The Fed on pause: navigating a slower phase of easing

The U.S. Federal Reserve kept interest rates steady at its January meeting and signaled that the pace of future rate cuts will be slower than in 2024.

What happened?

After cutting interest rates by 100 basis points (bps) over the last four months of 2024, the Federal Reserve kept interest rates steady today. That leaves the target range at 4.25%-4.50%. As we enter 2025, the Fed is moving to a new phase of the easing cycle, characterized by a slower, more cautious pace of rate cuts.

The policy statement made several changes, which Chair Powell described as “a bit of language cleanup” that was “not meant to send a signal.” Nevertheless, the changes leaned hawkish versus the prior language. The statement no longer says that “inflation has made progress,” and sounds more optimistic about the labor market, saying “the unemployment rate has stabilized at a low level.”

In his press conference, Powell said that “we do not need to be in a hurry to adjust the policy stance.” He repeated that “we are looking at the data to guide us,” and views the balance of risks as evenly balanced. He said the FOMC expects to see further progress on inflation, and that policy is currently still “meaningfully above the neutral rate.”

We continue to expect two more rate cuts this year, taking the policy rate to 3.75%-4.00%. The timing and magnitude should depend on the incoming inflation and labor market data, as well as policy developments.

Growth and inflation continue a steady, modest slowdown

Growth has remained strong since the last FOMC meeting in December. Fourth quarter GDP, due to be published tomorrow, is likely to show another healthy quarter of growth around 2.5%. That level is down from the above-3% pace set in 2023 and remains consistent with our forecast for growth to slow toward 2.0% this year. Inflation is showing more signs of progress, and we continue to forecast core PCE inflation this year at 2.5%.

The labor market has stabilized over recent months, with headline job growth rebounding and the unemployment rate stabilizing. Both have clearly softened, with headline job creation down 45% from its 2023 peak and the unemployment rate +0.7 percentage points (pp) from its low. However, both of these key metrics have stabilized and are roughly flat over the last six months.

Meanwhile, inflation has steadily improved. Most encouragingly, housing inflation has finally dropped meaningfully, down to +3.7% on a three-month-annualized basis. That compares with +5.8% at the start of last year and a 2022 peak of +9.0%. Other categories of core inflation have been noisier, and upside, tariff-driven risks remain to core goods inflation this year.

We expect tariffs to be more moderate than the full suite of measures President Trump has suggested, which will ultimately put around +0.3 pp of upside pressure on core PCE inflation this year. Under a more extreme scenario with a high, across-the-board tariff, the impact could be 3-5x as significant. In that scenario, the Fed would be unlikely to cut rates this year barring a much worse growth outcome than we expect.

What does this mean for investors?

With Fed policy in a holding pattern and interest rates set to remain somewhat elevated, we believe investors should position to take advantage of income where available, while balancing defensive and growth opportunities.

In equities, we still think the U.S. market offers the best combination of relative safety and growth. We are becoming more positive on small caps and infrastructure, two sectors that may benefit from shifts in tax policies and more protectionist trade practices. Outside the U.S., we are increasingly cautious about developed and emerging markets, due to expectations for weaker economic expansion and the likelihood of a stronger U.S. dollar.

Municipal markets show value across the ratings spectrum. The curve remains steep, providing attractive yields for investors willing to extend duration in high quality segments. At the same time, high yield municipal credit spreads remain inefficiently priced. While spreads in many other credit markets have compressed to multiyear or multidecade tights, high yield municipals still offer an attractive yield pickup versus AAA municipals. Fundamentals remain solid and issuers are in a strong position to weather any potential economic uncertainty.

Taxable fixed income yields are also attractive, with many at their highest levels in years. For example, investment grade corporates yield 5.30% and the Aggregate Index yields 4.90%. The majority of fixed income returns come from income, not capital appreciation, and high starting yields have historically correlated with attractive total returns.

Plus sectors offer opportunity, including preferred securities and senior loans. Preferreds offer attractive income potential, qualified dividend income and a healthy risk/reward balance. Senior loans currently offer some of the highest yields in the liquid fixed income universe, yielding more than 8.5%. The floating-rate nature of the asset class should be a tailwind if the Fed keeps near-term policy steady.