The Federal Reserve might need to see the impact of President-elect Donald Trump's economic policies, including import tariffs, before it can sharpen its forecast for inflation and interest rate moves over the first half of next year.
The Fed lowered its benchmark Federal Funds Rate last week to 4.375%, marking its third rate cut in succession, even as it lifted its near-term inflation forecast and cited the "highly conditional estimates of economic effects of policies" from the incoming administration.
Anticipating that new economic reality, which could include massive spending cuts, wholesale changes to immigration policies and a host of tariffs on imported goods, the Fed also halved its forecast for 2025 rate cuts, with markets now pricing in only two reductions over the next 12 months.
"The slower pace of cuts for next year really reflects both the higher inflation readings we've had this year and the expectation inflation will be higher," Fed Chairman Jerome Powell told reporters last week in Washington.
"I think the actual cuts that we make next year will not be because of anything we wrote down today," he added. "We're going to react to data; that's just a general sense of what the [policy-making Federal Open Market Committee] thinks is likely to be appropriate."
Uncertainty tied to Trump's tariff plans
That reaction may take time to evolve, however, given that the President-elect might not be able to impose the kinds of tariffs he's articulated and that the response from U.S. trading partners has yet to be fully communicated.
Current legislation allows the president to impose targeted tariffs on the basis of national security risks, but across-the-board levies must be approved by lawmakers.
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Republicans will have only a five-seat majority in the upcoming House of Representatives, the smallest in modern history, according to the Pew Research Center, and could lose three of those seats to special elections during the first half.
Tariffs on goods from Mexico and Canada, meanwhile, could violate the very trade agreement that Trump himself negotiated in 2020 and are likely to face lengthy legal hurdles.
The same is true for spending, where the president-elect has floated myriad unfunded tax cuts and only last week unsuccessfully pressed Congress to extend or abolish the debt ceiling.
“Investors should expect tariffs, minor reductions in government spending, and broad tax policy extensions to be rapidly implemented in the first quarter of next year," said Patrick Welton, founder and chief investment officer of Welton Investment Partners.
"But will tariffs be long term or just something to bring to the negotiating table?" he added.
Similar uncertainty surrounds Trump's tax and spending plans.
Spending debate in Congress
House lawmakers have already defied the president-elect's bully pulpit in passing a stop-gap budget deal. And they must balance the pressure from outside agents such as Elon Musk, who is tasked with identifying billions of spending from the federal budget, with the political need to fulfill campaign promises.
"[Last week's] rejection by 34 House Republicans of a slimmed-down funding bill — even after the two-year suspension of the debt limit was removed — demonstrates that Mr. Trump will struggle to find enough support next year for tax cuts unfunded by spending cuts," said Samuel Tombs of Pantheon Macroeconomics.
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"A fiscally neutral package which funds tax cuts by reducing federal jobs and squeezing welfare payments would hit consumer demand," he added.
Slowing consumer demand paired with the inflationary impact of tariffs could not only derail the current growth trajectory of the world's biggest economy, it could also keep the Fed from making decisive interest rate moves well into the second half of next year.
At present, CME Group's FedWatch tool has the chances of a May rate cut pegged at a coin flip, with only slightly better odds of a move lower in June.
Treasury bond yields, meanwhile, continue to push higher, with 2-year notes trading at 4.321%, only a shade lower than the current Federal Funds Rate, even in the wake of last week's softer-than-expected November inflation data.
Dovish Fed tilt on interest rates?
"Contrary to Powell’s earlier statements that the Fed 'doesn’t guess, doesn’t speculate, and doesn’t assume' specific policy developments," said EY's chief economist, Gregory Daco, "the stronger inflation projections in 2025 without a commensurate shift in the GDP and unemployment projections suggest that some policymakers did account for potential shifts in regulation, immigration, trade and tax policy."
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That said, Daco says that when the Fed does revisit its rate forecasts in the spring, its likely to emerge with a more dovish outlook.
"While economic uncertainty is unusually elevated, we stress that the consensus of strong growth and elevated inflation in early 2025 seems suspicious," he said.
"Given the high degree of data dependence, it would come as no surprise if Fed rate-cut expectations are revised higher in three months."
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