Fed's hawkish surprise ahead of the holidays puts January pause in spotlight

Investing.com -- The Federal Reserve delivered a hawkish present to markets at its December meeting ahead of the holidays as the widely expected rate cut in December was served up with forward guidance that caught markets by surprise, raising the risk that a January cut is now firmly off the Fed's monetary policy table.    

"Following the outcome of the December FOMC meeting, which was decidedly more hawkish than we anticipated, we change our outlook for Federal Reserve policy to include two-25bp rate cuts in 2025, in March and June,"   Morgan Stanley   (NYSE:MS) analysts said in a note.

The Federal Open Market Committee, or FOMC, cut its benchmark rate by 25 basis points to a range of 4.25% to 4.5%, marking the third rate cut of the year since the first cut in September. Fed members, however, now see the benchmark rate falling to 3.9% for next year, suggesting just two rate cuts, compared with a prior forecast in September for four cuts.

Does the Fed's sharper inflation forecast suggest its prejudging fiscal policy? 

The Fed's hawkish tilt, Morgan Stanley said, appeared to "reflect the incorporation of potential changes to trade, immigration, and fiscal policy by some members that led to a firmer inflation path and, in turn, a firmer policy rate path."

At the December press conference, Fed chairman Jerome Powell suggested that some members had filtered the possible impact of fiscal policy changes from the incoming Trump administration. 

"Some people did take a very preliminary step and start to incorporate highly conditional estimates of economic effects of fiscal policies into their forecast at this meeting," Powell said. 

That paled in comparison to November's meeting when Powell stressed that the Fed wasn't prepared to speculate on fiscal policy because there was uncertainty as to the eventually policies that President-elect Donald Trump may choose to enact.  

Fed's hawkish outlook rattles markets

The Fed's hawkish surprise rattled risk assets as equities slumped sharply and Treasury yields spiked. As the forecast for just two rate cuts for 2025 was expected somewhat, ING said it believes the major selloff in risks assets following the meeting reflects the drop in confidence from Fed on disinflation.    

In the summary of economic projections, Fed members forecast inflation to reach the 2% target later than previously expected, with core PCE inflation revised to 2.5% for next year, up from a prior estimate in September for 2.2%.  

"Less confidence on inflation slowing sufficiently and the fact we had one FOMC member dissenting – Cleveland Fed President Beth Hammack preferring no change – means markets aren’t fully pricing another cut until July with only 35bp now priced for 2025 in total," ING said.

Rate-cut cycle set for January pause?

The Fed is likely to remain on hold in January, ING said, though it continues to call for three 25bps rate cuts for next year amid uncertainty on fiscal policy and the economic outlook. 

"There is a huge amount of uncertainty given a lack of clarity on how far and how fast President Trump will go on policy, plus how quickly the jobs market is actually cooling and what this means for inflation," ING said.

Wells Fargo   (NYSE:WFC) agrees, saying that "barring some dramatic unexpected development, the Committee likely will keep rates on hold at its next meeting on January 29."