Federal Reserve: Is there a pause in interest rate cuts?
The Federal Reserve cut interest rates by 25 basis points in December, bringing the target rate down to 4.25%-4.5%. The dot plot indicates two rate cuts in 2025, with economic forecasts revised upward and inflation expectations rising, signaling a slowdown in rate cuts. Although there is still room for future rate cuts, the threshold has been raised. The labor market is slowing, and the unemployment rate has risen to 4.2%. Powell stated that rates remain restrictive, and the Federal Reserve will continue to cut rates
In December, the Federal Reserve's interest rate cut of 25 basis points is almost certain, with the dot plot indicating two rate cuts in 2025 and a significant upward adjustment in the quarterly economic forecast for inflation in 2025, signaling a slowdown in rate cuts. Although there is still room for further cuts, the threshold for additional reductions will become higher. The uncertainty of Trump's policies remains, and in the face of an "uncertain" economic outlook, the Federal Reserve will follow a "step-by-step" approach.
Interest Rate Decision: Cut by 25 basis points, bringing the federal funds target rate to 4.25%-4.5%, in line with market expectations.
Economic Outlook (SEP): The inflation forecasts for 2024 and 2025 have been raised by 0.1 and 0.4 percentage points respectively, signaling a slowdown in rate cuts. The GDP forecasts for 2024 and 2025 have been raised, while the unemployment rate forecasts for 2024 and 2025 have been lowered.
Dot Plot: Adjusted the pace of rate cuts to two times in 2025 and two times in 2026 (the September dot plot indicated four cuts in 2025 and two in 2026), aligning the dot plot with market expectations.
The continuation of rate cuts this time is reasonable, and there is still room for cuts in the future.
The labor market is slowing down, and inflation is still "on track." Excluding short-term disturbances, the employment trend shows a clear direction of slowdown. The unemployment rate rose to 4.2%, up 0.5 percentage points from the beginning of the year; the six-month moving average of new non-farm payrolls was 140,000 in November, significantly weaker than the level of 240,000 at the end of the first quarter. In terms of inflation, month-on-month figures remain controlled at a low level, with housing cooling in November. At the press conference, Powell pointed out that "the labor market is still cooling" and "inflation is generally still on track to fall back to 2%."
There is still room for rate cuts in this round, entering a new phase. From the perspective of neutral interest rates and the Taylor rule, the estimated levels of neutral interest rates from different models have been trending down since the peak in 2022, but there is significant uncertainty; the "Taylor rule" calculates the appropriate monetary policy rate based on inflation, the natural real interest rate, and the output gap, indicating that there is still room for rate cuts. At this meeting, Powell stated, "Rates are still restrictive," and the Federal Reserve is on a "continued rate cut" trajectory.
Reviewing the first 6 rounds of interest rate cuts, the pace was slowed and cuts were paused midway. During the first 6 rounds of interest rate cuts, the Federal Reserve paused cuts when the unemployment rate stopped rising or inflation rebounded significantly. For example, the "preventive" rate cuts that began in 1995 saw cuts of 25 basis points in July, December of 1995, and January 1996, after which the unemployment rate fell and inflation rebounded, leading to a halt in cuts, followed by a rate hike in March 1997 and three more cuts in 1998.
In a scenario of narrow fluctuations in the unemployment rate, the "balance" of the Federal Reserve's policy may shift towards inflation next year. A significant decrease in net immigration (or a return to levels similar to 2019) has lowered the center of new non-farm employment, and the unemployment rate may remain low, fluctuating within 4.5%. The "balance" of the Federal Reserve's policy may shift towards inflation data: In the first half of next year, as the inflation rate returns to a downward trend, the Federal Reserve may initiate the next rate cut; in the second half of next year, with the boost from tariffs and immigration policies, when CPI growth rebounds again, the Federal Reserve may pause rate cuts.
The "threshold" for rate cuts has risen, and the next rate cut may require a return to declining inflation. There may be 2-3 rate cuts throughout next year, with the pace potentially being earlier, and in the second half of the year, the Federal Reserve may enter a "wait-and-see" period: waiting for the impact of Trump's policy "combination punches" on economic data to further transmit, as the effects of tariffs and tightened immigration on the demand side become evident, there may be further rate cuts in 2026.
For the market, after the Federal Reserve's statement was released, U.S. Treasury yields rose, with the 10Y U.S. Treasury returning above 4.5%. Recently, the market has been operating in the direction of "no landing" and "re-inflation," and the upward pressure on the dollar and U.S. Treasury yields may temporarily ease in the first quarter of next year.
Author of this article: Minsheng Macro Pei Mingnan (SAC No. S0100524080002), Source: Chuan Yue Global Macro, Original Title: "Federal Reserve: A Pause in Rate Cuts?"
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