Fed cut rates by 25 basis points. Here's why there may not be another cut in 2025

Key Concepts

• Federal Reserve Interest Rate Cut: A reduction in the benchmark interest rate by the Federal Reserve.
• Basis Points (bps): A unit of measure equal to one-hundredth of a percentage point (0.01%).
• Federal Funds Rate: The target rate that the Federal Reserve wants commercial banks to charge each other for the overnight lending of reserves.
• Balance Sheet Runoff: The process by which the Federal Reserve reduces the size of its balance sheet by allowing assets to mature without reinvesting the principal.
• Economic Growth: The increase in the production of goods and services in an economy over time.
• Job Market/Labor Market: The supply and demand for labor in an economy.
• Unemployment Rate: The percentage of the labor force that is unemployed and actively seeking employment.
• Downside Risks: Potential negative factors that could impact economic growth or employment.
• Dissent: A disagreement with a majority decision, particularly within a committee or board.
• Inflation: A general increase in prices and fall in the purchasing value of money.
• Pricing Power: The ability of a company to raise prices without significantly impacting demand.
• Tariffs: Taxes imposed on imported goods.
• Data Dependency: The practice of making policy decisions based on incoming economic data.
• Neutral Rate: The theoretical interest rate that neither stimulates nor restrains the economy.
• 10-Year Treasury Yield: The interest rate on U.S. Treasury bonds with a maturity of 10 years.
• Multiples (Stock Market): The ratio of a company's stock price to its earnings per share, used to value stocks.
• GDP (Gross Domestic Product): The total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period.
• PCE (Personal Consumption Expenditures) Price Index: A measure of the prices that consumers pay for goods and services.
• FOMC (Federal Open Market Committee): The principal monetary policymaking body of the Federal Reserve System.
• AI (Artificial Intelligence): The simulation of human intelligence processes by machines, especially computer systems.
• Capex (Capital Expenditures): Funds used by a company to acquire, upgrade, and maintain physical assets such as property, buildings, technology, or equipment.

Federal Reserve Rate Cut and Economic Outlook

The Federal Reserve has implemented a 25 basis point rate cut, lowering its benchmark interest rate to a new range of 3.75% to 4%. This marks the second rate cut of the year. The decision was not unanimous, with Governor Steven Myron dissenting and advocating for a more aggressive 50 basis point cut. Conversely, Kansas City Fed President Jeff Schmid preferred to hold rates steady, citing concerns about inflation and the potential for rate cuts to ignite demand and give firms additional pricing power, especially in light of tariffs.

Fed officials also announced they will stop shrinking their balance sheet by December 1st.

Regarding the state of the economy, Fed officials described economic growth as expanding at a moderate pace, a slight shift from the previous month's assessment of moderated growth.

Job Market Assessment

The job market has seen little change according to Fed officials, though they acknowledge that official data has been unavailable since August due to the government shutdown. The policy statement noted that "Job gains have slowed this year and the unemployment rate has edged up, but remained low through August. More recent indicators are consistent with these developments." They reiterated that downside risks to employment have risen in recent months.

Press Conference Insights and December Policy Outlook

During the press conference, Fed Chair Jerome Powell is expected to emphasize a data-dependent approach for future policy decisions, taking things "meeting by meeting." While official data remains scarce, insights into the Fed's thinking for December will be gleaned from Powell's characterization of the job market and the evolving outlook. The statement that "downside risks had deteriorated" suggests a potential concern about the job market, which could point towards another rate cut in December.

Powell indicated that a December rate cut is "no sure thing" and "far from it," suggesting a cautious approach.

The "234 Logic" and Neutral Rate

A key analytical framework discussed is the "234 logic": if inflation reaches 2%, the Fed Funds rate should be 3%, and the 10-year Treasury yield should be 4%. Currently, with inflation at 3%, the neutral Fed Funds rate would theoretically be 4%. This suggests that the recent cut is likely the "last of the easy Fed cuts" as further meaningful reductions will require progress towards the 2% inflation target. The 10-year Treasury yield's increase of 10 basis points this week, despite the Fed cut, is attributed to inflation not yet being at 2%.

Market Reactions and Investment Strategies

Stock Market Impact

A pause in rate cuts is not expected to be a significant headwind for equity markets, nor is a cut a substantial tailwind, as the long end of the yield curve is likely to remain stable. Multiples for large-cap stocks are primarily driven by longer-term yields. However, small-cap stocks and emerging markets, which have more short-term debt, could benefit from Fed rate cuts.

Economic Environment for Rate Cuts

The decision to cut rates was questioned by some, given that GDP is holding steady, unemployment is low, and the stock market is performing well – typically not an environment for rate cuts. The current economic setting, with 3% inflation and balanced risks to employment and inflation, suggests a neutral policy stance is appropriate until inflation declines further.

Inflation Outlook and Tariffs

Powell believes the economy is closer to 2% inflation than many perceive, estimating it to be around 2.8%. The impact of tariffs on inflation is considered transitory, a view held since the post-COVID context. However, the economic impact of tariffs, if they remain high, could lead to a small reduction in GDP due to decreased demand.

Trade Relations and Investor Considerations

The de-escalation of tensions between the U.S. and China is viewed positively by investors. The hope is that both inflation and GDP impacts from tariffs are transitory. Economically, tariffs can lead to a slight decrease in GDP as demand adjusts to higher prices.

Former Fed President's Perspective (Jim Bullard)

Former St. Louis Fed President Jim Bullard views the recent rate cut as widely anticipated and the end of balance sheet runoff as a set-in-train event. He anticipates the December decision to be more open, requiring data to support a cut. He also suggests that future moves will be spread out at a slower pace.

Challenges of Data Scarcity

Bullard acknowledges the difficulty in making decisions without official data, particularly the non-farm payrolls report, which is a favored piece of data for the FOMC. He notes that alternative data sources, like the Kansas City Fed's labor market conditions index, suggest the labor market is at equilibrium. The primary concern is the reacceleration of the economy despite high inflation, which may lead to a halt in rate cuts by year-end.

Layoffs and AI

Bullard attributes some recent layoffs to an "AI feeding frenzy" among large tech companies reallocating resources to avoid falling behind competitors. Other companies face different business-specific issues.

FOMC Dynamics and Inflation Concerns

The dissent from both Schmid and Myron highlights a contingent on the committee concerned about inflation still running at 3%. They desire more evidence of inflation moving down before committing to further rate cuts. The current rate cuts are seen as a recalibration of monetary policy, maintaining a slightly restrictive stance to exert downward pressure on inflation.

Succession of Fed Chair

Regarding the upcoming succession of the Fed Chair, Bullard believes the Treasury Secretary's process for selecting candidates is sound, and the listed individuals are respectable. The key qualities sought would likely involve adapting to the position and making judgments about market perception and commitment to the 2% inflation target. A market concern about unnaturally low interest rates could lead to an inflation risk premium.

Balance Sheet Strategy

Bullard suggests that questions about the balance sheet, particularly plans to reduce its size, might be a focus. He notes a potential divergence between the current committee's orientation and the Treasury Secretary's preferences.

Expert Analysis of Powell's Remarks

Forward Guidance and Neutral Rate Conceptions

Meera Pandit highlights Powell's emphasis that a December rate cut is not a foregone conclusion. She points out a potential divergence between market expectations of a neutral rate around 3% and the Fed's perception of it being closer to 3.5%. Powell's characterization of cuts as risk management suggests the Fed may be closer to their desired policy stance.

Labor Market and Growth Outlook

Colin Martin echoes Powell's sentiment that a December cut is far from certain. He notes Powell's observation of a cooling labor market that is not falling off a cliff, but rather a gradual slowdown. Powell also questioned the sustainability of current GDP growth, suggesting a focus on the labor market and unemployment rate might be more pertinent. The current unemployment rate of 4.3% and inflation near 3% suggest the economy is not far from neutral.

Investment Advice

Pandit advises clients to consider market fundamentals over committee assessments. She stresses the importance of focusing on quality, managing concentration and valuation risks, and "AI-proofing" portfolios. She also points to financials as a sector expected to contribute significantly to S&P 500 earnings growth outside of tech.

AI Trade and Interest Rate Sensitivity

Powell distinguished the current AI boom from the dot-com era, emphasizing that current AI companies have earnings. While some investors see echoes of the dot-com bubble, Powell suggests that much of the AI-related capital expenditure is funded by companies' existing cash and revenue, making it less interest rate sensitive.

Data Gaps and Alternative Metrics

The lack of government data presents a challenge, but analysts are using alternative data metrics such as ADP employment releases, district bank surveys, ISM surveys, and consumer confidence to fill the gaps. However, the absence of comprehensive government data like CPI and jobs reports makes it difficult to obtain a complete picture. The reliance on private data raises concerns about accessibility and potential bias.