. The recent sell-off in the S&P 500 might get worse in the near term, but historically, periods of weakness have typically been great buying opportunities.
