Harder Fed cut raises debate over interest rate hikes: MacGyver by Reuters

Written by Jamie MacGyver

ORLANDO, Fla. (Reuters) – The end of the Federal Reserve’s rate-cutting cycle is suddenly in sight, and a full turnaround by raising interest rates next year can no longer be ruled out.

The Federal Reserve cut the federal funds rate by 25 basis points on Wednesday to a target range of 4.25%-4.50%, as expected. But if ever there was a “hard cut,” this was it.

The market’s reaction was quick and strong: the dollar rose to its highest level in two years, stocks fell, and Treasury yields rose. Markets can get over days like this, but there was plenty here to support the moves, whether investors were looking forward to the Fed’s statement, its revised forecasts or Chairman Jerome Powell’s news conference.

First, the decision to cut was not unanimous, as Cleveland Fed President Beth Hammack objected to it. Powell described the 25 basis point cut as “closer” than recent decisions. He also said monetary policy was now “significantly less restrictive” and “much closer to neutral.”

In addition, policymakers significantly raised their average inflation forecast for 2025 to 2.5% from 2.1%, raised their view on the long-term neutral interest rate back to a six-year high of 3.0%, and reduced the number of cuts expected in Interest rates will halve next year two.

While the Fed’s new forecast still calls for 50 basis points of monetary easing next year and 100 basis points by the end of 2026, interest rate markets are seeing none of that. They are now pricing in cuts of just 35 basis points next year and that’s about it. no more.

In short, the market is basically defying the Fed’s bluff.

This is largely due to the puzzling logic behind the Fed’s 2025 forecasts: Policymakers expect inflation to be much higher than they previously thought, yet they still plan to cut interest rates. It’s a difficult cycle to solve, as Powell discovered in his press conference.

This position might be more defensible – and less disruptive to markets – if growth and employment were also collapsing. But they are not. The Fed’s forecasts for both were barely changed, with economic activity and the labor market expected to remain strong through 2026.

Never judge anything inside or outside

Just one year after Powell’s dovish stance, markets may now be considering the possibility of turning in the other direction.

Torsten Slok, chief economist at Apollo Global Management (NYSE:), was one of the first to float the idea that interest rates might actually rise next year. Wednesday’s developments reinforced his view that the economy is strong and therefore interest rates should remain higher for longer.

“I think there is now a 40% probability that the Fed will raise rates in 2025,” Slok said after the meeting.

It’s not a strange call, considering interest rate markets expect the Fed to begin an extended pause at its next meeting that will last through 2025. The next quarter-point rate cut isn’t fully priced in until September.

Of course, a lot can happen in nine months, especially in light of President-elect Donald Trump’s return to the White House in January. If its proposed trade policies and tariffs are published, inflation could rise, further complicating the Fed’s task.

Economist Phil Satell believes this may force the Fed to act.

“My view remains that the Fed’s next move will be to raise interest rates in July, after tariff-driven inflation spikes in the second quarter,” he wrote on Wednesday.

It’s true that financial markets are not explicitly anticipating a complete U-turn by the Fed, and Powell on Wednesday dismissed that possibility as an unlikely outcome.

But the dollar has risen 8% since the Fed’s first interest rate cut in September, and Treasury yields have risen 80 basis points. This suggests that some sectors of the financial world are already anticipating tougher policy.

As Powell also said on Wednesday when asked about a possible rate hike next year: “You’re not completely in control of things in or out of this world.”

Given how poorly the market has predicted Fed policy over the past few years, keeping an open mind is probably a very good idea.

(The opinions expressed here are those of the author, a Reuters columnist.)

(Writing by Jimmy MacGyver, Editing by Michael Perry)