The Federal Reserve delivered another 25-basis-point (bp) cut to its policy rate in December, but paired this decision with revisions to its economic projections that imply reemerging concerns around inflation risks and relative confidence in the labor market. As a result, after lowering the policy rate by 100 bps over the past three months, the Fed signaled that the timing and extent of additional cuts are now more uncertain. The outlook for fiscal policy feeds that uncertainty, but with downside economic risks more contained, the Fed has room to wait and watch for developments to unfold in 2025 before shifting monetary policy any further.
The Fed’s projections for monetary policy hew fairly close to our baseline outlook: With a generally resilient U.S. economy amid somewhat sticky inflation and elevated fiscal policy uncertainty, a more gradual and data-dependent approach to further rate cuts is likely.
However, bond markets may have now overshot their repricing consistent with this view: Fed funds futures imply the policy rate will end 2025 at around 4%, slightly above the Fed’s revised projection. While in our baseline we expect the U.S. economy to remain resilient, we also believe markets appear to be underpricing recessionary risks, and therefore, the risk that the Fed will have to cut more aggressively.
A changing balance of risks
While the Fed’s 25-bp rate cut was expected, officials paired this with hawkish revisions to the economic projections for 2025 and beyond. The most notable revision was the outlook for inflation, with the median core Personal Consumption Expenditures (PCE) projection moving up 30 bps in 2025. This is consistent with stalled progress on inflation over the past several months. Notably, not only are Fed officials anticipating a more gradual decline in inflation, they also revised higher their view on the balance of risks around this outlook.
The Fed’s shift on the balance of inflation risks likely reflects growing uncertainty around the scale and scope of fiscal policy pivots suggested by the incoming Trump administration. Indeed, in the press conference, Fed Chair Jerome Powell noted that “some [officials] did identify policy uncertainty as one of the reasons for their writing down more uncertainty around inflation” in their economic projections.
A foggier path ahead
Elevated fiscal policy uncertainty is also consistent with a more uncertain path forward for Fed policy. We believe potential changes to U.S. trade policy present upside risks to inflation and downside risks to growth in the short run, which would have conflicting implications for the Fed’s dual mandate (price stability and maximum employment).
Against this backdrop, Fed officials revised higher their estimates for the path of the policy rate over the next several years. The projections also showed an unusually large range of views: For example, the individual dots estimating the median policy rate in 2026, 2027, and over the longer run span 1.5 percentage points from high to low.
Given the increase in uncertainty, it makes sense that Fed officials want to slow down to see what happens. Powell said, “It’s not unlike driving on a foggy night or walking into a dark room full of furniture. You just slow down.”
We believe the upward revisions to the Fed’s projections reflect officials’ view that they likely have more flexibility now that they’ve cut rates 100 bps. The current policy rate range of 4.25%–4.5% is closer to the range of estimates that Taylor-type rules suggest are appropriate, reinforcing the Fed’s ability to move as slowly or quickly as evolving conditions warrant.
Inflationary scenarios that could shift the Fed away from gradually cutting toward actually hiking rates would likely require large global supply shocks that both significantly lift inflation and start to feed into inflation expectations. However, even then, the negative impacts on growth and the labor market could serve as a counterbalance. Alternatively, if the U.S. economy performs worse than we expect and the labor market weakens, the Fed could cut more quickly in an effort to close the gap between current policy and Taylor-type rules.
Investment implications
We are entering 2025 with a more data-dependent and cautious Fed. However, Powell reiterated that rate hikes are not currently on the table, noting that a resilient economy was consistent with a slower pace of cuts or a pause.
Markets have already repriced to this view, and stocks dropped sharply and bond yields rose further following the Fed announcement. Given the distribution of risks to the Fed’s trajectory and markets underpricing the risk of a more aggressive cutting cycle, intermediate-maturity fixed income looks attractive.
Disclosures
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.
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CMR2024-1218-4110126
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