Summary
- The FOMC cut its target rate for the federal funds rate by 100 bps between September and December. However, a pause in its easing cycle seems like a done deal when the Committee meets next on January 29.
- Not only has the economy entered 2025 with a solid head of steam, but progress on returning inflation to the Fed’s target of 2% has been painfully slow in recent months. Therefore, many FOMC members seem to question the need for further policy accommodation at this time.
- The FOMC is not scheduled to release a “dot plot” at the conclusion of the meeting, so it will need to signal any policy intentions it wishes to give via the post-meeting statement and Chair Powell’s press conference. We expect the FOMC will make only modest tweaks to its post-meeting statement. We also believe Chair Powell will continue to indicate that the Committee is not on a preset course, and that future policy moves will depend on incoming data.
- Looking forward, we expect the FOMC will maintain its target range for the federal funds rate at 4.25%-4.50% through the first half of the year. We have penciled in a 25 bps rate cut at the September policy meeting, and a similar-sized reduction in December. We then look for the FOMC to remain on hold at 3.75%-4.00% throughout 2026.
- That noted, the FOMC’s policy actions in coming months will be dictated in part by policy choices, especially related to tariffs, that the Trump administration makes. In our view, uncertainty related to the new administration’s economic policy imparts uncertainty onto the outlook for monetary policy.
- We have pushed back our forecast for the end of quantitative tightening (QT). We now expect the FOMC will announce the end of QT at its May meeting, one meeting later than our previous forecast. We look for balance sheet runoff to cease at the beginning of June, although MBS runoff likely will continue, with mortgage paydowns replaced one-for-one with Treasury securities.
All Signs Point to a Pause in the Easing Cycle on January 29
As we discussed in our recent U.S. Economic Outlook, the American economy entered 2025 with solid momentum. We estimate real GDP grew 2.7% (annualized rate) on a sequential basis in the fourth quarter of last year. (The Bureau of Economic Analysis will publish real GDP data for Q4-2024 on January 30.) If this estimate is reasonably accurate, then real output would have expanded at a strong rate of 2.8% on an annual average basis in 2024. Moreover, job creation, which is a good coincident indicator of the pace of economic activity, remained solid as the economy created 170K jobs per month on average in the fourth quarter (Figure 1).
Meanwhile, progress on returning inflation to the Fed’s target of 2% appears to have stalled. The year-over-year change in the core PCE deflator, which most Fed officials believe is the best measure of the underlying rate of consumer price inflation, fell from 5.6% in September 2022 to 2.6% in June 2024 (Figure 2). However, this rate of inflation has subsequently edged up to 2.8% in November, and we estimate it stayed at 2.8% in December.
Market participants widely expect the policymaking Committee to keep its target range for the federal funds rate unchanged at 4.25%-4.50% at its upcoming meeting on January 29, an expectation we share. There are a few factors that support our expectation of a pause in the recent easing cycle. First, the solid pace of economic growth and disappointing news on inflation that we highlighted above argue against the need for more policy accommodation at this time.
Second, many FOMC members have indicated that pausing the easing cycle, at least for the time being, may be appropriate. Beth Hammack, the president of the Federal Reserve Bank of Cleveland, voted against the Committee’s decision to cut rates by 25 bps at the previous FOMC meeting on December 18. Three non-voting members seemed to agree with her, with a total of four participants leaving their “dot” for the appropriate policy rate at the end of last year at 4.50%-4.75%. Minutes of that meeting revealed that “a majority of participants noted that their judgments about this meeting’s appropriate policy action had been finely balanced.” With the economy showing few signs of deterioration since December 18, these members presumably feel even less need to cut rates further, at least at this time.
The “dot plot” that was released at the conclusion of the December 18 meeting showed that 14 of the 19 Committee members judged that a target range for the federal funds rate of 3.75%-4.00% or higher at the end of 2025 would be appropriate (Figure 3). This range is only 50 bps lower than the current one. When the previous dot plot was released in September, 17 of the 19 members judged that it would be appropriate to reduce the target range below 3.75%-4.00% by the end of this year. Clearly, there has been a significant reassessment among FOMC members about the degree of additional policy easing that is appropriate this year.
There will not be a Summary of Economic Projections (SEP) released at the conclusion of the meeting on January 29. Therefore, the FOMC will need to signal its intentions via the post-meeting statement and comments that Chair Powell makes in his press conference. We expect the FOMC will make only modest tweaks to its post-meeting statement relative to the one that was released on December 18. The Committee likely will continue to characterize the pace of economic growth as “solid,” and it probably will continue to refer to inflation as “somewhat elevated.” The last statement used the clause “in considering the extent and timing of additional adjustments to the target range for the federal funds rate…” to help signal the FOMC’s “bias” to ease further. Because the vast majority of Committee members at the last FOMC meeting viewed some additional policy easing as appropriate in 2025, we believe the January 29 statement will retain this clause in order to preserve policy optionality. We also believe Chair Powell likely will continue to indicate that the Committee is not on some preset course, and that future policy moves will depend on incoming data.
New Voting Members on the FOMC at this Meeting
The first meeting of 2025 will include the annual shift in the voting members of the FOMC. All 19 FOMC officials participate in every Committee meeting, but only 12 get to vote on the policy decision. For the seven-member Board of Governors, there will be no changes. There are not currently any vacancies on the Board, with the next vacant seat scheduled to be Adriana Kugler’s in January 2026. Governor Michael Barr intends to step down from his position as Vice Chair of Supervision effective February 28, 2025—or earlier if a successor is confirmed. However, Barr has signaled his intention to continue to serve as a member of the Board of Governors. The remaining five voters on the FOMC are drawn from the ranks of the 12 regional Federal Reserve Banks, with the Federal Reserve Bank of New York holding a permanent voting seat. The new 2025 voters will be Austan Goolsbee (Chicago), Susan Collins (Boston), Alberto Musalem (St. Louis) and Jeffrey Schmid (Kansas City). We believe the new voters include a healthy mix of policymakers with both more dovish leans (e.g., Goolsbee) and hawkish leans (e.g., Schmid), and we do not expect this year’s rotation to result in a dramatic departure from the policy course that was signaled at the December FOMC meeting.
Upcoming Policy Choices of the Administration Imparts Uncertainty onto Outlook for Monetary Policy
As we also outlined in our U.S. Economic Outlook, we have made some adjustments to our forecast for Fed policy this year. Previously, we had expected the FOMC would cut rates by 25 bps at each of its meetings in March, June and September. We now think the FOMC will keep its target range unchanged at 4.25%-4.50% until the second half of this year. We currently are forecasting a 25 bps rate cut at the September policy meeting followed by a similar-sized reduction in December (Figure 4). We then look for the Committee to remain on hold at 3.75%-4.00% throughout 2026.
That noted, the FOMC’s policy actions in coming months will be dictated in part by policy choices, especially related to tariffs, that the Trump administration makes. Across-the-board tariffs on America’s trading partners could lead to a modest rise in inflation this year. Higher inflation would erode growth in real income and weigh on growth in real consumer expenditures. The growth-slowing effects of tariffs could be exacerbated if foreign countries levy retaliatory tariffs on U.S. exports. The FOMC’s response to any tariff-related effects on the U.S. economy will depend on how Committee members judge the risks to the achievement of their dual mandate (i.e., price stability and full employment). In short, the uncertainty at present that is related to the economic policy choices of the incoming administration imparts uncertainty onto the outlook for Fed policy.
QT: Expected End Date June 2025
We expect the upcoming FOMC meeting to include a preliminary discussion about the path ahead for the Federal Reserve’s balance sheet runoff program, more commonly known as quantitative tightening (QT). QT has been ongoing since June 2022, when the Federal Reserve began reducing its holdings of Treasury securities and mortgage-backed securities (MBS) by up to $60 billion and $35 billion per month, respectively. These caps remained in place until June 2024, at which time the Committee reduced the cap for Treasury securities to $25 billion in an effort to slow, but not stop, the pace of balance sheet runoff. Those caps remain in place today.
At present, the Federal Reserve’s security holdings total $6.4 trillion, a $2 trillion decline from the central bank’s peak holdings in 2022. The Federal Reserve’s balance sheet has fallen even more as a share of GDP, declining from 35% at the peak to 23% today (Figure 5). This passive balance sheet runoff has been a secondary form of monetary policy tightening and likely has contributed to some modest upward pressure on longer-term interest rates, perhaps on the order of 20-40 bps or so.
The upshot of the reduction in the Fed’s security holdings has been a reduction in the abundant liquidity in the financial system. Cash parked at the Federal Reserve, whether from banks holding reserves or money market funds and other institutions utilizing reverse repurchase agreements, has declined considerably from its peak both in dollar terms and as a share of GDP (Figure 6). The Federal Reserve aims to maintain reserves that are “ample” enough such that the financial system operates smoothly but not so ample that its balance sheet is larger than is necessary.
Identifying that Goldilocks zone of not-too-big and not-too-small involves a rigorous amount of analysis and monitoring. The Federal Reserve tracks a wide variety of indicators to assess the degree of scarcity for bank reserves. One key indicator is conditions in the market for Treasury repurchase agreements, also known as the Treasury repo market. Treasury repo transactions form the basis for the secured overnight financing rate (SOFR), a benchmark lending rate in the United States.
Because SOFR is an overnight financing rate like the federal funds rate, it generally fluctuates in the FOMC’s target range for the federal funds rate. SOFR generally has traded near the bottom of the fed funds target range in recent years in a sign that reserves have been more than ample (Figure 7). SOFR has printed above the top end of the target range a couple of times in recent months, including year-end when balance sheet pressures in the financial system tend to be must acute. That said, the spikes generally have been short-lived and less volatile than what occurred in the last episode of QT from 2017–2019, and they have been well-shy of the more than 300 bps blowout that occurred in September 2019. Furthermore, the effective federal funds rate has remained very stable and well-within the FOMC’s desired target range. Federal Reserve Bank of New York President John Williams recently stated he saw “no signs of disruption in the repo market” as a result of ongoing QT.
Given that balance sheet runoff has gone smoothly so far, we think the Committee is inclined to let balance sheet runoff continue for a bit longer than we previously believed. We now look for QT to continue at its current pace through the end of May. Starting in June, we expect the Federal Reserve to keep its balance sheet flat through at least the end of the year. Note that even if aggregate balance sheet runoff ceases, the composition can continue to evolve. We look for MBS runoff to continue past June indefinitely as the Federal Reserve strives to reduce its mortgage holdings and slowly return to holding primarily Treasury securities. In order to keep the total balance sheet unchanged amid ongoing MBS runoff, we look for the Federal Reserve to start buying Treasury securities such that they replace MBS paydowns one-for-one.
