Despite several weeks remaining until Trump's inauguration, the president-elect's promise of sweeping policy reforms has cast a shadow over the Fed.
On Thursday, the Fed cut rates for the third consecutive time, lowering rates by 25 basis points, but officials' forecasts for the number of rate cuts next year were halved compared to September's projections, leading to significant market volatility.
Federal Reserve Chairman Powell stated that the more cautious outlook on the prospects for rate cuts is due to the stagnation in progress towards the Fed's 2% inflation target, but some officials have begun to incorporate Trump's policies into their forecasts.
Former Fed economist and current head of MacroPolicy Perspectives, Julia Coronado, stated, 'Almost every aspect of Trump's policies seems to threaten their goals,' referring to the Fed's targets of keeping inflation low and stable and maintaining a healthy labor market.
Coronado added that the Fed's message is clear, 'We are no longer in the 'Trump 1.0' era. We are now in the 'Trump 2.0' era, where we face inflation above target and need to respond proactively.'
Investors and analysts noted that Trump's threats to implement tariffs, conduct mass deportations of illegal immigrants, and cut taxes and regulations could have widespread effects on the economy. Some economists are concerned that these reforms will lead to rising inflation, slowing growth, and increased volatility.
Economists acknowledge that preparations for the Fed to shift to a more gradual pace of rate cuts began forming before Trump won the election in early November. Inflation data in September and October exceeded expectations, replacing summer concerns about the health of the labor market.
The Fed's preferred measure of inflation—the core PCE price index—showed a year-on-year increase of 2.8% in October, and a FactSet survey of economists indicates that the year-on-year growth rate of core PCE is expected to accelerate to 2.9% in November.
Powell pointed to these changes on Thursday and made it clear that after the December rate cut, the Fed has entered a 'new phase,' in which, given that rates are now closer to officials' best estimates of the 'neutral' rate level, the Fed needs to be more 'cautious' in its actions.
Although the Federal Reserve's policy setting remains 'noticeably restrictive,' Powell has made it clear that further rate cuts will depend on further progress in inflation.
However, Powell also hinted at a significant shift in how the Fed is considering Trump's promised reforms, which is different from his stance after the November election when he stated that the Fed would not 'guess' or 'assume' what the next administration 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 percentage point rate cut next year, most officials now expect only a 50 basis point cut, and they have also lowered their rate cut expectations for 2026 and 2027.
Officials have also significantly raised their median inflation forecasts. The 'median' core PCE price index (excluding the highest and lowest three estimates) jumped to a range of 2.5%-2.7%. This is higher than the 2.1%-2.3% range in September.
Following the Fed's interest rate decision, financial markets were 'in shambles,' with the S&P 500 falling nearly 3%, the dollar rising to a two-year high, and U.S. government bond yields increasing. Asian stock markets were under pressure in Thursday's early trading.
Dean Maki, Chief Economist at hedge fund Point72, called the Fed's shift 'stunning,' adding that its roots lie in speculation about Trump. 'If they haven't incorporated factors like tariffs 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, it seems that concerns over tariffs may be penetrating the Fed's psychological landscape.'
In a conversation with reporters on Thursday, Powell acknowledged that some officials have 'very preliminarily' begun incorporating 'highly conditional estimates of the economic impact of policy into their forecasts for this meeting.'
When directly asked how the Fed is considering its policy response to tariffs, Powell stated that the committee is 'discussing paths' and working 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 response when we finally see what the actual policies are.'
Ellen Zentner, Chief Economic Strategist at Morgan Stanley Wealth Management, stated that given the language used in the policy statement, which has previously been used to imply a prolonged pause, a rate cut at the next January meeting is 'absolutely not possible.'
Economist Derek Tang from research firm LHMeyer expects the Fed to delay further rate cuts until June, ultimately cutting rates only three times over the course of next year. This forecast also depends on whether inflation expectations can be controlled.
Tang expressed concern that if Trump's policies undermine economic growth, the labor market could be weaker than expected, which could pose complex issues for the Fed.
Tang said, 'People may underestimate how weak the labor market actually is, while the Fed is now facing rising inflation and trying to prevent the economy from sliding into recession. It’s a double whammy.'
Article reprinted from: Jin Shi Data