The U.S. Federal Reserve has two main objectives: Keeping the Consumer Price Index (CPI) measure of inflation increasing at an annualized rate of 2%, and maintaining full employment in the economy (although there is no specific target for the unemployment rate).

The Fed adjusts the federal funds rate (overnight interest rate) to help it achieve those objectives. For example, it embarked on one of the most aggressive campaigns to hike interest rates in its history in 2022, when the Consumer Price Index (CPI) surged to a 40-year high of 8%.

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Thankfully, inflation has cooled significantly since then, which allowed the Fed to cut interest rates in September for the first time since March 2020. It followed that up with another cut in November, and there could be more on the way.

Conventional wisdom suggests lower interest rates are great for the stock market, but history points to a potential downturn in the S&P 500 (SNPINDEX: ^GSPC) in the near term.

The surge in the CPI during 2022 was driven by a cocktail of inflationary pressures:

The Fed started increasing rates in March 2022, and by the last hike in August 2023, the federal funds rate was at a range of 5.25% to 5.5%. That marked a two-decade high, which was necessary to cool the economy down after two years of stimulative policies.

Thankfully, it worked. The CPI cooled to 4.1% in 2023, and it came in at an annualized rate of 2.6% in October 2024 (the most recent reading). In other words, the Fed's 2% inflation target is within reach.

That gave the Fed's Federal Open Market Committee (FOMC) confidence to slash the federal funds rate by 50 basis points in September, followed by another 25 basis points in November. The FOMC's own projections suggest another 25-basis-point cut might be on the way in December, followed by 125 basis points' worth of cuts during 2025 and 25 basis points' worth of cuts in 2026.