The Fed just signaled its first interest rate cut since March 2020. It could be bad news for stocks.

“The time has come for politics to adapt.” Those were the words of Federal Reserve Chairman Jerome Powell at the annual Jackson Hole Economic Symposium on Friday.

The Fed has been locked in an intense battle to tame inflation, which hit a 40-year high in 2022 when the Consumer Price Index (CPI) climbed to 8%. That was well above the Fed’s annual target of 2 percent, and the central bank responded with the fastest series of interest rate hikes in its history.

But inflation has cooled significantly this year, and the Fed is now poised to cut the benchmark federal funds rate for the first time since March 2020. While lower rates may be great for stocks over the long term, history suggests the initial response in S&P 500 (^GSPC -0.60%) the index could actually be negative.

A rate cut in September looks certain

The rise in inflation in 2022 was a product of the pandemic. The US government has provided trillions of dollars in stimulus in 2020 and 2021 to combat the negative impact of the COVID-19 crisis on the economy. At the same time, the Fed cut the federal funds rate to a historically low range of 0% to 0.25% and used quantitative easing (QE) to inject trillions of dollars into the financial system.

These factors eventually combined with global supply chain disruptions and shortages to create an inflationary cocktail that forced the Fed to sharply raise interest rates. In the 17 months between March 2022 and July 2023, the central bank raised the federal funds rate from near zero to a range of 5.25% to 5.50%.

Federal funds rate target upper bound data by YCharts.

Fortunately, tighter monetary policy is working. The CPI fell to 4.1% in 2023 and reached an annual rate of 2.9% in July 2024, which was the most recent reading. That’s close to the Fed’s 2% target, which is part of why Chairman Powell thinks it’s time to adjust the federal funds rate downward.

right CME GroupFedWatch’s tool, traders are pricing in a certain chance of a rate cut at the Fed’s next meeting on Sept. 17 and 18 — the only point of debate is whether it will be 25 basis points or 50 basis points. FedWatch predicts further rate cuts in both November and December.

Stock markets don’t always love rate cuts

The stock market’s response to interest rate cuts has been quite negative in recent history, at least initially. Every rate cut cycle since 2000 has foreshadowed a decline in the S&P 500, as evidenced by the chart below, which overlays the index with the federal funds rate.

Federal funds rate target upper bound data by YCharts.

However, the Fed cut interest rates in the early 2000s as the dot-com bubble burst, triggering a recession. It then cut rates in 2008 due to the global financial crisis. It finally cut rates in 2020 due to the pandemic.

Therefore, it is possible that the S&P 500 fell on each of these occasions because of major economic shocks that the Fed was responding to, not because the Fed was cutting rates. Fortunately, there doesn’t seem to be an economic catastrophe right now, so maybe investors will respond to these rate cuts more positively.

Furthermore, in each of these previous instances, the S&P 500 recovered to set new all-time highs. Lower rates are positive for companies in the long run because companies can borrow more money to fuel their growth and their interest payments are lower, which is a tailwind for their earnings.

Lower benchmark rates also reduce returns on risk-free assets like cash and bonds, pushing investors who want better returns into growth assets like stocks. So investors certainly shouldn’t rush to sell their stocks when the Fed cuts rates in September.

Will September’s rate cut be 25 basis points or 50 basis points?

Although the US economy is in relatively good health right now, its growth is clearly slowing. The unemployment rate, for example, was 3.7% at the start of 2024, but has since risen to 4.3%. Rising unemployment may trigger a slowdown in consumer spending, which would be a drag on the economy.

The Fed is taking note. On Friday, Powell commented that inflation poses a downside risk to the US economy, while the unemployment situation now poses a rising risk. Against this background, the upcoming non-farm payrolls (jobs) report, which is scheduled to be released on September 6, could determine whether the Fed will cut rates by 25 basis points or 50 basis points at its meeting from September.

If the US economy creates fewer jobs than expected — or if the unemployment rate rises further — the central bank could opt for a 50 basis point cut to prevent further deterioration. In this scenario, the S&P 500 is likely to slide on fears among traders that the economy is weaker than it currently appears.

In any case, long-term investors should stay the course, as history suggests that any decline in the S&P 500 is likely a buying opportunity rather than an excuse to sell. Over time, American consumers and companies alike will benefit from lower interest rates, which will be positive for stocks.