Why Did the Stock Market Crash After the Fed Cut Interest Rates Last Week?

On Dec. 18, the U.S. Federal Reserve concluded its final policy meeting for 2024. There was a broad consensus among experts that the central bank would cut the federal funds rate (overnight interest rates) by 25 basis points, and that's exactly what happened.

The Fed has now cut interest rates three times since September due to a decline in the rate of inflation and some modest weakness in the jobs market. Lower rates are usually good for stocks for a number of reasons (more on those later), but this particular cut was met with a wave of selling among investors.

The S&P 500 (^GSPC -1.11%) plunged 2.9% on the day of the decision, and the technology-heavy Nasdaq-100 plummeted 3.6%. Here's why.

Image source: Getty Images.

It's all about the Fed's forecast

The stock market is a forward-looking machine. Investors are less concerned about what's happening now because that information is already known -- what they really care about is what might be around the corner.

Once per quarter, the Fed issues its "summary of economic projections" (SEP), which tells the public where members of the Federal Open Market Committee (FOMC) think inflation, economic growth, and interest rates could be in the future.

The December issue of the SEP delivered a major surprise. The FOMC now forecasts just two interest rate cuts (25 basis points each) in 2025, compared to five in the previous SEP from September. That means the federal funds rate could be somewhere between 3.88% and 4.12% at the end of 2025, as opposed to somewhere between 3.13% and 3.62%, which was the FOMC's previous forecast range.

So, why the big shift in consensus among FOMC members? First, the median projection for U.S. Gross Domestic Product (GDP) growth in 2025 rose from 2.0% in September to 2.1% most recently. Simply put, a stronger economy doesn't need as many interest rate cuts.

Second -- and this is a big one -- the median projection for Personal Consumption Expenditures (PCE) inflation also increased from 2.1% to 2.5% for 2025.

The Fed has a mandate (as legislated by Congress) to maintain price stability. That means keeping inflation increasing at a steady rate of 2% each year, and since it's now expected to accelerate in 2025, fewer rate cuts are on the table.

Lower interest rates can be great for the stock market

When interest rates decline, the yields on risk-free assets like cash and Treasury bonds also decline. That makes growth assets more attractive to investors, so they shift a higher portion of their money into the stock market, which can drive prices higher.

Companies can also borrow more money to fuel their growth when rates are lower and their interest expense falls, which is a direct tailwind for their earnings. Stock prices can move for a number of reasons, but growing earnings will almost always send the market higher over the long term.

However, investors don't want to see the Fed slashing rates because of a weak economy. There is no apparent crisis on the horizon right now, but the unemployment rate has ticked higher from 3.7% to 4.2% during 2024, and a further deterioration in the jobs market might be a precursor to weaker consumer spending. That would harm corporate earnings, which could drive stock indexes like the S&P 500 lower, even if the Fed is cutting rates.

Since the year 2000, the S&P 500 has temporarily dipped every single time there has been an economic shock, even while the Fed was slashing rates. The Fed cut rates when the dot-com bubble burst in 2001 because it triggered an economic recession. It cut rates again in 2008 when the global financial crisis struck and then again in 2020 to fight the economic effects of the COVID-19 pandemic:

Data by YCharts.

The Fed risks overstaying its welcome

Interest rate adjustments typically have a lagged effect on the economy. In fact, some estimates by central bankers suggest it could take up to two years for an interest rate hike (or reduction) to actually impact inflation. As a result, it's possible the U.S. economy still hasn't felt the full effects of the Fed's most recent hikes, the last of which was in Aug. 2023.

That's one reason the Fed started cutting interest rates in September, even though the rate of inflation wasn't quite at the central bank's 2% target. To quote Fed chairman Jerome Powell, "The upside risks to inflation have diminished, and the downside risks to employment have increased."

In other words, he felt confident in the downward trend in the rate of inflation back in September, so keeping interest rates at an elevated level became far too risky -- the Fed's goal isn't to crash the economy or cause a recession.

Powell might be taking a lesson from history. The chart below shows the federal funds rate going back to the 1960s, with recessionary periods highlighted in gray. You might notice that recessions consistently occurred after the Fed hiked interest rates:

Data by YCharts.

The U.S. economy is large and highly complex, but it appears the Fed has a history of misjudging the lagged effects of interest rate policy. Therefore, I give Powell a lot of credit for being conscious of that risk and preemptively moving rates lower.

However, investors apparently don't feel confident that two rate cuts in 2025 will be enough to eliminate that risk completely, which is a key reason stocks sold off following the Fed's announcement.

But the shift in forecasts between the September and December meetings is proof that nothing is set in stone. There could easily be more than two rate cuts in 2025 (or there could be none at all), so investors shouldn't rush to sell stocks every time the FOMC issues a new prediction. It's better to buy high-quality stocks and take a long-term view of the market to smooth out the noise.