Khan Capital | December 2024
Key Takeaways
- The Fed cut rates by 25bp to 4.25-4.50% but revised its 2025 projection from four cuts to two, sending the S&P 500 down nearly 3% in the sharpest post-FOMC sell-off in months.
- Inflation progress has stalled, with core PCE remaining above 2.5% after declining from a peak of 9.1%, as services inflation and shelter costs prove resistant to prior rate hikes.
- The longer-run neutral rate estimate was raised to 3.0%, implying that the current rate is only modestly restrictive and the cutting cycle may be closer to its endpoint than markets had assumed.
- The incoming Trump administration’s tariff, immigration, and fiscal policies add inflationary risks that the Fed must incorporate into its outlook even before specific policies are implemented.
- The rate-cut-driven equity rally must transition to an earnings-driven rally in 2025, as the pace of monetary easing slows and the bond market’s tightening of financial conditions substitutes for Fed action.
The Federal Reserve cut the federal funds rate by 25 basis points on 18 December 2024, bringing it to 4.25-4.50%, the third consecutive reduction since the easing cycle began in September. The cut itself was expected. What rattled markets was the accompanying Summary of Economic Projections: the dot plot was revised to project just two rate cuts in 2025, down from the four cuts projected in September. The median longer-run rate estimate was raised to 3.0% from 2.9%. And Chair Powell’s press conference struck a distinctly hawkish tone, noting that inflation progress had been “slower than expected” and that the Committee would need to see “further progress on inflation” before continuing the cutting cycle.
The market’s response was swift and severe. The S&P 500 fell 2.95%, its worst day in months. The Nasdaq dropped 3.6%. The 10-year Treasury yield surged above 4.50%, its highest level since May. The dollar rallied sharply. Gold fell. The message was unambiguous: the era of easy rate cuts is over before it truly began, and 2025 will be characterised by a more cautious, data-dependent Fed that is no longer in a hurry to normalise policy.
The Hawkish Cut: An Oxymoron Explained
The concept of a “hawkish cut” seems contradictory but has become a recurring feature of modern monetary policy communication. The Fed delivered the rate reduction that the market expected, but simultaneously communicated that the pace of future cuts would be slower than previously anticipated. The net effect on financial conditions was tightening, not easing: longer-term interest rates rose, the dollar strengthened, and equity markets declined. The 25-basis-point cut was more than offset by the repricing of the forward rate path.
The mechanics of the hawkish pivot were visible in the dot plot. In September, the median FOMC projection had implied four cuts in 2025 (bringing the rate to approximately 3.25-3.50% by year-end). The December dots pulled this back to just two cuts, with a wider dispersion of views: some members projected no cuts at all in 2025, while others maintained the case for three or more. The widening distribution reflects genuine uncertainty about the inflation trajectory and the appropriate level of neutral interest rates.
Why the Pivot: Inflation’s Stall
The proximate cause of the hawkish shift was the stalling of inflation progress. After declining from a peak of 9.1% in June 2022 to approximately 2.4% by September 2024, inflation’s descent had plateaued. Core PCE, the Fed’s preferred measure, remained stubbornly above 2.5% through the autumn months. Services inflation, driven by shelter costs and wages, proved resistant to the rate hikes of 2022-2023. The “last mile” of the inflation fight, bringing core inflation from 2.5% to 2.0%, was proving far more difficult than the journey from 9% to 3%.
The incoming Trump administration’s policy agenda added further complications to the inflation outlook. Proposed tariffs on major trading partners, immigration restrictions that would tighten the labour market, and unfunded tax cuts that would increase the fiscal deficit all represented inflationary risks that the Fed’s projections needed to incorporate, at least directionally, even before specific policies were implemented.
What the Market Is Misunderstanding
The September dot plot was always aspirational, not a commitment. Markets had taken the September projection of four 2025 cuts as a quasi-promise, pricing the forward curve accordingly and positioning risk assets for a supportive monetary policy environment. The December revision is a reminder that the dot plot is a snapshot of Committee expectations at a given moment, not forward guidance. The Fed’s reaction function is data-dependent, and the data changed.
The neutral rate is higher than pre-pandemic estimates. The upward revision of the longer-run rate estimate to 3.0% (and the broader debate about whether neutral is 3%, 3.5%, or higher) has profound implications for asset valuations. If the neutral rate is 3%, then a fed funds rate of 4.25-4.50% is only modestly restrictive, which means the urgency to cut is lower. If neutral is closer to 3.5%, the current rate may already be near neutral, implying that the cutting cycle is almost complete.
The bond market is doing the tightening for the Fed. The surge in long-term yields following the December meeting represents a market-driven tightening of financial conditions that complements the Fed’s messaging. Higher mortgage rates, wider credit spreads, and a stronger dollar all act as substitutes for additional rate hikes. The Fed can afford to pause or slow its cutting pace precisely because the bond market is doing some of the work.
Implications for Investors
The “rate cut rally” is fading as a market catalyst. The equity market’s 2024 gains were partly driven by expectations of a sustained easing cycle. With the cutting pace slowing and the terminal rate higher than expected, multiple expansion from falling rates will be harder to sustain. Earnings growth, not rate cuts, must drive the next leg of the equity market.
Duration exposure in fixed income should be managed carefully. The rise in long-term yields creates both risk and opportunity. Investors holding long-duration bonds face mark-to-market losses if yields continue to rise. Short-duration instruments offer attractive yields with lower rate sensitivity.
The dollar’s renewed strength has implications across asset classes. A stronger dollar creates headwinds for US multinationals’ earnings, for commodity prices (which are dollar-denominated), and for emerging market assets (which face capital outflow pressure). Currency dynamics should be monitored as a first-order risk factor for portfolio construction.
The Fed’s credibility is intact but will be tested. Powell’s willingness to deliver a hawkish message at the risk of a market sell-off demonstrates the Committee’s commitment to its inflation mandate. But the incoming administration’s fiscal and trade policies may create pressures that test the Fed’s independence and its ability to maintain restrictive policy if political pressure for lower rates intensifies.
Conclusion
The December 2024 FOMC meeting marked the end of the “easy cuts” phase of the easing cycle. The first three reductions, totalling 100 basis points, brought rates down from their peak with minimal resistance. The remaining journey toward neutral will be slower, more conditional, and more contested, both within the Committee and between the Fed and the incoming administration. For markets that had priced a smooth glide path to lower rates, the December dot plot was a wake-up call: monetary policy in 2025 will be a source of uncertainty rather than a source of support.
Related Reading
The hawkish shift followed the initial cut covered in The Fed Cuts Rates: First Reduction Since 2020. For the end of the hiking cycle that preceded it, see Fed Funds at 5.5%.
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