SAN FRANCISCO (S&P Global Ratings) Jan. 30, 2025--The Federal Reserve left policy rate unchanged at 4.25%-4.50%, as expected. The decision was unanimous. The pause follows three consecutive cuts, totaling 100 basis points (bps).

It's not surprising that monetary policymakers chose to stay on the sidelines.   The data flow affords them the pause. Balance of risk to the dual mandate (inflation and employment) in the immediate near term looks more balanced now than six months ago. The data flow in the last three months helped alleviate the fear (from this summer) of over-cooling in the labor market, and inflation outturns--as measured by personal consumption expenditures (PCE) price index--stayed close to 2% on a month-over-month sequential basis. The case for so-called "insurance cuts" against further deterioration of the labor market has faded for the time being.

There was neither hawkish nor dovish tilt in its language.   The Federal Open Market Committee statement had a slightly hawkish tilt at first take, but Chairman Powell dismissed such sentiment during the press conference. (It turned out that the slight change in wording on inflation was just a "language clean up" to make the statement more consistent with the data. Nothing more, nothing less. Overanalyze every little change in wording at your own peril.)

The Fed moved even more toward an already established "current-data-dependent" stance from the "forecast-dependent" one.   This is a direct consequence of the Fed that can't possibly front-run government policy. Until they (like the rest of us) know the sequence and magnitude of policy, the Fed policymakers (and we) are on a wait-and-see mode. We can't stress enough that while the odds of new policy announcement any moment (before official review deadlines) are elevated, it is also the case that chances of a reversal of such policy announcement are also just as high. Judicial reviews are also going to be a hurdle.

Criteria for the next cut?   Chair Powell suggested that the next cut would come when policymakers see prices behaving in a way that builds confidence that inflation is coming down. An obvious natural follow-up to that is when will that happen. Powell quipped that the Fed will "know it when it sees it."

The Fed needs to see more sequence of inflation progress and/or deterioration in employment for further cuts.   Barring tariffs, we are of the view that there are reasons for disinflation to continue in the first half of 2025. The year-over-year comparison is favorable, changes to seasonal adjustment to inflation data should also help the cause, shelter price inflation and wage-linked components of core-services inflation are also poised to move further down in the first quarter.

The Fed may get in one more 25-bp cut this year (in the first half) before government policy-related inflation starts to show up in the data (the second half).   Unless price pressures intensify again, like they did in the opening months of last year, the core inflation rate should be 2.4% by March (down from 2.8% in the fourth quarter). We are also likely to get another downward benchmark revision to payrolls next week. The fourth-quarter GDP growth came in at 2.3% annualized, which is a step slower than 3.1% in the third quarter and slightly higher than 1.7% annualized that we had forecasted in our November forecast update. Net exports was a large negative contribution to growth after a big surge in the goods trade deficit in December. It is likely reflective of October's port strikes, leading to delay in imports as well as front-running of imports ahead of anticipated tariffs. That said, the growth rate of final sales to private domestic purchasers, our preferred gauge of underlying strength in domestic demand, dropped off only marginally, from 3.4% to 3.2%.

However, if the Fed doesn't resume rate cutting in the next few months (mid-March or early May), we suspect the window will have closed.   This is based on our own baseline assumption of immigration curbs and tariffs leading to inflation moving back up to 2.5%-3.0%. We now anticipate a longer pause before slower growth conditions force their hands to resume easing again in 2026. A temporary reversal of policy direction is not out of the question either, depending on how the mix of policies transpire. For now, we pencil in rates to land at 4.1% by the end of 2025, 3.6% by the end of 2026, before settling at 3.1% in 2027 (compared with 3.6%, 3.1%, and 3.1% for the end of 2025, 2026, and 2027 in our November 2024 forecast update).

A short-term conflict between the Fed's inflation and employment mandate appears to be brewing on the horizon.   An inflationary increase in the price of goods and services due to tariffs and labor shortage (as well as fiscal stimulus in 2026) could cause the Fed to choose between either accepting temporarily higher inflation or increasing interest rates, thus cooling down the economy and increasing unemployment. We suspect that the Fed is now more sensitive to the risk of inflation expectations getting unmoored, given the post-pandemic experience of inflation surge. This means disruption of their current underlying easing bias with a longer pause or even a temporary reversal in the direction of policy rate. Higher interest rates for longer likely, accompanied with lower economic growth, is a mix not conducive to investor returns.