As expected, the Federal Reserve cut interest rates by 0.25% on Wednesday.

Ordinarily, investors would cheer. After all, rate cuts have been a major driver of the near 14-month stock rally.

The Fed’s cut should have pushed the market to finish the year at new highs.

However, Wednesday’s reaction was anything but a celebration…

Investors were left licking their wounds when the major indexes tanked heavily. The Dow dropped by over 1100 points (or 2.6%) from the previous day’s close.

And the Nasdaq and S&P 500 fell around 3.6% and 3.0%, respectively…

A Rug Pull

Fed Chair Powell’s commentary about future rate cuts led to the plunge.

Coming into this week’s meeting, the market had been factoring in four rate cuts next year.

The Fed thinks inflation is under control. And the economy seems to be performing strongly but not overheating.

So the market had baked in 0.25% rate cuts at every other Fed meeting next year.

That belief has helped keep a floor under the market since September. It powered the rally until this week.

But Powell pulled the rug out from under those assumptions this week. Now he is expecting just two cuts.

What’s more, the 0.25% cut at this meeting wasn’t unanimous.

The Fed tends to vote in unison. So clearly there are dissenting views about how far the Fed should go in its rate-cutting cycle.

I’ve been telling my subscribers since Donald Trump won the presidency last month… The Fed might have celebrated its victory over inflation too soon.

And that’s before you get the new administration in the White House in January.

Because when you bring in inflationary policies, inflation is going to rise…

Rekindling Inflation

Take tariffs on imports, for example…

It doesn’t matter which country you target with those tariffs. The American consumer ultimately bears the additional cost.

Then add in the proposed tax cuts that will likely drive inflation higher.

Goldman Sachs puts the impact of tariffs alone at 0.3%. Other estimates have come in higher.

So the implications for inflation are clear…

This rise in inflation will take a while to wash through the economy. But inflation has stopped falling over the past few months. And by some measures, it already has started to creep up.

That leaves the Fed with baseline inflation above its long-term target.

And again, that’s before more inflationary measures enter the scene next year.

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Policy Shift

I see only two factors that could halt the Fed’s shift in interest rate policy: a quick deterioration in the jobs market or a dramatically slowing global economy.

Otherwise, the Fed’s more neutral stance looks here to stay.

Up until this meeting, the Fed sounded confident it would achieve a soft landing.

But now, after a two-plus year process of bringing inflation lower without blowing up the economy, the Fed is in danger of watching it all slip away.

The strain was starting to show in the post-meeting conference. And the Fed’s language dramatically shifted…

Fed Chair Powell is suddenly talking about a “new phase” in monetary policy… And the Fed is “going to be cautious about future cuts.”

The dilemma is clear…

A prudent Fed can’t stick to rate cuts when the economy is strong and inflation is on the rise.

So rates are going to stay higher for longer than markets had anticipated.

I suspect a rate rise could even be in the cards in the second half of next year.

And as traders, we’ll be on the lookout for how to profit from these evolving conditions in 2025…

Regards,

Larry Benedict
Editor, Trading With Larry Benedict