Editor’s Note: This post was updated to include additional analysis on Thursday December 19
Under the surface, Wednesday’s Fed projection of two rate cuts in 2025 is worse than it looks, even though it met futures market pricing ahead of the meeting. That’s why futures markets now only expect one cut in 2025 and mortgage rates spiked on the news.
Wall Street economists mostly expected the Fed’s projection to show three cuts, even if they eventually only cut twice based on the assumption that the central bank tends to move gradually. But the Fed’s decision ended up not even being a close call between two and three cuts. The Fed generally does not like to make sudden changes that might destabilize markets. For example, that is why they’ve only gradually moved up their estimate of the neutral rate in their projections, even though it was widely known that the neutral rate had jumped. The Fed’s willingness to make a sudden shift from projecting four cuts to two makes markets worry that it will actually end up being even less. Furthermore, the dots that show each individual assessment had 14 out of 19 participants projecting two or fewer cuts and only five of 19 projecting three or more cuts.
Fed officials not only increased their projection of 2025 inflation, they also indicated they are worried that inflation could actually come in even higher. Fed officials are asked to assess their confidence around each economic projection. In September, three out of 19 participants indicated that the risks to inflation were “broadly balanced”, but this time 15 of the 19 indicated that the risks to inflation were “weighted to upside.” That reinforces the point that Fed officials may actually foresee a future that includes fewer cuts than in the official projection.
Chair Powell’s discussion of the Fed’s potential response to any policy changes seemingly opens the door to the Fed keeping rates higher should tariffs increase. Powell was asked about the 2018 Teal Book analysis of the monetary policy response to tariffs (from when President Trump implemented higher tariffs in his first term). Specifically, he was asked about the scenario whereby monetary policy “sees through” the inflation impact because they are one-time price increases and does not react. Powell essentially pointed out that there were two scenarios in that analysis, one of which contemplates when it is not appropriate to see through inflation, and that they would assess which is more appropriate once the terms of any new tariffs are announced. He had earlier mentioned that several officials were accounting for the possibility of tariff increases in their individual projections.
This hawkish stance from the Fed will keep mortgage rates high until there is data showing a weaker economy and/or the incoming administration dials back their plans for policy changes, especially on tariffs. Ultimately, the Fed’s projection is not actual policy and often differs dramatically from the eventual realized outcome because of new information that comes to light. Rates appear poised to stay high in the near term, but scrutinizing the Fed’s projections can risk offering a false sense of precision when, ultimately, there are big outstanding questions around the path of inflation and which anticipated policy changes become reality.
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Original Post (Published 17:00 EST Wednesday December 18)
The Fed cut the fed funds rate by 25 bps on Wednesday, as widely expected, but mortgage rates increased as the Fed reduced its 2025 projections from four cuts to two amid stickier-than-expected inflation and considerable policy uncertainty.
Fed officials cut the fed funds rate for the third meeting in a row by 25 bps, which will have no effect on mortgage rates, as it was entirely priced in. The fed funds rate has now been cut by a total of 100 bps since September 18, from 5.5% to 4.5%. That represents considerable progress from a highly restrictive territory to something much closer to neutral rate estimates (the range in which monetary policy is neither restricting nor stimulating the economy), which range from around 2.5% to 4%. Mortgage rates have moved in the opposite direction since September, however, as they are long term rates influenced by many factors beyond the Fed’s policy rate.
The Fed expects that inflation will only decline slightly from 2.8% to 2.5% over the course of 2025. Recent inflation reports have shown little progress on inflation, with the 12-month change in prices largely going sideways rather than declining. Furthermore, Chair Powell shared that some Fed officials are now beginning to take into account the potential inflationary impact of any new tariffs. He also declined to commit to a policy of “seeing through” the inflationary impact of any tariff increases, as they are one-time price increases. These two factors led Fed officials to increase their expectations for inflation at the end of 2025 from 2.2% to 2.5%.
Chair Powell says we are now in “a new phase” where the Fed “is going to be cautious about further cuts.” Specifically, the Fed now only expects two cuts in 2025. This change was largely expected, but represents a considerable slowdown relative to the 100 bps of total cuts in the last quarter of 2024. It is also significantly less than the four 25 bps cuts they had projected in their September 18 meeting. Based on Chair Powell’s comments, futures markets are taking it even further and are now pricing in only one 25 bps cut.
Mortgage rates increased today as 10 year treasury yields rose throughout Chair Powell’s press conference. The ten year treasury yield is currently up by about 10 bps, with mortgage rates up 21 bps after the Fed’s announcement.
