The Fed just cut interest rates. It can signal a big move in the stock market.

The Federal Reserve cut its benchmark interest rate on Wednesday, September 18, for the first time in four years. Inflation has been trending downward and the labor market has softened, so the rate cut itself was not surprising. But the half-percentage-point cut imposed by policymakers was more aggressive than many experts anticipated.

The S&P 500 (^GSPC 1.70%) it has advanced 18% year-to-date, and history says the index could move even higher in the year ahead. Rate cuts have typically been a positive catalyst for the stock market, although there have been exceptions to this rule. Here’s what investors should know.

How the Federal Reserve Influences Interest Rates

The federal funds rate is a benchmark that influences other interest rates throughout the economy. The Federal Reserve does not directly control the federal funds rate. Instead, it uses various monetary policy tools to steer the benchmark to a target range, which is currently 4.75% to 5%.

Banks are required to maintain a certain balance of reserves at the Federal Reserve so that policymakers can adjust the interest paid on those deposits to influence the federal funds rate. It would make no sense for banks to lend money at a lower interest rate, so the reserve balance rate usually aligns with the lower end of the target range.

Banks can also borrow money from the Federal Reserve to meet short-term liquidity needs, so policymakers can adjust the interest (called the discount rate) charged on those loans to influence the federal funds rate. It would not make sense for banks to lend money at a higher rate, so the discount rate usually aligns with the upper end of the target range.

Lower interest rates encourage borrowing, which boosts economic growth by boosting consumer spending and business investment. In this sense, rate cuts can be good news for the stock market. But economic circumstances that call for rate cuts are often bad news. For example, the unemployment rate has risen 50 basis points year-to-date and job openings have trended lower.

History says rate cuts could trigger a big move in the S&P 500

The Federal Reserve has steered the US economy through five rate-cutting cycles over the past three decades. Cycles that began in 1995, 1998, and 2019 began with a quarter-point discount, and cycles that began in 2001 and 2007 began with a half-point discount.

The chart below shows how the S&P 500 has performed in the 12 months following the first rate cut in each cycle.

Data source: Trading Economics, YCharts. Chart by author.

As shown above, over the past three decades, the S&P 500 has returned an average of 10% in the 12 months following the first rate cut in a cycle. However, whether the economy suffered a recession following the first cut was an important determinant of stock market performance.

Specifically, a recession followed within a year of the start of the cut cycles in 2001, 2007 and 2019, and the S&P 500 fell an average of 14% during the 12 months after the first cut in those situations. But no recession occurred after the cut cycles began in 1995 and 1998, and the S&P 500 returned an average of 20% during the 12 months after the first cut in those situations.

Investors should also be aware of another pattern. Only 2 of the 5 rate cut cycles in the last 30 years started with a half point cut — in 2001 and 2007 — and both times, the economy went into recession and the S&P 500 fell sharply. The Federal Reserve may have moved so aggressively in those situations because the economy was deteriorating so quickly. The same sequence of events is also likely to follow the Fed’s latest rate cut.

Here’s the bottom line: No stock market indicator is infallible, but history says the S&P 500 is headed higher over the next 12 months, and the likelihood of a positive return becomes more likely if the economy remains healthy. However, if the economy slips into a recession, there is a good chance that the S&P 500 will decline in the following year.

In any case, investors can take solace in one fact: The S&P 500 has returned an average of 10.7% annually over the past 30 years, despite the economy going through three recessions during that time. Similar returns are likely over the next 30 years, so patient investors can make a lot of money in the stock market regardless of what happens next year.