The shift reflects a Federal Reserve that is facing faster growth and stickier inflation.
The Federal Reserve cut interest rates by a quarter point on Wednesday, as expected, but suggested that the pace at which it will reduce rates next year would be cut in half.
The move brings the Fed’s key overnight lending rate to a range of 4.25% to 4.5%. While anticipated, analysts will likely focus more on the updated projections for rates and the economy in 2025 and beyond.
The Fed now sees inflation remaining somewhat higher, with the federal funds rate now projected to end 2025 at 3.9%. That is a half point higher than the central bank forecast in September and the 2026 projection is for 3.4%, up from 2.9% in its earlier forecast.
The economy is “solid,” the Fed said in announcing its decision. While the labor market has softened, the Fed noted progress on getting inflation down to its 2% goal but acknowledged it remains “elevated.” It raised its outlook for economic growth upward to 2.5% this year from 2% three months ago.
“As we think about further cuts, we’re going to be looking for progress on inflation,” Fed Chairman Jerome Powell said at his press conference after the announcement. “We have been moving sideways on 12-month inflation.”
In lowering interest rates at a slower pace while also raising its growth forecast, the Fed is acknowledging the reality of an economy that has performed better than expected and inflation that has persisted a little longer than anticipated. It’s a reality that markets had already priced in but one the Fed needed to adjust to bring itself in line.
“While the Fed opted to round out the year with a third consecutive cut, its New Year’s resolution appears to be for a more gradual pace of easing,” said Whitney Watson, global co-head and co-chief investment officer of fixed income and liquidity solutions at Goldman Sachs Asset Management.
“Reflecting recent stronger data, changes to the (Fed’s) inflation and unemployment forecasts were hawkish and the dot-plot now sees just two cuts in 2025,” she added. “We expect the Fed to opt to skip a January rate cut, before resuming its easing cycle in March.”
The Fed is battling a lot of uncertainty with inflation remaining stubbornly above its 2% annual target and economic growth hovering around 3% annually – well above the supposed 1.8% growth rate that economists say is the point where it does not spark inflation or strain the ability of businesses to meet demand.
“Instead of the markets following the Fed, the Fed is now following the markets,” said Gene Goldman, chief investment officer at Cetera Investment Management.
Despite a 50 basis point cut in September that surprised markets and another 25 point cut in November just after the election, consumers have not really seen much benefit from lower borrowing costs. Interest on credit cards has barely budged while mortgage rates are around 6.8%, higher than they were in September. A lot of that has happened as yields on bonds have risen as Wall Street has come to grips with the idea of fewer rate cuts in 2025 and the stubbornness of inflation.
“I think that last mile (on inflation) is harder than anybody imagined,” said Brent Schutte, chief investment officer at Northwestern Mutual Wealth Management. “Inflation is a year over year measure and 2% means prices are still rising. That’s why you are seeing low-income consumers struggling.”
At the same time, Washington is about to experience a new governing regime with Republicans in charge of the White House and both houses of Congress. President-elect Donald Trump and his GOP colleagues want to extend tax cuts, even adding some new ones, and impose import tariffs on some key U.S. trading partners. Both could be inflationary or at the very least put some uncertainty into the economy.
Congress is about to vote on a new spending bill that will do nothing to control the nation’s debt, now at $36 trillion. That is causing market interest rates to remain high, putting a drag on overall economic activity.
“It’s all well and good making these commitments, but if you look at the economic maneuvering room the President-elect will have when he enters office, it looks near-on impossible that he’ll be able to follow through,” said Marko Papic, chief strategist and senior vice president at BCA Research. “The reality is that the US deficit is through the roof – Trump simply won’t be able to spend what he likes, which will pose serious issues for his tax policies.”
“The President’s only going to be able to slap an additional $1-$2 trillion onto the deficit before he seriously upsets the bond market,” Papic added. “Ultimately, he’s at the mercy of the vigilantes, who will only tolerate so much before they embark on an all-out riot.”