Fed charts more cautious path for rates as high prices persist

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The Federal Reserve is set to lower interest rates this week even as it charts a more gradual pace of cuts next year amid concerns that progress on driving down inflation is stalling.

The Federal Open Market Committee is expected to reduce its benchmark policy rate by a quarter-point when its two-day gathering concludes on Wednesday, about a month before Donald Trump returns to the White House for his second term as president.

The move would mark the third-consecutive cut from the US central bank this year as it grapples with how quickly to ease its grip on the world’s largest economy.

If officials reduce rates too quickly, inflation could get stuck above 2 per cent. If they reduce them too slowly, the labour market could weaken dramatically.

Policymakers will meet with those risks more or less in balance, after earlier this year appearing slightly more worried about the health of the labour market and more sanguine about the outlook for inflation.

“Given what we’ve seen over the last few months, the economy looks a little stronger and inflation looks a little higher, and that would mean a more gradual pace of rate cuts,” said Bill English, a Yale professor and former director of the Fed’s division of monetary affairs.

Despite this backdrop, the Fed is poised to follow through with a quarter-point cut for a number of reasons. Officials still believe that interest rates at their current levels are weighing on demand and, in turn, inflation. They have signalled that monetary policy should continue to be dialled back to a more “neutral” setting that is less stifling for growth. 

Moreover, the incoming data has yet to suggest that the Fed has lost its grip on inflation, even as certain price pressures prove stickier than expected. In fact, the latest consumer price index report showed encouraging signs that increases in housing-related costs, which have helped to keep inflation stubbornly high, have begun their long-awaited deceleration.

Officials also appear to be taking comfort in a recent “mini boom” in US productivity — as former Fed veteran John Roberts calls it — which some argue has raised the prospects that higher wages and a strong economy are not incompatible with inflation continuing to decline.

But after Wednesday’s likely downshift, which will lower the federal funds rate to a new target range of 4.25-4.5 per cent, the outlook is far murkier.

Chair Jay Powell has already said a strong economy means the Fed does not need to be in a “hurry” to lower interest rates, but little else has been specified about the pace. He has also underscored that the Fed is uncertain about where exactly neutral is and will “only know it by its works”.

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“I think it’s going to get harder to explain rate cuts and how the economy is performing,” said Esther George, the former president of the Kansas City Fed who retired in 2023. George said that if she was still at the Fed she would be “very comfortable not making another cut” and after that point going on a “more extended pause”.

Current officials are already expected to scale back their forecasts for rate cuts next year, compared to what they pencilled in to the “dot plot” of individual projections the last time it was updated in September.

Three months ago, a majority estimated the policy rate would fall a full percentage point to 3.25-3.5 per cent, assuming another quarter-point cut in December. It would later slip below 3 per cent by the end of 2026 as inflation finally reached their goal, the estimates showed.

Roberts sees only 0.75 percentage points’ worth of cuts slated for next year, although he noted that there is likely to be a wide range of estimates due to vast uncertainties about how aggressively the Trump administration will pursue the sweeping tariffs, mass deportations and steep tax and regulatory cuts that the president-elect discussed on the campaign trail.

Economists polled by the Financial Times in partnership with Chicago’s Booth School of Business also moved up their forecasts for the policy rate compared to the previous survey in September, with most thinking it would hover at 3.5 per cent or higher by the end of 2025 rather than below that level. Trump was set to have a negative impact on the US economy as well as stoke inflation, a majority said.

That is set to make the Fed’s jobs all the more tricky, not least because Trump favours lower interest rates and in his first term clashed with Powell over the Fed chair not giving in to his demands. Back then, the central bank was able to look through price pressures caused by Trump’s tariffs and instead opt for a series of rate cuts to stave off a weakening economy because at that point inflation was below the 2 per cent target as opposed to above it.

English suggested the Fed will be more constrained this time around, potentially leading to an even slower pace of rate cuts than expected. But lacking clarity yet, he anticipates little in the way of a signal from Powell on Wednesday. 

“Things are pretty uncertain, and that’s a good reason if you’re the Fed to provide as little guidance as you can about policy.”