FOMC Review: A New Phase

Summary

• The Fed eased as expected but communicated a shallower trajectory for the Federal Funds Rate (FFR) with only two 2025 cuts.
• Jerome Powell stressed the Fed was entering a new phase: with the FFR close enough to its neutral value, actual disinflation progress would be required for further FFR cuts.

Market Implications

• I still expect no cuts in 2025 against markets pricing about 1.5 cuts.

Fed Cuts as Expected

The Fed cut 25bp as expected. Contrary to consensus but aligning with my expectations, the Summary of Economic Projections (SEP) showed only two 2025 cuts (Table 1 and FOMC preview). Contrary to my expectations, the Fed increased the period needed for inflation to return to target by one year. The Fed now forecasts inflation to be back to the 2% target in 2027, against 2026 previously. By 2027, core PCE will have been above 2% for six years.

While the statement saw the risks to the employment and inflation legs of the mandate ‘roughly in balance’, the SEP showed the FOMC sees more risks to inflation risks than unemployment (Table 2).

Not all FOMC members supported the decision. Hammack dissented and four dots showed no December cut. These could have been either from voters who preferred to express a milder form of dissent than a vote, or from non-voters. Besides Hammack, the ‘dissenting dots’ could have been from Bowman (voter), Kashkari (non-voter), Musalem (non-voter). (‘Dissenting December dots’ have only happened three times since the Fed started publishing a dot plot, in 2015, 2017 and 2018 and only involved two meeting participants opposed to rate hikes).

Powell explained the decision to cut reflected confidence disinflation would continue together with labour market cooling.

Powell’s disinflation confidence was based on:

• Housing inflation steadily decreasing.
• Based on currently high productivity, wages are consistent with the inflation target; should productivity revert to trend wages would be ‘only a little bit above’ that level.
• Recently high imputed services prices (e.g., insurance, asset management) reflect computation conventions rather than resource pressures.
• Recently higher goods prices are more noise than signal.
• The flattening inflation trajectory in H2 reflects a base effect (Chart 1).

Powell also stated that while downside risks to employment were lower, ‘the labor market was looser than pre-pandemic and it’s clearly still cooling further.’ He added, ‘we don’t think we need further cooling in the labor market to get inflation down to 2 percent.’

A New Phase

Powell stressed that the Fed was entering a new phase. He stated, ‘our policy stance is now significantly less restrictive. We can therefore be more cautious as we consider further adjustments to our policy rate.’

He added the slower pace of cuts from now on reflected:

• Most importantly, higher inflation this year and in 2025.
• Stronger growth and lower unemployment.
• Greater closeness to the neutral rate that remained uncertain.
• Uncertainty, including around the incoming Donald Trump administration’s economic policies.

Powell further made clear that actual inflation progress would be needed for additional cuts: ‘the actual cuts that we make next year will not be because of anything we wrote down today. We’re going to react to data.’

Powell further clarified yesterday’s cut was not based on specific expectations around the incoming Trump administration’s economic program. As far as the SEP was concerned, ‘Some people did start to incorporate estimates of economic effects of policies into their forecasts at this meeting. Some people said they didn’t do so. And some people didn’t say whether they did or not.’

Asked about the impact of Trump tariffs on Fed policy, Powell stated the analysis included in the September 2018 Tealbook was ‘a good place to start.’ He added he had brought this with him. In the Tealbook, Fed staff assessed the impact of a 15ppt tariff increase on non-oil imports, with and without Fed policy tightening. They found demand and supply would fall and core PCE would surge temporarily to 3.25% over three quarters.

In the first scenario, policy was tightened in response to the inflation acceleration. As a result, the US entered mild recession. In the second, the Fed chose to look through the inflation increase and instead lowered the policy rate to reflect the slower growth. As a result, a recession was avoided while inflation was only mildly higher than in the first scenario.

Powell further added, ‘In any case, this is not a question that’s in front of us right now. We don’t know when we’ll face that question.’

Market Consequences

Following the FOMC, markets repriced the December 2025 FFR to 4% or about 1.5 cuts in 2025, less than the December SEP two cuts, from 3.8% or about 2.5 cuts before the FOMC (Chart 2).

I still expect no cut in 2025 largely because I do not think the pickup in productivity growth will be large and persistent enough to offset the slower growth in labour supply and therefore in potential output (Chart 10 in Fed On Hold Through 2025).

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)