Fed Will Cut Just Once More as Inflation Expectations Rise

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The Federal Reserve will cut interest rates next week in what one analyst says will be the final reduction of this cycle.

U.S. inflation is firmly rooted above the Federal Reserve's target of 2.0%, but market pricing suggests this won't prevent the central bank from cutting rates by 25 basis points next week.

U.S. CPI inflation met market expectations, rising to 2.7% in November from 2.6% in October, making for the fifth consecutive increase.

"The Fed cannot lower interest rates much further if it wants to avoid stoking excessive price pressures, in our view," says Atakan Bakiskan, U.S. Economist at Berenberg Bank. "We continue to look for just one more 25bp cut until the end of 2025. We believe the Fed will more likely than not pause on 18 December and then deliver this final cut in Q1 next year."

In Berenberg's view, if the Fed cuts interest rates next week, it will be the last "in the near term."

A key concern for Berenberg is that surveys show inflation expectations are sharply rising among consumers.

The University of Michigan's Survey of Consumers showed the share of participants responding that "it is a good time to buy household durables because prices are going higher" spiked to 25% in December from 10% in November, the largest monthly increase since 1979.

Economists say inflation expectations are an important driver of realised inflation.

The share of those stating that “it is a good time to buy vehicles because prices are going higher” jumped to 11% from 4% – the largest monthly increase since 1981.

"The data-dependent Fed is certainly aware of the recent rise in inflation expectations, and the important role they play in determining realised inflation. Therefore, to keep inflation expectations anchored, the Fed will hesitate to ease policy aggressively, in our view," says Bakiskan.

 

Fed Likely to Cut Again Next Week

A weaker Dollar and lower U.S. bond yields following the inflation release suggest the market was wary of an upside surprise, opening the door to a cut next week.

"The rise in inflation is unlikely to stop the Fed from cutting rates by 25 basis points in a week's time. The federal funds rate is still well above the inflation rate, which puts the U.S. policy-makers in a comfortable position," says Dr. Thomas Gitzel, Chief Economist at VP Bank.

Money market pricing shows investors are 90% primed for a rate cut next week.

However, with the Fed cutting into a stubborn inflationary backdrop, the tone of the meeting will be important and will be where the market's reaction function lies.

"It is four months in a row now that core CPI has been running at an annualised rate closer to 4% than to 2%. I don’t think that the Fed can ignore this, and markets are underpricing the risk that there is a surprise pause at next week’s meeting. While policymakers’ language of late tilts the odds towards a cut, at the very least, I expect there to be a strong signal towards the possibility of slowing down in the new year," says Kyle Chapman, FX Markets Analyst at Ballinger Group.

The rate cut is 'in the price' of the Dollar and U.S. bonds, but the Fed's guidance is not, which suggests there is potential for volatility around the event.

The general rule of thumb is that the Dollar can rise if the Fed pushes back against expecting further rate cuts anytime soon as it awaits further data and the new government's policy announcements.

A wait-and-see approach would be warranted, given that President-elect Donald Trump wants to hike import tariffs, which would be inflationary.

 

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