The U.S. Federal Reserve has a dual mandate. First, it's tasked with keeping inflation under control, which means ensuring the Consumer Price Index (CPI) increases by around 2% per year. Second, the central bank aims to keep the economy operating at full employment -- although it doesn't have a specific target for the unemployment rate.

If inflation or the jobs market deviate from where they should be, the Fed adjusts the federal funds rate (overnight interest rates) to influence economic activity and bring them back into line. The inflation surge in 2022 is a good example of this policy in action; the CPI hit a 40-year high of 8% that year, prompting an aggressive federal funds rate hike.

The Fed started reversing that policy in 2024 by reducing the federal funds rate three times between September and December, as it felt inflation was finally under control. The central bank held its latest policy meeting last week, and offered some fresh guidance for the future path of interest rates.

Here's how many cuts could be on the table in 2025.

Image source: Getty Images.

There is good news and bad news in the Fed's latest report

The Fed releases a report called the Summary of Economic Projections (SEP) four times per year, which tells the public where members of the Federal Open Market Committee (FOMC) believe inflation, economic growth, the unemployment rate, and interest rates could be in the future.

The latest SEP was issued during the central bank's March meeting last week. The bad news is that most FOMC members now think the U.S. economy will grow by 1.6% to 1.9% during 2025, down from their previous forecasted range of 2% to 2.3% in the December SEP.

To make matters worse, the median FOMC projection for the Personal Consumption Expenditures (PCE) measure of inflation also ticked higher to a range of 2.7% and 2.8% for 2025 (from 2.5% to 2.6% previously). FOMC members also revised their forecast for the unemployment rate higher for the year, to between 4.4% and 4.5%.

Simply put, compared to the December SEP, the Fed is now bracing for a weaker economy with more unemployment and higher inflation, which is typically a bad combination.

But here's the good news: The FOMC estimates the federal funds rate will end this year somewhere between 3.88% and 4.12%, which implies up to two interest rate cuts from the current level of 4.37%. However, the CME Group's FedWatch tool, an indication of where Wall Street thinks monetary policy could go, predicts there might be three rate cuts this year instead.

Therefore, weaker economic conditions will hopefully be offset by lower interest rates, which will bring relief to households and businesses alike.

Interest rate cuts are good for stocks, but beware of short-term volatility

Interest rate cuts can boost the stock market over the long term for a few reasons. They reduce the yield on risk-free assets like cash and government Treasury bonds, which pushes investors into growth assets like stocks in search of better returns, thus driving the market higher. Plus, rate cuts reduce borrowing costs for companies, which organically increases their earnings and allows them to take on more debt to potentially supercharge their growth.

However, the beginning of every rate-cutting cycle since the year 2000 has foreshadowed a correction (a drop of 10% or more) in the benchmark S&P 500 (^GSPC 0.16%) stock market index:

Target Federal Funds Rate Upper Limit data by YCharts

That said, there were some extenuating circumstances on each of the occasions depicted in the chart: The dot-com internet bubble burst in the year 2000, then the global financial crisis happened in 2008, and the pandemic struck in 2020. As a result, the S&P 500 was falling because of significant economic shocks, and the Fed happened to be slashing rates simultaneously for the very same reason. So Fed rate cuts can't really be blamed for stock market volatility.

However, during a normal cycle, the Fed will typically cut rates in the face of economic weakness. Corporate earnings sometimes decline during periods of slower economic growth, and a falling stock market is the natural response to those conditions (investors tend to pay less for companies with decelerating earnings growth).

Therefore, Fed rate cuts can be a sign of trouble ahead in the economy, which certainly impacts the S&P 500.

Some economic indicators are flashing warning signs

While there is no apparent catastrophe on the horizon for the U.S. economy, there have been some warning signs recently that suggest a slowdown is underway. For example, although the current unemployment rate of 4.1% is quite low by historical standards, it has trended higher over the last 12 months. Plus, we now know the Fed thinks it will continue climbing, to as high as 4.5% this year.

Weakness in the jobs market can precede lower consumer spending in the future, which can put a dent in corporate earnings. On that note, the University of Michigan U.S. Consumer Sentiment Index fell to 57.9 in March, marking the lowest reading since November 2022, when the S&P 500 happened to be in the midst of a bear market.

Economists at Goldman Sachs recently reduced their estimate for U.S. gross domestic product (GDP) growth to 1.7% for 2025 (from 2.2%), which is near the lower end of the Fed's own projections. Goldman cites some of President Trump's trade policies as a core reason for its lower forecast. The president is actively placing tariffs on imported products from other countries, and many of those countries have now imposed tariffs of their own, which could result in less consumption and even spark a global trade war. Goldman also reduced its price target for the S&P 500 to 6,200 (from 6,500) for the year, so it clearly believes weaker growth will translate to lower returns.

It isn't alone, because Yardeni Research just meaningfully slashed its S&P target from 7,000 to 6,400, and RBC Capital Markets also revised its expectations lower.

But investors shouldn't rush to sell their stocks, especially with the S&P 500 currently sitting 8% below its record high. History proves the market always climbs to new highs over the long term, so corrections are usually the best time to buy. Even if weaker economic activity and falling interest rates create some volatility in the near term, investors who can hold through the turbulence are likely to reap significant rewards in the future.