Fed takes a wait-and-see approach on rate cuts

Federal Reserve pauses rate cuts amid economic uncertainty and Trump’s policies.

"The easiest way to make a policy mistake is to speculate," Mary C. Daly, president of the Federal Reserve Bank of San Francisco, said in an interview. Photo by Graeme Sloan/Bloomberg

By Alana Salsabila and Widya Putri

The Federal Reserve concluded its final meeting of 2024 with notable divisions over how to handle future interest rate cuts, driven by strong economic growth, persistent inflation, and significant uncertainty surrounding the potential return of Donald J. Trump to the White House. Despite initial disagreements, weeks later, the Fed unanimously decided to pause any immediate cuts, signaling a unified approach to carefully assess the economic landscape as it evolves under a new administration.

In a recent interview, Mary C. Daly, president of the Federal Reserve Bank of San Francisco, affirmed this cautious stance. She stressed that the central bank does not feel the need to act preemptively and that it is “calibrating” its policies to align with current economic conditions. According to Daly, the Fed now has the time to monitor developments and adjust its approach based on a clearer understanding of how the economy responds to changes in policy under the potential new leadership.

Economic unpredictability and trade concerns

Daly’s comments came in the wake of a significant trade development, where Canada and Mexico, two of the United States' primary trading partners, narrowly avoided steep tariffs in a last-minute deal with President Trump. The threat of another trade war, coupled with major policy changes such as large-scale deportations, tax cuts, and deregulation, has disrupted economists’ forecasts, adding another layer of complexity to the Fed's decision-making process.

These shifts have muddied expectations for the Fed’s future rate-cutting trajectory, which had already been adjusted with a one percentage point reduction last year. Daly indicated that her focus is on understanding the "net effect" of Trump’s policies, rather than analyzing each individual change. Given the scope and timing of potential policy shifts, she stressed that much more information is needed before the Fed can accurately predict their economic outcomes.

Caution over speculation

Daly warned against premature speculation, acknowledging that any decisions based on incomplete information could lead to policy mistakes. “Until we know more about scope, magnitude, and timing, and how those features move through the economy, then we’re really doing nothing more than speculating,” she explained. “The easiest way for a policy mistake is to speculate.”

Despite the uncertainty, Daly expressed comfort with the Fed’s projections from December, which showed a consensus for a modest half-point reduction in interest rates this year, potentially bringing the target range down to between 3.75% and 4%. She highlighted the need for flexibility, noting that the exact number of cuts required may change as more data comes in. “We have to have a very open mind about whether fewer or more will be needed,” she said.

High inflation complicates decision-making

The challenges facing the Fed are underscored by the continued inflation above the target 2% level. This complicates the Fed’s ability to make rate cuts, as any sudden change could risk further accelerating inflation. The current economic environment differs greatly from the last time Trump’s trade policies created uncertainty. In 2019, the Fed took immediate action to prevent a downturn caused by the trade war with China, slashing interest rates three times in a row in what was described as "insurance" against a potential economic slowdown.

However, as Daly pointed out, the situation today is markedly different. While trade tensions still exist, inflation remains a major concern, and consumer and business sensitivity to price fluctuations is high. As such, the Fed must be cautious about taking action that could disrupt the balance between fostering growth and controlling inflation.

“The world is different right now,” Daly noted. “History is a data point, but it’s not a playbook.”

Inflation expectations remain stable

One bright spot for the Fed is that long-term inflation expectations have remained stable, providing some reassurance that inflation may not spiral out of control. Daly emphasized the importance of maintaining a close focus on these long-term expectations, as they are a key indicator of economic stability. "The thing that’s reassuring is that longer-run inflation expectations, which is really what we keep our mind on, haven’t really moved at all," she stated.

This stability allows the Fed some breathing room to continue monitoring the economy without feeling pressured to act hastily.

Job market provides further stability

The Fed also has the luxury of a strong labor market, which Daly described as having “no sign” of weakness. She pointed out that the economy is in a solid position, with businesses showing more optimism than they did in the latter half of the previous year. This optimism, coupled with the continued strength of the labor market, provides additional justification for a cautious approach to rate cuts.

Economists are awaiting the January jobs report, which will be released on Friday, for any signs that the labor market is beginning to slow down. Analysts are expecting slower growth than the 256,000 jobs added in December, partly due to annual revisions by the Bureau of Labor Statistics. However, Daly remains confident that there is no widespread pessimism among businesses, and many are more optimistic about the future.

Fed’s future outlook and policy considerations

As the economic environment continues to evolve, the Federal Reserve faces significant challenges in balancing its mandate to foster stable prices and full employment. While the uncertainties surrounding Trump’s policies, trade negotiations, and inflation present potential risks, the Fed’s cautious approach allows it to monitor these developments and adjust its strategy accordingly.

Ultimately, the Fed’s ability to navigate the complexities of the current economic landscape will be crucial in determining the long-term trajectory of the US economy. With a focus on maintaining stability while being responsive to emerging data, the Federal Reserve is positioning itself to respond carefully to future economic shifts.