The Federal Reserve’s recent 25 basis point rate cut, labeled a ‘hawkish cut,’ led to significant market shifts: the dollar soared, stock prices fell, and Treasury yields rose. Notably, not all Fed officials agreed with the cut, and projections for inflation and interest rates were revised upwards. Despite forecasts of future rate easing, market expectations remain skeptical. Economic resilience complicates the Fed’s strategy, with potential policy changes looming amid political developments.
Fed’s Hawkish Rate Cut: Market Reactions Explained
On Wednesday, the Federal Reserve made a significant move by reducing the federal funds rate by 25 basis points, bringing it to a target range of 4.25% to 4.50%. This decision, although anticipated, is being referred to as a ‘hawkish cut’ due to its implications on the market.
The immediate market response was dramatic: the U.S. dollar surged to its highest level in two years, stock prices tumbled, and Treasury yields increased sharply. While market reactions can often be exaggerated on such occasions, various factors justified these shifts, including the Fed’s statement, updated projections, and insights from President Jerome Powell’s press conference.
Key Takeaways from the Fed’s Decision
It’s noteworthy that the interest rate cut was not a unanimous decision; Beth Hammack, president of the Cleveland Fed, voiced her disagreement. Jerome Powell characterized the 25 basis point reduction as ‘tighter’ compared to previous cuts, indicating that monetary policy is now ‘significantly less restrictive’ and closer to neutral.
Moreover, officials at the Fed significantly revised their median inflation outlook for 2025, raising it from 2.1% to 2.5%. They also adjusted their long-term neutral interest rate projection to 3.0%, the highest it’s been in six years, while reducing the anticipated rate cuts for the next year from four to two.
Despite the Fed’s forecasts suggesting a 50 basis point easing next year and a total of 100 basis points by the end of 2026, the market’s expectations have shifted. They now foresee only 35 basis points of cuts in the upcoming year, signaling skepticism about the Fed’s plans.
Interestingly, the Fed’s outlook for 2025 presents a contradiction: policymakers anticipate higher inflation but still plan to lower interest rates. This inconsistency became evident during Powell’s press conference, where the challenge of reconciling these expectations was clear.
While it might be easier for the Fed to justify these projections if economic growth and employment were faltering, the current forecasts indicate resilience in both areas, with strong economic activity and a robust labor market expected to persist until 2026.
In the wake of Powell’s previous dovish stance last year, markets are now pondering a potential shift in direction. Torsten Slok, chief economist at Apollo Global Management, has suggested that interest rates could rise next year, reinforcing his outlook that the economy’s strength will necessitate sustained high rates.
Following the Fed’s meeting, Slok estimated a 40% chance that rates would increase in 2025, a realistic projection given the financial markets’ expectations of a prolonged pause in rate changes extending well beyond 2025. The next quarter-point cut is not anticipated until September.
As we look ahead, much can change in the coming months, especially with the anticipated return of President Donald Trump in January. If his proposed trade policies and tariffs are enacted, inflation could rise, complicating the Fed’s strategy further.
Economist Phil Suttle believes such developments could prompt the Fed to act sooner, predicting a rate hike in July if inflation spikes due to tariffs in the second quarter.
Currently, financial markets do not seem to account for a turnaround in Fed policy, with Powell deeming such an outcome unlikely. Nevertheless, the dollar has appreciated by 8% since the Fed initiated its first rate cut in September, and Treasury yields have increased by 80 basis points, indicating that parts of the financial landscape may already be bracing for a tighter policy.
As Powell highlighted during the press conference regarding potential rate hikes next year, ‘you can’t completely rule things out in this world.’ Given the unpredictability of Fed policy in recent years, maintaining an adaptable perspective is likely wise.
(The views expressed here are those of the author, a columnist for Reuters).