Fed Pauses Amid Stable Growth, Inflation Uncertainties

At its first policy meeting of 2025, the Federal Reserve (Fed) paused the aggressive rate-cut campaign it launched in late 2024. In the six weeks since the Fed’s last rate cut, economic and labor market data stabilized, President Donald Trump took office, and inflation inched higher. Against this backdrop, policymakers announced the target short-term lending rate would remain unchanged at a range of 4.25% to 4.5%.

The Fed’s decision reflects the competing economic and political factors that will ultimately shape a new market landscape. In the meantime, we expect uncertainty to prevail and volatility to remain elevated. In our view, this environment underscores the importance of maintaining a diversified portfolio with broad fixed-income exposure.

Fed in No Rush to Change Rates

In announcing the decision to keep rates steady, Fed Board Chair Jerome Powell said he and his colleagues remain committed to lowering inflation to 2%. And while the road may be bumpy, he said policymakers expect to see continued, albeit slow, progress toward achieving the inflation target. He indicated a wait-and-see approach is prudent, given solid economic data, last year’s rate cuts and the start of Trump’s second term.

Powell noted interest rates are now “significantly less restrictive” than before 2024’s rate cuts. Because of that, “We do not need to be in a hurry to adjust our policy stance,” he added.

The Fed chair declined to comment specifically on tariff proposals or any other Trump agenda item. But he did insist the Fed will watch the political climate closely, as it does at the beginning of every new administration.

The Fed still believes the risks to the central bank’s dual goals of promoting stable prices and maximum employment are balanced. Nevertheless, Powell suggested meaningful movements in either metric would trigger a policy change.

U.S. Exceptionalism Is Likely to Persist

With the Fed on hold, U.S. central bankers are once again on a different course than their peers:

• Most observers expect the European Central Bank to cut interest rates again on January 30, as the eurozone economy struggles.

• Amid stalled U.K. growth, the Bank of England is also likely to lower rates another quarter point when it meets in early February.

• The Bank of Canada cut interest rates another quarter point on January 29, as the nation’s growth rate remained weak.

U.S. exceptionalism refers to the superior performance of the U.S. economy and financial markets versus the nation’s global counterparts. Such exceptionalism has generally been the norm for the last decade, and it seems likely to continue.

Despite the uncertainties associated with Trump administration proposals, the consensus forecast for real gross domestic product in 2025 is a healthy 2.1%. Forecasts for Europe, the U.K. and Japan are considerably lower. Of the world’s major economies, only China is set to outperform the U.S. growth rate.

Competing Factors Complicate Fed’s Policy Outlook

This latest policy move highlights the complicated situation facing the Fed. Economic growth has remained stable and relatively healthy — a backdrop that appears to support the Fed’s recent series of interest rate decisions. But inflation, which has lingered above the Fed’s 2% target, recently edged higher — a scenario that has triggered concerns about Fed policy.

Worries about current inflation, inflation expectations and Fed easing amid persistent pricing pressures have fueled recent bond market volatility and a Treasury market anomaly. In late December, after the Fed had cut rates by 1 percentage point, the yield on the 10-year Treasury note had climbed by1 percentage point. This dynamic defied bond market norms, as the 10-year Treasury yield historically has moved in tandem with the federal funds rate.

Inflation Uncertainties Under Trump’s Economic Agenda

While the futures market currently expects up to two Fed rate cuts this year, this outlook remains fluid. Fed policy largely depends on the inflation trajectory. And inflation’s path depends partly on Trump’s unfolding policy priorities.

Some fear inflation will rise if Trump follows through on his tariff threats, given their potential to raise inflation expectations and, ultimately, consumer prices. Other Trump agenda items, including deportations and increased onshore investments, could also potentially reignite inflation. However, other factors, including a strong U.S. dollar and energy-sector deregulation, could alleviate some inflationary pressures.

At his confirmation hearing with the Senate Finance Committee, Treasury Secretary Scott Bessent downplayed the potential inflationary effects of Trump’s tariff proposals. He suggested the dollar’s value would likely rise, so consumers wouldn’t absorb the full impact of tariffs. Bessent also argued that foreign manufacturers could cut prices to preserve market share, thus reducing the tariffs’ effect on consumers.

Trump’s Policies and Their Possible Economic Consequences

We believe 2025 may unfold in two parts, underscoring the Fed’s shift to a more cautious monetary policy. We expect Trump’s America First agenda to rearrange global order in favor of U.S. interests, prolonging the economic divergence between the U.S. and other nations.

This reset is likely to slow down the economy in the first half of 2025. New tariffs may weaken consumer demand, while government efficiency initiatives could lead to rising unemployment. By the year’s second half, the impacts of deregulation and onshoring, along with renewed market optimism, may start to emerge, fueling positive economic momentum.

Diversification: A Potential Antidote for Uncertain Times

In our view, broad portfolio diversification remains a standout strategy for all market environments. But it’s particularly appealing in times when uncertainty and volatility reign.

As the Trump administration and its policy priorities continue to take shape, volatility is likely to ease. Until then, staying diversified across high-quality stocks to capture upside potential and high-quality bonds to foster risk management may help manage market fluctuations.

Ultimately, we believe Trump’s pro-growth agenda should support economic gains, which could aid stock market performance while pushing interest rates and inflation higher. This interest rate/inflation combination often creates challenges for certain bonds, but it presents opportunities for others. Specifically, we believe shorter-duration, higher-yielding bonds and inflation-protected securities may merit consideration in well-diversified portfolios.