The Fed Cut Again Even Though Economic Data Called for a Pause
Federal Reserve officials this week came as close as they are probably ever going to get to admitting that the aggressive interest rate reduction they enacted weeks before the 2024 election was a mistake.
The Federal Open Market Committee (FOMC), the Fed’s monetary policy unit, cut its benchmark interest rate by one-quarter of a point, reducing the federal funds rate to a range of 4.25 percent to 4.50 percent. This was widely anticipated by financial markets, with the fed funds futures market pricing in a 95 percent chance of the 25 basis point cut on the eve of the Fed meeting.
It would be extremely hard to justify the cut based on the incoming economic data. Demand remains strong; unemployment remains very low; and optimism among investors, businesses large and small, and households is soaring following the election of Donald Trump. Manufacturing remains in the doldrums, highlighting the failure of the Biden administration’s industrial policy; but even factory executives are anticipating better times ahead.
The Fed Now Sees More Growth and More Inflation Next Year and the Year After That
The projections of Fed officials indicate that the economy is much stronger than they expected when they announced their 50 basis point cut in September. Back then, the median projection for 12-month GDP growth through the end of this year was 2.0 percent. Now they expect the economy will grow 2.5 percent this year. Similarly, officials now expect the unemployment rate to be 4.2 percent at year’s end, down from their earlier projection of 4.4 percent.
Inflation is running higher than they expected. In September, they forecast a 2.3 percent annual increase in the personal consumption expenditure price index. Now they see it coming in at 2.4 percent. Core PCE inflation is seen as coming in at 2.8 percent, up from the 2.6 percent projected in September.
More strikingly, the Fed is projecting significantly higher inflation next year than they were in September. Headline PCE inflation is seen at 2.5 percent next year in the latest projections, 40 basis points higher than the September projection of 2.1 percent. Importantly, Fed officials now see inflation rising over the coming year The projection for the end of next year is higher than the projection for the end of this year.
The best way of reading this is that the Fed now agrees that progress on inflation has stalled and inflation is likely to stick around for longer than previously thought. If Fed officials had seen this back in September, it seems likely they would have adopted a more moderate rate cut or held off on cutting altogether.
The projections also show that Fed officials expect core inflation to be higher next year than they were forecasting earlier. The median projection rose from 2.2 percent to 2.6 percent. While that’s not a projection of a rise in core inflation from where the Fed thinks we’ll end up this year, it is a sign that the Fed does not think core inflation will come down by much over the coming 12 months. In other words, the Fed is admitting that progress on bringing inflation down has stalled.
Note that the Fed does not think we’ll get much more real growth next year. Officials raised the median 2025 projection for real GDP growth from 2.0 to 2.1 percent. So, we haven’t traded off more real growth for more inflation. We’re just getting more inflation and a tad more growth.
Nominal growth is expected to be higher. Putting together the expected real growth of 2.1 percent and the expected inflation rate of 2.5 percent produces a nominal growth estimate of 4.6 percent, a significant increase from the 4.1 percent projected in September. That is probably good news for investors in the stock market, since higher nominal growth tends to support higher equity prices, at least in the short-to-medium term.
Rates Will Stay Higher for Longer—and Maybe Forever
On the other hand, the stock market likely will not love the fact that the Fed has dramatically reined in its rate cut forecast and once again raised its view of longterm interest rates. The year-end 2025 forecast for the policy rate was increased to 3.9 percent from 3.4 percent, suggesting two fewer cuts next year. The 2026 projection is now 3.4 percent, up from 2.9 percent, which means that the Fed now thinks it will take another full-year to bring interest rates down to where it thought it would be at the end of 2025.
Even as far out as 2027, the Fed thinks its interest rate target will remain above its long-term view, projecting a 3.1 percent rate two years from now. The Fed also increased its long-run estimate to 3.0 from 2.9 percent. This raises the question of how much higher the Fed might bring its long-run estimate.
The Fed has realized that it is going to take higher interest rates and more time to bring down inflation. That’s a tacit admission that it began cutting rates too early and too quickly earlier this year.