Fed Meeting – Driving on a Foggy Night
The Federal Reserve lowered its key interest rate by a quarter percentage point yesterday, the third consecutive reduction. This brings the total reduction to 1% since the Fed began cutting rates in September. The rate cut to a target range of 4.25%-4.5% is back to the level where it was in December 2022 when rates were moving higher. The cut came even through the Fed raised its projection for full-year gross domestic product growth to 2.5%, lowered its expected unemployment rate this year to 4.2% while it pushed up expected core inflation to 2.8%. This is a slightly higher inflation expectation than the September estimate of 2.1% and above the Fed’s 2% goal. The 10-year yield subsequently rose to a 6-month high of 4.5%, creating a difficult balancing act for the Fed.
In delivering the 25-basis point cut, one FOMC member dissented. The Fed indicated that it probably would only lower rates twice more in 2025. The two future cuts mean only 50 basis points instead of 100 basis points when last updated in September. Assuming quarter-point increments, officials indicated two more cuts in 2026 and another one in 2027. Over the longer term, the committee sees the neutral funds rate at 3%, slightly higher than the September update. A surprise to market watchers.
If inflation could be higher next year, why cut rates?
Powell noted at his press conference that the economy remains solid, unemployment is low, and policy restraint has been reduced. Per Powell, a projected economic slowdown “keeps not happening.” Consumer spending has been resilient and the economy expanded 2.8% in the third quarter. The Fed sees 2% GDP growth for the next few years. The labor market is less tight than in 2019 and not a source of significant inflation pressure. Inflation is somewhat elevated versus a 2% goal, with core inflation up 2.8% over the last twelve months. However, inflation expectations seem to be well anchored. Maximum employment and stable prices are roughly in balance.
If inflation expectations for 2025 are higher than recently expected, then why cut interest rates at all? Powell said it was “a close call” and believes we are significantly closer to a “neutral” rate: not too hot nor too cold. However, like driving on a foggy night or walking into a dark room filled with furniture (Chairman Powell’s words), there is reason to slow down the rate cuts.
International economies are cutting rates too, but markets are lagging
We tend to focus on U.S. monetary policy, but economies are inter-related. The largest trading partners of the U.S. are Canada, Mexico, China, Japan and the U.K., as both suppliers and buyers of our goods and services. Seven of the 10 large developed-market central banks are in easing mode, two are keeping rates higher for longer and one outlier, Japan, has been hiking rates until today when they came out flat. The European Central Bank cut rates by 25 basis points last week for the fourth time this year while the Bank of England left its interest rate steady at 4.75% today.
British manufacturers recently reported the biggest fall in output since the COVID-19 pandemic and they are even more downbeat about 2025. Manufacturers are facing weak domestic and external demand, political instability in some key European markets such as France, and uncertainty over US trade policy. The Bank of England expects Britain’s headline inflation rate to rise in 2025, but it has said it plans to cut borrowing costs gradually even as inflation rose to an eight-month high in November.
Canada’s economy grew at an annualized rate of just 1% in the third quarter, less than predicted, prompting markets to boost bets for a jumbo rate cut. The boost to GDP came from growth in consumer spending and persistent government expenditures, but it failed to offset declines in business investments. GDP per person, a measure of Canada’s standard of living, shrunk by 0.4% in the third quarter, its sixth consecutive quarterly decline. Canada may adjust rates lower in late January 2025.
In China, retail sales in November were only 3% higher than a year ago, reflecting the chronic caution of China’s households. Consumer confidence has never recovered from its collapse during the Covid-19 lockdowns of spring 2022. Exports and manufacturing investment, which have helped prop up the economy in 2024, face the prospect of a new trade war with the U.S. and potential tariffs of 60% or higher. China has resorted to handing out coupons to upgrade dishwashers and refrigerators. We will see if that works, but so far credit demand in China has remained weak.
The U.S. still leads international markets year to date, even after yesterday’s downdraft. The S&P500 is up 23% this year, beating most international markets. Canada’s stock market is up 16% while Mexico’s is down 13%. European markets are up about 10% overall although France’s stock market is down 2%. Japan’s market is up 17% and China’s is up 16%, while South Korea’s market is down 6%. The U.S. continues to dominate returns and economic growth. In fact, fourth quarter U.S. GDP growth is pegged at close to 3%. Volatility across the globe will likely continue until economies solve the riddle of persistent inflation and potential trade battles ahead. In the meantime, long-term investment opportunities should arise as valuations adjust.
Jennifer Beals of Flashdance fame turns 61 while her co-actor, Michael Nouri, turned 79 just last week. Jake Gyllenhaal turns 44, Alyssa Milano turns 52, and Magician Criss Angel levitates to 57.
Christopher Crooks, CFA®, CFP® 610-260-2219