Fed Watch – Easing cycle will end in restrictive territory

Based on incoming data, Fed commentary, and our evolving view since our Global outlook, we are revising our forecast for the Fed’s policy rate. Formally, we are pencilling in a 25 bps cut in both March and June of 2025, after which the upper bound of the federal funds rate will stay at 4.0% for our projection horizon. This means that rates will remain in restrictive territory indefinitely.

This week’s CPI inflation reading was relatively benign, and our nowcast for core PCE over December is a m/m reading that would be consistent with a 2% annual rate. Relative to long-term averages and the situation at the start of the easing cycle, car prices and transportation services have been the major components to halt the disinflationary process. We anticipate that residual seasonality, which contributed to these categories rising in the last months of 2024, will reverse, leading to further benign inflation readings in the first half of the year. Shelter inflation has also cooled, and we do not see any other significant sources of inflationary pressure. We expect the disinflationary process to restart, allowing the Fed to even consider further rate cuts.

At the same time, despite the hot jobs data for December, we expect the labour market to call for action. The upcoming labour market report will contain the final revisions of non-farm payrolls over the first part of 2024, which will tell us more about the magnitude and especially the dynamics of the weakness over the past year. We continue to expect a gradual weakening of the labour market. Hiring over the past year has been highly concentrated in effectively just three sectors, including government, while other sectors were almost flat. This fragile constellation increases the probability of a few more weak readings, which would be enough to shift the narrative on the labour market back again.

The considerations for our updated view could also result in just a single cut, or even none at all. We assess the probability of two cuts as higher than a single one and significantly higher than no cuts, while the potential for more rate cuts has decreased to the extent that we are now changing our call. The timing of the remaining cuts is also highly uncertain, and dependent on incoming data and government policy. At the same time, projection meetings seem like the most likely candidates.

By the second half of the year, we expect to have clarity and first attempts at implementation of the various policies of the Trump administration. As previously explained, we expect the tariffs to provide an inflationary impulse, continuing the need for restrictive rates. Changes in immigration policies, and abrupt shifts in federal hiring practices could significantly impact the labour market. Depending on their relative impact, the Fed may be pulled in either direction, or be forced to stay put. Our base case now sees the Fed on hold in the second half of 2025 and through 2026. The likely direction will become clearer in the coming months.