The Fed pauses, leaves its options open
The Federal Reserve kept interest rate policy unchanged, but left the door open for future actions. After reducing the federal funds rate by 100 basis points (or one percentage point) over the past three meetings, to a range of 4.25% to 4.50%, it looks like a plateau has been reached. With inflation stalled above the Fed's 2% target, the unemployment rate low, and economic growth running in the 2.5% to 3.0% range, there is little reason for adjusting policy. Moreover, there are risks associated with potential U.S. government policies on tariffs, immigration, and taxes that could potentially push up inflation. We do not expect a change in interest rate policy from the Fed for at least the first half of 2025.
There were only a few changes to the accompanying statement from the December meeting, but its characterization of inflation stood out. It indicated that inflation "remains elevated" instead of "making progress" toward the Fed's 2% target. That change is consistent with the recent data, as the deflator for personal consumption expenditures (PCE) has stalled in the 2.5% region.
Inflation has stalled above the 2% target level
The reluctance of the Fed to provide more forward guidance is likely due to the uncertainty about policy changes that could be potentially inflationary and/or slow growth. Without more clarity on these issues, it's difficult for the Fed to formulate policy. A "wait-and-see" approach is a logical stance.
Cut, hold steady, or hike in the future?
We expect the Fed to hold policy steady for the first half of the year. Fed Chair Jerome Powell indicated that the committee believes it "doesn't need to be in a hurry" to adjust policy, with the job market solid and inflation stuck at its current level. However, it still sees its policy stance as "restrictive," with rates high enough to have an adverse impact on some segments of the economy, such as housing. Consequently, the Fed's overall bias is still toward further rate cuts in the future if inflation comes down.
Meeting the criteria for another cut in rates may prove difficult because inflation risks are tilted to the upside in the short run. Tariffs could raise import prices, while immigration rule changes could lift wages by reducing the supply of labor. Longer term, these same policies could slow economic growth.
The Fed will no doubt try to model the impact of policy before markedly changing its outlook. As of the December 2024 meeting, the Fed's median projection for the federal funds rate was for two more rate cuts this year. Given the wide range of potential outcomes, it would not be surprising if the Fed ended up keeping policy on hold throughout the year. Rate hikes seem less likely.
Market reaction
Bond yields rose moderately on the back of the Fed's statement changes that indicate a cautious stance, but ultimately gave back some of the increase by the end of Powell's press conference. The economy is doing well, inflation isn't moving lower as quickly as it would like, and the labor market is still in good shape. Those are the factors driving the Fed's current views. Going forward, any policy developments that alter the outlook open the door to changes. With the Fed leaving its options open and policy uncertainty heightened, it looks like the bumpy ride in the bond market is likely to continue.
We continue to suggest investors also take a cautious stance, keeping average duration in portfolios near benchmark levels or below. However, volatility also creates opportunities. For investors, intermediate-term high credit quality bonds with yields near 5% can make sense for a core fixed income allocation.
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