Eastspring Investments
Jan 2025 | 5 min read
Summary
The Fed: On hold for now, but sensitive to unemployment. The FOMC’s January statement and Chair Powell’s press conference contained important changes that the market has taken as slightly hawkish, reducing pricing for rate cuts this year. We differ slightly in hearing Chair Powell as still leaning dovish. The Fed is clearly data watching to determine its next move, but we sense particular sensitivity to any potential labour market weakness that implies a cut in May is possible even if March is highly unlikely.
The market has taken two main innovations from the January FOMC meeting as hawkish. One is that the language of the statement shifted from the sentence:
“Inflation has made progress toward the Committee’s 2 percent objective but remains somewhat elevated.” to “Inflation remains somewhat elevated.”
We agree that the removal of “made progress” reads less hopeful and leads to a suggestion that the Fed fears inflation might be stuck. However, when questioned about this, Powell said the meaning has not changed, that lower inflation in December was viewed positively, that he still sees inflation as likely to fall further, and that the statement change was just an effort to “clean up” the language.
The other impactful innovation was Powell’s statements at the press conference that “we are going to be focusing on seeing real progress on inflation or try to at least see some weakness in the labor market before we consider making adjustments” followed shortly thereafter by “we do not need to be in a hurry to adjust our policy stance.” Markets have taken this to imply that a March cut is highly unlikely and even May is uncertain.
Markets responded by trimming pricing for the May FOMC meeting from 15.3bps the day before the FOMC meeting to 12.3bps after and for full year cuts falling from 49.6bps to 46.2bps.
Although we agree that the Fed is almost certainly on hold through March, and is in data watching mode, several of Powell’s other statements lead us to see a bias to ease.
One is that he described policy as “meaningfully restrictive.” That suggests lots of room to ease as a baseline.
Another is that he was clear that although the FOMC want further progress toward its 2% inflation target “I wouldn’t say all the way down to 2% on a sustainable basis” is necessary for another cut. So, after four years of inflation being above 2% the Fed Chair believes it would be ok to cut again before getting back to 2%, presumably because he views policy as “meaningfully restrictive.”
Against this background, we believe Powell’s comments about unemployment to be potentially crucial. He stated that “the labour market is not a source of significant inflationary pressure” and “we don’t need to see further weakening in the labour market to achieve” the Fed’s inflation goal.
Taken together, we think these statements suggest the Fed may be responsive to successive rises in the unemployment rate from the current 4.1% even if inflation remains close to current levels.
Recent labour market data suggest employment remains strong and the unemployment rate is unlikely to rise on trend in January – February. The four-week average of initial jobless claims fell to 212.5k in the latest week, the lowest level since April of last year. Challenger layoffs have fallen in the recent month.
Most telling though is spending. Although just released Q4 GDP growth was lower than expected at 2.3%qoq annualized, down from 3.1% in Q3, personal spending growth accelerated to 4.2% from 3.7% respectively and final sales remained at a robust, above potential 3.2%. The majority of the slowing in overall growth came from a fall in inventories that is likely to be reversed in Q1 this year.
The bottom line is that the Fed remains on hold because the economy continues to grow robustly. We expect growth to remain at or above 2% in Q1 and likely into Q2, assuming no major policy shock from tariffs that transmits into equities and leading consumers to pull back from spending.
In this scenario the Fed would remain on hold in March and quite likely in May unless inflation falls for another several months consecutively. Evidence of falling apartment rents and stabilising house prices suggests some downward pressure on inflation, but not necessarily enough yet to overwhelm other components of the CPI, particularly if President Trump follows through on imposing 25% tariffs on Mexico and Canada on February 1.
However, we think that if the unemployment rate were to begin trending higher to above 4.3%, the Fed would likely shift gears to signal cuts.
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