Are the U.S. Economy and Stock Market in the Fed’s Hands Now?
The Federal Reserve made some waves at the end of last year.
The 25 basis-point rate cut they announced at their December meeting was widely expected. What the market was not expecting, however, was the insinuation that rates may not necessarily follow the downward trajectory the Fed had previously projected. The one particular comment that jolted markets appeared to be when Chairman Jerome Powell said: “From here, it’s a new phase, and we’re going to be cautious about further cuts.”
Cautious about further rate cuts? Wasn’t the inflation fight largely won, with the benchmark fed funds rate destined to fall back to a neutral rate in the 3% to 3.5% range? The financial media and investor community were aghast at the news.
My advice to investors: do not overthink or overstate the importance of rate cuts in 2025. The economy and markets can do just fine with or without them.
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Just take 2024 as your prime example. At the end of 2023, futures markets were forecasting six or more rate cuts for 2024, which turned out to be quite wrong. As it turned out, the Fed cut rates three times during the year, lowering the fed funds rate to a range of 4.25% to 4.5%. The economy and stock market did not seem to mind the ‘higher-for-longer’ level of rates, with GDP growth coming in strong and stocks rallying more than +20%.
If we know the economy and stock market can perform well even with the benchmark fed funds rate north of 4.5% or even 5%, then why would a 4% level of rates somehow be prohibitive to growth? Fed officials projected at the December meeting that rates would finish 2025 at 3.9%, which is one fewer cut than they had suggested at the September meeting. Investors who are up in arms over this news are missing the big picture, I think. I do not see 25 basis points in either direction as a very meaningful move.
The big debate in markets now is where the so-called “neutral rate” is for benchmark fed funds. The neutral rate is a moving target depending on economic conditions—it’s the rate of interest that sustains the economy at full employment with stable inflation. In other words, the interest rate that keeps the economy not too hot, and not too cold. If consumers and businesses are borrowing and spending too much, and inflation starts to tick higher again, it likely means rates are too low. If the jobs market is loosening and lending activity is tepid, rates may be too high.
If you want to know exactly where the Fed sees the neutral rate today, you will not get a clear answer from Chairman Powell. After the December meeting, he said: “We don’t know exactly where it is, but … what we know for sure is that we’re a hundred basis points closer to it right now.” Some Fed officials think it’s closer to 3%, some say it’s 4%. Perhaps it’s somewhere in between.
The point I’d repeat here is that I’m not sure the level of rates matters as much as many think. The idea that the U.S. economy and the stock market’s fate are in the Federal Reserve’s hands—and hinges on whether they get the neutral rate exactly right—is simply not substantiated by what we know from history, or even from 2024 for that matter. Interest rates remained ‘higher-for-longer’ all year, and stocks powered higher.
Monetary policy decisions are not meaningless, of course, but my argument here is that they are not as important as many investors assign them to be.
In my view, what would hurt markets most is if inflation and inflation expectations start to drift higher and become un-anchored from their current 2.5% to 3.5% level, perhaps because of some unforeseen shock in geopolitics or the global economy. If the Fed is forced to go in the other direction—raising rates instead of cutting them because of a negative inflation surprise—I think that could be very detrimental to stocks. For now, however, inflation data continues to show modest progress toward the Fed’s long-term goal. In November, the Fed’s preferred inflation gauge—the PCE price index—came in at 2.4% year-over-year, well within striking distance of the target.
Bottom Line for Investors
With inflation hovering near its target and the unemployment rate at 4.2%, there is little expectation that interest rates will go any higher. Whether or not they go lower, and by how much, is an ongoing debate. But it’s not one I think investors should be focused on. If you spend too much time framing your market and economic outlook around shifting expectations for interest rates, it may mean de-emphasizing stocks’ main driver—earnings growth.
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