The Fed is about to cut, and sound tough doing it

The Federal Reserve is widely expected to cut rates by 25 basis points at its December meeting, as markets have priced. Its problem is presentation. Policymakers want to deliver the cut without letting financial conditions loosen further before the tariffs arrive.

The Fed has cut by three-quarters of a point since September, taking its policy rate to 4.5 to 4.75 per cent, and a further quarter-point would bring the total to a full percentage point. The backdrop has shifted since the easing began. Core inflation has risen at 0.3 per cent a month for four months running, the economy has kept growing at a solid pace, and the incoming administration has promised tariffs that would push up import prices. Jerome Powell said this month that the economy was stronger than officials had expected in September, which gives the committee room to be more cautious.

A cut with a warning

Jerome Powell’s likely answer is to pair the cut with a hawkish Summary of Economic Projections. If the committee trims the number of cuts pencilled in for 2025 and raises its long-run rate dot, it can signal a long pause. Cutting rates while telling markets not to expect more is a delicate act, and it could easily be misread.

What the dots said last time

The benchmark is September's projections. Then, the median official expected the policy rate to fall by a full percentage point during 2025, and put the long-run neutral rate, the level that neither stimulates nor restrains the economy, at 2.9 per cent. Both numbers now look generous. A median showing only two or three cuts next year, and a long-run rate nudged higher, would tell markets that the Fed sees less need to ease and less room to do so. Because the projections are anonymous, the median can move even if Mr Powell's own view barely changes.

The long-run dot matters more than it sounds. If officials think the neutral rate is higher than they once did, then today's policy rate is less restrictive than it appears, and further cuts risk stimulating an economy that needs no help. A rising neutral estimate would also support higher long-term bond yields, since it raises the level at which short-term rates are expected to settle.

Why conditions matter

Monetary policy works largely through financial conditions: bond yields, share prices, credit spreads and the dollar. Those have not tightened as the Fed intended. Share prices sit near record highs, and corporate borrowers face narrow spreads over Treasuries. The ten-year Treasury yield, at around 4.4 per cent, has risen since September, which is the one part of the picture moving in the direction the Fed might like. If a cut led markets to price many more, yields would fall, share prices would rise further and the easing would be amplified well beyond what the committee intended.

The tariffs complicate matters further. Officials cannot yet know their size, timing or scope, but most estimates suggest they would raise prices at least for a time. A Fed that has just eased would then have to decide whether to look through a one-off price rise or respond to it, and it would prefer to face that choice from a position of patience rather than momentum.

Precedents for mixed messages

The Fed has tried this before, with uneven results. In July 2019 Mr Powell cut rates and described the move as a mid-cycle adjustment rather than the start of a long easing cycle; markets were disappointed, shares fell that afternoon, and the Fed cut twice more within months. In December 2018 he raised rates and signalled that the shrinking of the balance sheet would continue on its set course, and a sharp sell-off forced a change of tone within weeks. Both episodes show that markets tend to hear the part of a message that surprises them, and that the Fed often ends up following.

The case for a clean cut

There is an argument for cutting without the warning. The labour market has cooled from its peak, unemployment is well above its low, and real rates remain positive even after the cuts so far. Signalling a long pause could tighten conditions more than intended, especially if the dollar strengthens further and weighs on exports. The tariffs may also slow growth as much as they raise prices, in which case the Fed would want to be cutting, not pausing.

That risk is real, but it can be managed later. A Fed that pauses and then resumes cutting suffers little damage to its credibility. A Fed that keeps easing into rising inflation, and then has to reverse, suffers a great deal.

Who gains, who loses

A hawkish cut would keep short-term rates falling while holding long yields up. Floating-rate borrowers would gain a little. Mortgage borrowers, whose rates track long yields, would gain little or nothing. Savers in money-market funds would keep earning healthy returns for longer. A strong dollar, supported by a Fed less eager to cut than its peers, would weigh on emerging markets that borrow in dollars and on American multinationals' overseas earnings.

Expect the Fed to cut this week and all but shut the door on further moves early next year. If markets hear only the cut, Powell will have to repeat the warning, probably more bluntly, in January. The most likely result is a median projection showing about half as many cuts next year as September's did, a ten-year yield that stays at or above today's level into the new year, and mortgage borrowers the clearest losers from the change in tone.