As the dust settles in the wake of a tumultuous election season, financial analysts and policymakers are keeping a close eye on the shifting economic landscape of the United StatesWith the election of a new president, uncertainty around future policies is on the rise, raising the specter of renewed inflation—commonly referred to as "reflation." This could put added pressure on the Federal Reserve, compelling it to reassess its current approach to interest rates and monetary policy.

On December 18, during its final policy-setting meeting of the year, the Federal Reserve announced a reduction in the federal funds rate from a range of 4.5%-4.75% to 4.25%-4.5%. This marked the second consecutive rate cut of 25 basis points, cumulative reductions totaling 100 basis points over three meetings

Despite a seemingly proactive approach in slicing rates, the Fed's future guidance has taken on a hawkish tone, suggesting that the path ahead may not be as straightforward as it appears.

The announcement sent shockwaves through the stock market, which experienced a sharp decline following the newsThe Dow Jones Industrial Average dropped by 2.6%, while the S&P 500 plunged by 3%, marking one of the largest single-day drops following a rate cut since 2001. In stark contrast, the yield on the benchmark 10-year Treasury climbed to 4.57%, and the U.Sdollar index surged above 108, both indicative of investor apprehension regarding future interest rate hikes.

Furthermore, projections shared by the Fed officials concerning future benchmark rates revealed a conservative outlook, anticipating only two rate cuts totaling 50 basis points by 2025. This forecast strongly contrasts with earlier predictions made in September, where expectations were set for a more substantial reduction of 100 basis points by the same year.

In a press conference following the decision, Fed Chairman Jerome Powell emphasized that despite the recent cuts, the economic atmosphere necessitates a more cautious approach moving forward

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The anticipated aggressive tariff policies of the newly elected president could exacerbate risks associated with inflation, prompting the Fed to temper its enthusiasm for further cutsThe worry is clear: larger tariffs may lead to increased costs, which could inadvertently fuel inflationary pressures.

Preparing for "Reflation"

The question arises: why did the stock market react so negatively despite the rate cuts? The answer lies in the market's focus not on policy decisions made in the moment, but rather on forecasts concerning future policyThe specter of rising rates and inflation often sends investors into a state of caution.

While the Fed has already implemented significant rate cuts this year, the terminal interest rate at which the Fed intends to halt its reductions appears set to be higher than in previous easing cycles

Notably, the anticipation of a prolonged period of robust economic performance under the new administration has tempered expectations for aggressive cutsRather than seeing the anticipated continuation of historic reductions, there is a shift toward a more cautious fiscal stance.

During the press conference, Powell outlined several important reasons that warrant a slow pace in cutting rates further:

Firstly, the American economy remains resilientThe GDP growth rate for the third quarter of 2024 saw an annualized increase of 2.8%, indicating that the economy continues to recover steadilyStrong consumer spending and investments in equipment have led the Fed to revise its 2024 economic growth forecast upward from 2% to 2.5%. Projections for 2025 have also seen a slight rise to 2.1%.

Secondly, the current unemployment rate is stable

Compared to September's more pessimistic view on labor market trends, recent employment data indicates that the labor market is holding relatively steadyFed officials have noted an improvement in the risk and uncertainty surrounding employmentHowever, concerns about potential inflation remain central to their discussions.

Thirdly, the risks associated with "reflation" are on the risePowell acknowledged that while inflation has eased significantly over the past two years, it still hovers above the Fed's long-term target of 2%. In the year ending November, the PCE price index increased by 2.5% year-on-year, with core PCE prices (excluding food and energy) climbing by 2.8%.

In response to ongoing volatility, the Fed has begun assessing the potential impact of tariffs on inflation

Powell referenced previous analyses—specifically from the Teal Book released in September 2018, which examined how tariffs can affect price levels.

Predictions from Fed officials for inflation in 2025 have risen to 2.5%, a significant 0.4% increase from the September forecastThe anticipated policy uncertainty resulting from the newly elected president's potential regulations is a significant factor driving these revised inflation expectationsAs Powell succinctly put it, “Some members indeed view policy uncertainty as a reason for their increased inflation uncertainty forecasts.”

One popular method of projecting future Federal Reserve policy is the "Taylor Rule," which combines inflation and unemployment rates to determine the appropriate benchmark interest rate

Based on the latest projections shown in the December dot plot, the Fed's long-term inflation forecast is set at 3%, while the long-run unemployment rate is projected at 4.2%. Using equal weighting, the resulting target rate would cluster around 3.1%, aligning closely with indications from the dot plot for 2026.

Market Reactions Ahead

Labeling this cycle of cuts as "preventative" aligns it with previous similar periods, such as the rate cuts from 1995 to 1996. During that time, the U.Seconomy exhibited signs of recovery, and bond yields began to stabilize as the Fed made its decisionsBack then, both the dollar index and the 10-year Treasury yield reacted to the Fed's policy adjustments.

In light of the expanding fiscal deficit, the naturally resultant increase in Treasury issuance could disrupt bond yields further, either through changes in demand dynamics or potentially pushing long-term rates higher.

However, the evolution of these financial elements is rarely linear

As suggested by several analysts, akin to the post-1995 experience, the markets may experience fluctuations, presenting opportunities for savvy traders to capitalize on new dynamicsWatching the rollout of new policies following the presidential transition on January 20, 2025, as well as corporate earnings announcements in the fourth quarter of this year, will be crucial.

Further analysis posits that while the bottom for Treasury yields is likely behind us, levels above 4.5% might offer interesting trading avenuesCoupling current neutral interest rate figures with qualitative assessments positions the reasonable range for long-term Treasury yields between 3.9% and 4.1%.

Lastly, the persistent strength of the dollar has posed significant depreciation pressures on other currencies