The last week saw the U.S. stock markets react positively, at least on the final trading day, following a favorable report on inflation indicators that caught the attention of the Federal Reserve. On that Friday alone, major indices such as the Dow Jones, S&P 500, and Nasdaq rose by over 1%, with the Dow increasing by 1.18%, the S&P gaining 1.09%, and Nasdaq climbing by 1.03%. Yet, despite this single-day upturn, the weekly outlook remained bleak, as all three indices recorded declines over the week. The Dow dropped 2.25%, marking its largest single-week drop since late October, while the S&P 500 and Nasdaq saw similar downtrends of 1.99% and 1.78%, respectively, both also representing their largest weekly downturn in the past month.

This volatility in the market has led some financial experts to weigh in on the situation. Jeremy Siegel, an emeritus professor of finance at the Wharton School of the University of Pennsylvania, assessed that the recent sell-off in the U.S. stock market might actually represent a “healthy” correction. He argued that the Fed's cautious outlook on future interest rate cuts has prompted investors to confront a more realistic understanding of the economic landscape. This perspective is crucial, especially as the customary “Santa Claus Rally” approaches, which statistically tends to bring a lift to stock prices during the last trading days of the year and the first days of January.

The notion of the “Santa Claus Rally” has historical roots. According to the Stock Trader's Almanac, since 1969, the S&P 500 index has averaged a 1.3% increase during these seven trading sessions. However, speculation is rife this year about whether strong inflation data and the Federal Reserve’s hawkish stance might prevent such a rally from manifesting.

Turning to the inflation indicators, the core PCE price index, a favored measure by the Fed, provided some respite for anxious traders. The data revealed that in November, the PCE price index had a year-over-year growth of 2.4%, slightly below the anticipated 2.5%. Moreover, the month-over-month increase was just 0.1%, again lower than predictions of 0.2%. The core PCE price index, which strips out the more volatile categories of food and energy, also came in below expectations, marking a year-over-year increase of 2.8% instead of the expected 2.9%.

Following the release of this favorable inflation data, traders appeared confident that the Federal Reserve would keep interest rates unchanged at the next meeting in January while increasing the likelihood of a potential cut in March. This anticipation fueled a rebound in the stock market as optimism began to seep back into trading decisions.

The dot plot, which reflects policymakers' expectations regarding future interest rate changes, indicated that officials expect to implement two rate cuts by 2025, a reduction from earlier forecasts that had suggested as many as four cuts next year. Additionally, the median long-term federal funds rate was adjusted from 2.9% to 3%.

Market strategists, such as Zhao Yaoting from Invesco, highlighted the instinctive reaction of the market to the updated dot plot in the Federal Reserve’s data presentation. While past dot predictions have been notoriously inaccurate—such as in December 2021 when the Fed anticipated a rate hike of less than 100 basis points for the following year, which resulted in more than 400 basis points worth of hikes—it is important for investors to keep a level head amid fluctuating forecasts.

Fed Chairman Jerome Powell noted that the central bank is at or nearing a point of slowing down interest rate hikes, where any significant monetary policy decisions regarding rate cuts in 2025 would hinge on emerging economic data rather than the current economic backdrop. The dual mandate of maintaining a robust labor market while curbing inflation to a 2% target continues to shape the Fed's strategic approach, suggesting fewer instances of raising rates next year.

Tom Porcelli, chief U.S. economist at RBC Capital Markets, reiterated that the future direction of Fed policy will largely depend on whether inflation continues on a downward trajectory. He forecasts that given the Fed's recent hawkish posture, they will likely hold off on rate cuts in January while assessing further economic data before transitioning to either resume or terminate this cycle of reductions. With a cautious approach, he cautioned that the market will need to stay alert to economic developments in the upcoming year.

In recent comments, key figures such as John Williams from the New York Fed anticipated further rate cuts if inflation trends downward but acknowledged that current monetary policies remain restrictive. This indicates that short-term interest rates will continue to suppress the economy, offering a conducive environment to mitigate inflationary pressures.

Meanwhile, market analysis noted the impact of the upcoming holiday season, anticipating a quiet week for the overseas markets with lower data releases and significant events slated. Notably, the Bank of Japan’s decision regarding interest rates is under scrutiny, coupled with the effects of traditional trading breaks for U.S. markets on Tuesday and Wednesday due to Christmas festivities.

Despite the recent downturn observed in the stock market, some analysts from Wall Street maintain a sense of optimism. They believe that the current market vibrations could represent an opportunity for investors to buy on dips, as they consider it unlikely that the Federal Reserve would jeopardize the potential for a year-end rally.

Carol Schleif, chief investment officer at the Wealth Management Office of the Montreal Bank, remarked that the market might have overreacted to the Fed’s signals about pausing rate cuts. She emphasized that the overarching strength of the economy is paramount and has seemingly been overlooked by market participants. The rationale for the Fed to slow its rate adjustments stems from the resilience of the economy, which ultimately bears significant weight on stock performance and corporate earnings.

Even with notable uncertainties surrounding the implications of protectionist policies, Wall Street analysts collectively predict that the S&P 500 may rise approximately 8% in the upcoming year. Jean Boivin from BlackRock Investment Institute articulated that while the Fed’s cool expectations for sizable rate cuts by 2025 dampened some market excitement, it is not enough to alter the promising landscape for U.S. equities, which continue to benefit from advancements in artificial intelligence, robust GDP growth, and expansive earnings growth.

Historical patterns suggest that the Fed's expectations concerning monetary policy often fluctuate in response to incoming economic data. As noted by Andrew Hollenhorst, chief U.S. economist at Citigroup, signs of weakness within the job market may prompt a shift away from a hawkish stance towards a more dovish outlook. A differential of weak job trends could accelerate rate cuts beyond what the market currently anticipates, leading to a pivot in Fed policy over the coming months that may favor expansionary measures.