Too-high inflation and the prospect of new price pressures has Federal Reserve officials expecting to lower interest rates by just half a percentage point next year, compared with a full percentage point of cuts just in the past four months. Continued economic strength and potentially inflationary fiscal policies in 2025 make even that reduced pace of rate cuts far from a done deal.
The Federal Open Market Committee delivered a quarter-point rate cut Wednesday, as Fed Chair Jerome Powell declared that the U.S. central bank had entered a new phase. The "recalibration" of monetary policy in recent months has given way to heightened uncertainty about the Fed's forward path, as changes in interest rates will be contingent on lower inflation readings in 2025.
If things play out according to Fed officials' latest quarterly update to their Summary of Economic Projections, the Fed will cut rates by half a percentage point not only next year but in 2026.
"This felt much more like a 'pause' than a 'skip' to me," says Olu Sonola, Head of U.S. Economic Research at Fitch Ratings. "It's clear they don't precisely know what next year will bring, and they want to wait and see before taking action."
In his postmeeting press conference on Wednesday, Powell likened the coming slowdown in rate moves to driving a car on an unfamiliar road on a foggy night, noting the driver will naturally decelerate to remain on track. The stock market tumbled on Powell's comments, with the Dow Jones Industrials shedding 1,123 points, or almost 2.6% on the day.
A particular source of uncertainty is the outlook for inflation. For several months, Powell and other Fed officials have professed their confidence in inflation's sometimes-bumpy path toward the central bank's 2% annual target. That progress stalled out in late 2024, and next year will present new and different challenges to continued disinflation, an acknowledgment apparent in Fed officials' latest forecasts.
Their median estimate on Wednesday called for a 2.4% rise in the personal consumption expenditures price index in 2024, followed by a 2.5% increase in 2025. Their median estimates put the core PCE price index -- which excludes food and energy components -- up 2.8% this year, and 2.5% next year.
All four of those figures are meaningfully higher than the ones officials penciled in just three months ago, when most expressed confidence that inflation would continue to move lower and turned their focus to supporting the U.S. labor market. "We've had a year-end projection for inflation [that's] kind of fallen apart as we've approached the end of the year," Powell said.
Meanwhile, policymakers' late-summer alarm about a faltering labor market has proven too severe. The unemployment rate has bounced around since then, but remains at relatively low levels. Although buffeted by hurricanes and labor strikes, monthly hiring has extended a solid longer term trend. That strength means the Fed can afford to slow down its policy easing.
The current backdrop sets a higher hurdle for future rate cuts: Fed officials need to see a renewed decline in the inflation numbers, rather simply counting on their confidence in the data's downward trend. "As we think about further cuts, we're going to be looking for progress on inflation," Powell said.
That progress isn't guaranteed, as Fed officials' projections make clear. Policymakers also see faster economic growth this year and next than they did in September. And that's before the potential impact of many of the fiscal policy promises of the new administration in Washington.
Many of President-elect Donald Trump's campaign promises could further lift economic growth -- but bring the side effect of boosting inflation. Powell and other Fed officials have stressed that they aren't going to react to policies that haven't yet been enacted. As plans for tariffs, tax cuts, immigration crackdowns, and more become clearer, their implications for inflation should as well.
Expect a cautious, wait-and-see approach from the Fed in 2025. Says Fitch's Sonola: "They don't want to pre-empt any of the Trump policies, and now they're not going to pre-empt inflation coming down either."
Comments