Fed cuts key interest rate but signals elevated inflation is likely to persist

The Federal Reserve announced a quarter-point cut to its key interest rate Wednesday, an effort to keep what appears to be a steady but cooling economy stable. 

The move, the Fed’s third rate cut of the year, reduces the central bank’s target rate to between 4.25% and 4.5%.

In its statement announcing the cut, the Fed now projects just two interest rate cuts for 2025. It said the unemployment rate remains low, while the rate of inflation “remains somewhat elevated.” A separate document the Fed released Wednesday now indicates the central bankers don’t believe they’ll hit their desired 2% inflation target until 2026.

Economists surveyed by Bloomberg had expected three cuts next year on the belief that the economy, and price growth, would have cooled further by now.

Despite the cautious outlook, Fed Chair Jerome Powell sounded an upbeat note on the state of the U.S. economy, especially relative to how other countries have performed.

“The U.S. economy has been remarkable,” Powell said after the announcement. He added: “If you look around the world, there is a lot of slow growth and continuous struggle with inflation. So I feel very good about where the economy is.”

The Fed’s moves are designed to prevent the economy from overheating when growth is strong or falling into recession when it is slow. To do that, it changes what is known as the federal funds rate, which helps set borrowing rates throughout the rest of the economy. By making it easier — or harder — to borrow, the Fed seeks to control the pace of economic growth.

Right now, there is intense debate about which one is more likely going forward.

At the moment, the pace of inflation remains far below its post-pandemic highs. But last week, the Bureau of Labor Statistics reported that the 12-month Consumer Price Index (the most-watched inflation indicator) had climbed 2.7% for November — above the 2.6% pace seen the previous month. 

Consumers seem unfazed. On Tuesday, the Census Bureau reported retail sales had climbed 0.7% in the same month, ahead of forecasts of 0.6%, while the October figure was revised up to 0.5%, from 0.4% 

Those data points suggest the economy remains on relatively firm footing, but some warning signs are flashing about underlying weaknesses — which would justify the looser monetary policy the Fed, not to mention President-elect Donald Trump, has been seeking.

Most worrisome is the labor market, where job growth has largely become concentrated in sectors like health care and state and local government. Those sectors tend to say little about where we are in the business cycle. 

Meanwhile, the pace of job gains in sectors that usually point to continued growth, like manufacturing, business and professional services, has virtually flatlined. 

Overall, hiring rates have plummeted, while job openings continue to fall. 

Finally, after an incredible bull run for most of 2024, some stock indices are pulling back from all-time highs. The Dow Jones Industrial Average has been in a nine-day losing streak, its worst multiday performance since the 1970s.

Right now, market participants overwhelmingly believe that after the Fed announces its quarter-point cut for December, it will “pause” and hold rates steady at its January meeting to assess how overall financial conditions are faring. 

For the most part, analysts remain relatively sanguine about the current state of affairs. A new Bank of America survey finds the Fed still appears likely to pull off a “soft landing” for the U.S. economy in which unemployment and inflation remain relatively low. 

Yet if anything, according to Goldman Sachs analysts, inflation was expected to have fallen even more by now, which would have come at the expense of slightly higher unemployment.  

“The unemployment rate is no longer rising as quickly” as it was earlier this fall, those analysts said in a chart accompanying a recent note to clients. Still, they said, “it is too soon to conclude that the broader labor market data have convincingly stabilized.”

Even with a still-shaky labor market, Federal Reserve officials have signaled they may want to slow the pace of cuts soon — not only in response to stickier inflation but also given uncertainty about the incoming Trump administration’s tariff policies.

To illustrate the Fed’s thinking, the Goldman analysts pointed to a speech this month by Beth Hammack, president of the Federal Reserve Bank of Cleveland, laying out the state of play.

“Resilient growth, a healthy labor market, and still-elevated inflation suggest to me that it remains appropriate to maintain a modestly restrictive stance for monetary policy for some time,” Hammack said. “Such a policy stance will help to sustainably return inflation all the way back to 2 percent in a timely fashion.”

There has also been a broader rethinking about whether interest rates need to be higher in general given structural changes that may be occurring in the economy that have led to faster growth, like large fiscal deficits and elevated productivity growth. 

Whereas the 2008 financial crash set the stage for more than a decade of low interest rates, Hammack said, “some of the forces that appeared to be holding down the neutral rate following the Global Financial Crisis may have finally run their course or reversed.”

Investor and economist sentiment has also become more unsure about what impact the Trump administration will have on the economy. In particular, fears about tariffs’ increasing prices have become widespread. 

“When it rains, it rains on everybody,” Gary Millerchip, the chief financial officer of Costco, said on the company’s most recent earnings call.

Still, the base case appears to be relatively smooth sailing, thanks mostly to Trump’s pro-business agenda. The Bank of America survey showed not only an eight-month high of 33% of respondents expecting the economy to continue to grow at a steady clip, but also that only 6% expect a recessionary scenario — a six-month low. Meanwhile, overall investor sentiment remains “super bullish,” with funding allocation into stocks at highs and cash at lows — on hopes for ongoing consumption and cheaper financing after Trump takes office.   

Ironically, when sentiment gets to that level, it is usually a sell signal, Bank of America said in the note.