Federal Reserve recalibrates monetary policy as inflation recedes

For the third consecutive meeting, the Federal Reserve’s (Fed’s) Federal Open Market Committee (FOMC) lowered the federal funds target rate, the rate banks charge each other for overnight lending. Following up on September’s 0.50% fed funds target rate cut, and November’s 0.25% cut, the FOMC at its December 2025 meeting cut rates by another 0.25%. The fed funds target rate is now set at 4.25% to 4.50%.

The Fed held rates at 5.25% to 5.50% from July 2023 to September 2024. Between March 2022 and July 2023, the Fed raised rates eleven times, from near 0%.

Notably, Fed officials, coming out of December’s meeting, appeared to scale back 2025 rate cut plans. The FOMC now projects just two 2025 rate cuts, compared to earlier projections of four rate cuts. “December’s Fed actions can be read as a hawkish cut,” says Rob Haworth, senior investment strategy director with U.S. Bank Asset Management. “It sets the market up to be ready for the Fed to go into a pause rather than set the stage for immediate additional rate cuts.”

In a statement issued after December’s FOMC meeting, the Fed indicated that current economic data requires a policy balancing act. “Recent indicators suggest that economic activity has continued to expand at a solid pace (2.8% in 2024’s third quarter).¹ Since earlier in the year, labor market conditions have generally eased, and the unemployment rate has moved up but remains low (4.2% in November 2024).² Inflation has made progress…but remains somewhat elevated (Personal Consumption Expenditures at 2.5% in November 2024),”¹ read the statement.³ In his own comments, Powell stated that given the Fed’s recently initiated rate cuts, “our policy stance is now significantly less restrictive. We can therefore be more cautious as we consider further adjustments to our policy rate.”⁴

Along with the latest interest rate cut, the Fed continues, as it has since 2022, reducing its balance sheet of fixed income assets. At its peak, the Fed’s balance sheet grew to nearly $9 trillion dollars. Each month, the Fed trims its Treasury bond holdings, which now have declined to approximately $6.9 trillion.⁵ “It seems unlikely the Fed will drop its balance sheet back to the $4 trillion level, as it stood in 2015-16, but given the extent the economy has grown since then, a larger Fed balance sheet may be justified,” says Haworth.

Economy projected to stay on course

After December 2024’s meeting, the FOMC issued its Summary of Economic Projections (SEP), reflecting each FOMC member’s forward view on key economic variables. The SEP suggests most major economic measures are expected to show little change in 2025.⁶
 

GDP is Gross Domestic Product, a measure of economic growth. PCE is Personal Consumption Expenditures index, an inflation measure. Core PCE is inflation for items outside of food and energy. Source: Federal Reserve Board of Governors, Summary of Economic Projections, December 18, 2024.

“The U.S. economy is just performing very, very well, substantially better than our global peer group,” says Powell. He sees little near-term recession risk.⁷

“The Fed is seeing a lot of what they want in terms of economic data,” says Haworth. “Inflation in general is slowing, except for recent upticks in food and energy, which are considered transitory. The job market remains healthy as well.”

Markets react negatively to Fed policy

In the immediate aftermath of the Fed’s policy statements, equity markets tumbled. Key indices such as the Dow Jones Industrial Average, the S&P 500, NASDAQ Composite, and Russell 2000 all showed a one-day loss (on December 18) of 2.5% or more. It appeared to be a negative reaction to the Fed’s scaled-back rate cutting plans.

Bond markets also declined. The 10-year Treasury yield jumped from 4.40% to 4.50% in a single day (bond prices fall when bond yields rise), representing its highest yield since May 2024. 2-year Treasury yields also experienced a similar change, rising from 4.25% to 4.35%^.8

The Fed’s Balancing Act

The Fed’s primary purpose in raising rates and keeping them elevated was to combat the highest inflation since the early 1980s. At its peak, inflation, as measured by the Consumer Price Index (CPI), reached 9.1% for the 12 months ending in June 2022. The most recent CPI reading, for the 12 months ending in November 2024, showed inflation at a much improved 2.7%.2 However, over the most recent months, inflation moved modestly higher. “There is a risk of a reacceleration of inflation,” says Haworth. “The potential for added tariffs under the new Trump administration could add to that risk.”

At the same time, says Haworth, “The Fed doesn’t want to see too much softness in the employment market.” That would contribute to a slowing economy. Although the nation’s unemployment rate moved above 4% in mid-2024, it has, in recent months, held steady.²

Haworth notes initial jobless claims provide a helpful “real-time” guide on the state of the jobs market. Claims held steady, but then in early December experienced a sudden uptick.⁹

Where does the Fed go from here

The policymaking FOMC meets next at the end of January 2025. Markets are expecting the Fed to hold the line on rates at that meeting, and possibly at its follow-up meeting in mid-March.¹⁰

As the Fed continues to address monetary policy, be sure to consult with your financial professional and review portfolio positioning. Explore whether changes might be appropriate given your goals, time horizon and feelings toward risk in today’s evolving interest rate environment.