Highlights:
· The yearlong trend of monetary easing continued in the fourth quarter, but the Federal Reserve signaled future interest rate cuts are likely to be more limited than previously thought. The path of inflation is crucial for determining how much further the Fed can cut rates.
· By tempering expectations for upcoming cuts, it is possible that the Fed is hinting that its neutral rate of interest has gone up.
· The Bank of England continued taking a more guarded approach to cutting rates, while the European Central Bank struck a more dovish tone.
Commentary:
“Today was a closer call, but we decided it was the right call. We are at or near a point at which it will be appropriate to slow the pace of further adjustments”
-Jerome Powell, Fed Chair
The Federal Reserve (Fed) trimmed interest rates by a quarter-point at its December meeting, but signaled that future cuts may be more limited than previous market expectations. Prior to the December Fed meeting, the consensus was that the Fed would cut rates four times in 2025, but that has now been revised down to only two cuts in the year. The news spooked investors that had assumed Fed rate cuts would slow down to every other meeting and led to a surge in the dollar against most currencies.
Nevertheless, the Fed has now cut rates by a full percentage point and the economy appears to be in reasonably good shape. The Fed’s focus will now shift to attempting to determine the appropriate neutral rate of interest, or the rate that keeps the economy at full employment with stable inflation. This rate cannot be directly observed, but rather must be inferred from the behavior of the economy. If borrowing and spending are strong and price pressures are rising, the current interest rate must be below neutral. If they are weak and inflation is receding, rates must be above neutral.
By tempering expectations for future rate cuts, the Fed seemed to be tipping its hand that it believes the neutral rate may have gone up and it might be getting closer to its ultimate destination. “We don’t know exactly where it is, but…what we know for sure is that we’re a hundred basis points closer to it right now,” Fed Chair Jerome Powell said at the Fed’s December meeting. “From here, it’s a new phase, and we’re going to be cautious about further cuts.” This was consistent with Powell’s previous comments indicating it was unlikely interest rates would return to the ultralow levels that prevailed before the pandemic. “My own sense is that we’re not going back to that, but, honestly, we’re going to find out,” he had previously said. “It feels to me the neutral rate is probably significantly higher than it was back then.”
President-elect Donald Trump’s promise to revamp trade and immigration policies could add new shocks that further complicate efforts to determine the economy’s new normal and complicate the balancing act the Fed has been trying to pull off for the last couple of years. The Fed wants to prevent the aggressive rate increases of the past two years from unnecessarily slowing down economic activity now that price and wage growth has cooled, but it does not want to undo recent progress on inflation. Powell is staying neutral on what changes the new administration may bring, saying, “We don’t guess, we don’t speculate, we don’t assume” what policies will be put into place. “In the near term, the election will have no effects on our policy decisions.”
However, the bottom-line was that progress on bringing down inflation stalled in November, with the consumer-price index of goods and services costs ticking up to a 2.7% increase. The prices of consumer goods increased at the fastest month-over-month pace in a year and a half. This reversed a trend that had seen prices for many goods fall or stay flat for the past year. Economists fear that goods inflation could accelerate further if the incoming Trump administration follows through on threats to impose across-the-board tariffs.
On the jobs front, 256,000 jobs were added in December and the unemployment rate edged down to 4.1%. These numbers seem to indicate that the U.S. labor market has recovered from its midyear stumble and alleviates the concern that the labor market is cooling too fast. Wage growth continued to moderate, however, which leaves intact the Fed’s thesis that the labor market isn’t a source of inflationary pressure, but raises questions about whether wage stagnation will impact consumer spending.
The Fed’s decisions have an impact on other economies through movements in the U.S. dollar because a stronger dollar can make their imported goods and services more expensive and fuel inflation. For example, in contrast to the U.S., the U.K.’s economy has grown slowly over recent years and the Bank of England (BOE) is expecting its economy to have stagnated the final three months of 2024. Despite that economic weakness, wages continue to increase at a rapid pace and inflation continues to rise above the BOE’s 2% target.
In the face of this conflicting data, the BOE left its key interest rate unchanged at its December meeting, which marked the second time in the last three meetings that it has held off on lowering rates. “We think a gradual approach remains right, but with the heightened uncertainty in the economy we can’t commit to when or by how much we will cut rates in the coming year,” said BOE Governor Andrew Bailey. European Central Bank (ECB) President Christine Lagarde, on the other hand, struck a more dovish tone, stating that, “If the incoming data continue to align with our baseline, the path forward is clear, and we anticipate further reductions in interest rates.”
Potentially facing fresh pressure from the re-election of Donald Trump as U.S. president, China unveiled a 10 trillion yuan (~$1.40 trillion) debt package to ease local government financing strains and stabilize flagging economic growth. The package aims to repair municipal balance sheets as a long-term objective, rather than by directly injecting money into the economy, marking a departure from the all-out stimulus strategies to revive growth that China has deployed in the past. More stimulus is likely coming, but China appears to be waiting until Trump officially takes over in January before firing all its fiscal weapons.
These are just a few of the overabundance of headlines that we are watching as we enter the New Year. 2024 saw central banks transition to monetary easing after fighting inflation for several years, a global movement towards populism that led to several world leaders changing hands, and stock markets continuing to diverge. There is no shortage of issues that investors will be monitoring in 2025, including geopolitical risks, foreign policy stances, debt levels in the U.S., regulatory, tax and tariff agendas, central bank actions, and immigration programs. Of course, it is what no one is currently talking about or seeing that typically affects markets most significantly moving forward.
Throughout history, human ingenuity and technology have improved how we work and live, and changed our lives for the better. Many times these improvements are occurring slowly and quietly in the background, often times without us even realizing it. We believe the long-term trend of increasing productivity and convenience will continue and thus we remain, as always, cautiously optimistic that this will be reflected in continued global economic growth and corporate profits.
Urban Financial Advisory Corporation – January 2025
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