Despite the fact that there are still weeks until Trump is sworn in, the elected president's vow to implement sweeping policy reforms has cast a shadow over the Federal Reserve.
On Thursday, the Federal Reserve cut rates for the third consecutive time, lowering rates by 25 basis points, but officials' predictions for the number of rate cuts next year were halved compared to the September forecast, leading to significant market volatility.
Federal Reserve Chairman Powell stated that while the more cautious outlook on interest rate cuts is due to the stagnation in progress toward the Fed's 2% inflation target, some officials have also begun to incorporate Trump's policies into their forecasts.
Julia Coronado, a former Federal Reserve economist and the current head of MacroPolicy Perspectives, stated, "Almost every aspect of Trump's policies seems to threaten their goals," referring to the Fed's objectives of keeping inflation low and stable and maintaining a healthy labor market.
Coronado added that the message from the Federal Reserve is very clear: "We are no longer in the 'Trump 1.0' era. Now it is 'Trump 2.0,' and we are facing inflation above target that needs to be addressed proactively."
Investors and analysts have stated that Trump's threats to impose tariffs, carry out mass deportations of illegal immigrants, and cut taxes and regulations could have widespread impacts on the economy. Some economists worry that these reforms could lead to rising inflation, slower growth, and increased volatility.
Economists acknowledge that preparations for the Federal Reserve's shift to a more gradual pace of interest rate cuts began forming before Trump won the election in early November. The inflation data for September and October exceeded expectations, replacing concerns about the health of the labor market that had persisted since summer.
The Federal Reserve's preferred measure of inflation—the core PCE price index—showed a year-on-year growth of 2.8% in October, and a FactSet survey of economists indicates that the year-on-year growth of core PCE is expected to accelerate to 2.9% in November.
Powell pointed out these changes on Thursday, clearly stating that after the rate cut in December, the Federal Reserve has entered a "new phase" where, given that interest rates are now closer to officials' best estimates of a "neutral" rate level, the Fed needs to be more "cautious" in its actions.
Although the Federal Reserve's policy setting remains "clearly restrictive," Powell made it clear that further interest rate cuts will depend on further progress in inflation.
However, Powell also indicated a significant shift in the way the Federal Reserve is considering the reforms that Trump has vowed to implement, which differs from his stance after the November election when he stated that the Fed would not "guess" or "assume" what the next government would do.
This is most evident in the revised economic forecasts from officials released alongside the interest rate decision. Compared to the September forecast of a one-point cut next year, most officials now expect only a 50 basis point cut, and they have also lowered their expectations for cuts in 2026 and 2027.
Officials have also significantly raised their median inflation forecasts. The "median" core PCE price index (excluding the three highest and lowest estimates) surged to a range of 2.5%-2.7%. This is up from 2.1%-2.3% in September.
After the Federal Reserve announced its interest rate decision, financial markets were "in disarray," with the S&P 500 index dropping nearly 3%, the dollar rising to a two-year high, and U.S. government bond yields increasing. Asian stocks faced pressure in early trading on Thursday.
Point72 chief economist Dean Maki described the Federal Reserve's shift as "shocking" and indicated that its roots lie in speculation about Trump. "If they haven't factored in tariffs and other factors into their forecasts, it’s hard to see why they would expect inflation to be so high."
JPMorgan strategists expressed a similar view, stating, "Beneath the surface, we can see that concerns about tariffs may be seeping into the Federal Reserve's psychological landscape."
During a conversation with reporters on Thursday, Powell acknowledged that some officials have "very preliminarily" begun to incorporate "highly conditional estimates of the economic impact of policies" into their forecasts for this meeting.
When directly asked how the Federal Reserve is considering its policy response to tariffs, Powell stated that the committee is "discussing pathways" and striving to better understand how such policies will affect the economy. He said, "This allows us to make a more cautious and thoughtful assessment of the appropriate policy responses when we finally see what the actual policies are."
Ellen Zentner, chief economic strategist at Morgan Stanley Wealth Management, stated that given the language in the policy statement previously used to imply a long pause, it is "absolutely unlikely" that the Federal Reserve will cut rates at its next meeting in January.
Derek Tang, an economist at research firm LHMeyer, expects the Federal Reserve to delay further rate cuts until June, ultimately cutting rates only three times next year. This forecast also depends on whether inflation expectations can be controlled.
Tang expressed concern that if Trump's policies harm economic growth, the labor market may be weaker than expected, which could pose complex issues for the Federal Reserve.
Tang said, "People may underestimate how weak the labor market really is, while the Federal Reserve now faces the dual challenge of rising inflation and trying to prevent the economy from falling into recession. This is a double whammy."
Article reposted from: Jin Shi Data