Fed Cut Rates Again Despite Raising Inflation Forecast

Despite characterizing the economy as solid and inflation as stubborn, the Federal Reserve (Fed) cut interest rates another quarter-point on December 18. With this latest move, the Fed’s short-term lending target has fallen a full percentage point since September. The federal funds rate range enters the new year at 4.25% to 4.5%, its lowest level since January 2023.

The Fed eased even as inflation edged higher, policymakers lifted their 2025 inflation outlook, and the timeframe for reaching target inflation lengthened. The Fed’s preferred inflation gauge, annual core Personal Consumption Expenditures, increased 2.8% in October, the fastest pace in six months and above the 2% target. Meanwhile, private sector economic activity jumped in December to post its largest expansion since March 2022, while the November unemployment rate inched higher.

Policymakers’ easing bias in an era of persistent inflation, resilient growth and mixed labor market data represents a tightrope walk. If Fed officials cut too much, they risk provoking inflation; if they don’t cut enough, they risk triggering a recession. Additionally, the uncertainties surrounding Trump administration policy priorities are complicating this balancing act.

With three rate cuts already on the books, the Fed shifted to a wait-and-see approach that will slow its easing strategy in 2025. The tempered rate-reduction plan arrives as attention shifts to a new power structure in Washington, D.C., and how that change may affect the economy. In terms of bond market opportunities, we expect a relatively favorable backdrop.

Fed Raised Its Inflation Outlook, Lowered Its Rate-Cut Forecast

Amid persistently high consumer prices, Fed Board Chair Jerome Powell conceded that inflation would remain higher than the 2% target in 2025. In fact, the Fed lifted its projected year-end 2025 core inflation rate from 2.2%, which it forecasted in the September economic projections, to 2.5%. Now, the Fed doesn’t expect core inflation to drop to 2% until 2027, a year later than it projected in September.

Coinciding with that revised inflation outlook, Fed officials lowered their 2025 rate-cut expectations. The Fed’s December economic projections penciled in only two rate cuts in 2025, down from the four cuts policymakers forecasted in September.

Powell noted that cutting rates further in 2025 would depend on inflation’s trajectory and the strength of the labor market. He reiterated the central bank’s commitment to a monetary policy that prevents job market weakness while maintaining economic resilience.

In achieving that goal, policymakers believe they’re closer to “normal” interest rate policy. In the post-financial crisis, pre-pandemic economy, economists generally pegged the normal, or neutral, rate at 2%. Neutral refers to the rate level that should neither stimulate nor slow the economy.

Powell still believes the current short-term interest rate target is restrictive. He also recently said the neutral level is probably higher than the previous 2% consensus. Yet, it’s unclear what he believes that higher rate will be.

Fed’s ‘Wait-and-See’ Approach for 2025 Rate Cuts

Although the Fed continues to view the interest rate backdrop as restrictive, further easing moves will depend on the prevailing economic data. Along with digesting the effects of prior rate cuts, the Fed will likely assess Trump’s agenda items as it cautiously administers monetary policy. Figure 1 highlights Trump’s initial priorities and their potential effects.

Economic Slowdown and Rebound: Effects of Trump’s Policies

Regarding the economy and inflation, 2025 will likely unfold as a year of two halves, underscoring the Fed’s shift to a more measured rate-cut strategy. 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 have a range of effects:

• Economy: We expect the economy to slow down in the first half of 2025. New tariffs may weaken consumer demand, while government efficiency initiatives could lead to a rising unemployment rate. By the year’s second half, the impacts of deregulation, onshoring and rekindled animal spirits should start to emerge, fueling positive economic momentum.

• Inflation: Despite recent upticks, we still expect inflation to moderate in the first half of 2025. However, new tariffs, deportations and increased onshore investments may reignite inflation in the year's second half. We believe a strong U.S. dollar and energy-sector deregulation should alleviate some inflationary pressure.

Trump’s Fiscal Plan: Focus on Extending Tax Cuts

Extending 2017’s tax cuts, slated to expire in 2025, will likely be the focus of Trump’s first-year fiscal policy. The sweeping Tax Cuts and Jobs Act (TCJA) of 2017 has been the nation’s prevailing tax policy for more than six years. The law included some of the biggest changes to the U.S. tax code in three decades, affecting individual taxpayers and businesses.

Trump campaigned on making the TCJA’s tax cuts permanent, and with a Republican Congress, he will likely be able to keep that promise. However, new large-scale fiscal programs remain unlikely given the nation’s extraordinarily large deficits, Republicans’ thin majorities in Congress and the bond market’s disciplinary reaction.

Bond Market Outlook Amid Fed Rate Cuts and Trump’s Policies

As we enter 2025, bond market valuations, as measured by credit spreads, are close to record-tight levels. However, in our view, yields are at their most attractive levels in years, providing strong inflows into credit-sensitive bonds. We believe Trump’s pro-growth policies and additional Fed easing may continue to support positive fundamentals in the bond market.

Meanwhile, potential trade wars, renewed inflation fears and elevated interest rate volatility could widen credit spreads. But if the growth backdrop remains relatively healthy, these spread-widening events could create potentially attractive buying opportunities.