There is widespread agreement in markets and among economists that the Federal Reserve will cut interest rates at its policy meeting on Wednesday. There is also agreement that this will be accompanied by forward guidance suggesting fewer cuts in 2025 than previously indicated, a higher terminal rate and a pause in January. Beyond this, much will depend on the evolution of Fed thinking about an inflation rate that is proving to be sticky above its 2% target.
Markets are pricing in a more than 90% probability of a 0.25-percentage-point cut in the fed funds rate this week. Officials are likely to pencil in higher “dot plots” for rates, notwithstanding the dispersion in forecasts among them, together with a move up in the terminal rate closer to what the market expects. Finally, while Chair Jerome Powell will not close off his options for January completely, he is expected to signal at his press conference that the central bank will stand pat when the Federal Open Market Committee meets next month.
What comes after January is the subject of an interesting debate. Many anticipate the “skip” will be followed by a resumption in easing, with cuts continuing on a quarterly basis throughout 2025. Some think of it more as a “pause,” assigning greater uncertainty to rate reductions thereafter. Very few, at least for now, think that Wednesday’s reduction may mark the end of the current cutting cycle.
Varied assessments about inflation, the economy and the policy intentions of the incoming administration explain this range of opinions. The fact that the path of Fed easing in 2024 has ended up diverging by some 75 basis points from the consensus in markets of a year ago is also playing a role.
Last week’s inflation data confirmed the now more hesitant nature of the journey back to the Fed’s 2% target, something that a few of us have noted for a while. Consumer prices, excluding volatile food and energy costs, rose 0.3% for a fourth straight month, the report released last Wednesday showed. The producer price index report that followed the next day was somewhat hotter than expected. The components of both do not translate comfortably to a quick 2% for the Fed’s favorite inflation gauge.
It is also notable that the data coincide with upside surprises from a series of reports on economic activity and intentions. Meanwhile, though few are rushing to confidently estimate the precise effects of President-elect Donald Trump’s policies, most believe that some combination of higher tariffs, migration curbs and repatriation, and fiscal pressure could prove inflationary before significant deregulation and liberalization produce supply-side benefits. After all, we also have indications that liquidity conditions are quite loose.
In such a world, the Fed will soon be forced to confront an important policy choice, with implications for continued US economic exceptionalism and the health of the stock market.
Should it both implicitly and explicitly reaffirm its 2% inflation target and redouble efforts to get the economy there? Powell said last month that “we don’t guess, we don’t speculate, and we don’t assume” when it comes to the incoming administration’s policies. Holding to the current target would still involve the Fed delivering quite a “hawkish cut” on Wednesday. Behind closed doors, the thinking on future cuts would start to shift from, “We can continue to cut rates as it’s simply a matter of time until inflation gets to our target,” to, “We need to maintain policy restrictiveness for quite a bit longer than we anticipated.” Indeed, in such a scenario, a U-turn that includes a rate hike is not entirely out of the question.
Else, should it implicitly acknowledge that with all the ongoing structural changes, domestically and internationally, the economy’s equilibrium inflation rate has moved higher? Put another way, the economy can run at an inflation rate closer to 3% without de-anchoring expectations and, therefore, without harming growth prospects. If that’s true, the more the Fed tries to force the economy to a strict 2% inflation world, the greater the threats to US economic exceptionalism, the stock market and financial stability.
To be clear, this second scenario is not one in which the Fed publicly abandons its inflation target for a new range of 2.5%-3%. This won’t happen, given the extent to which it has missed it in the last three years. Instead, in its public remarks, the Fed would simply keep pushing back the date for attaining the current target. Behind closed doors, policy would be run with a de facto higher goal for now. How long this continues would depend in part on the progress the administration makes on its productivity-enhancing, supply-side policies, companies’ pricing approaches, and developments in the global economy.
To navigate well what I think may be an inevitable decision point, the Fed will have to change how it formulates policy. It will need to move from what is currently an excessive dependence on historical data to incorporating more of a strategic forward-looking approach. Where it ends up in its choice will have significant implications for growth, as well as market valuations and volatility — in America and well beyond.
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