Fed Cuts Rates for the Third Time This Year

The Federal Open Market Committee (FOMC) delivered another 25-basis-point interest rate cut at its December meeting. The cut is the third this year—all since September—and was no surprise to market participants after the futures market built in roughly 90% odds of an easing. However, there were three dissenting votes—two in favor of no change and one in favor of a 50-basis-point rate cut.

The Fed indicated that it lowered the federal funds rate—the rate banks charge each other for overnight loans—to a range of 3.50% to 3.75%. In its statement, the FOMC noted that job gains have slowed this year and the unemployment rate has edged up through September. Though there's been little official data since then due to the government shutdown, the FOMC's statement alluded to more of the same, saying "More recent indicators are consistent with these developments."

There were little in the way of changes to the previous statement, and the Fed's Summary of Economic Projections indicated stronger economic growth, no change to unemployment, and lower inflation ahead.

In its "dot plot" of rate projections, the median expectation for the fed funds target range at the end of 2026 remained at 3.25% to 3.5%, the same as in September and implying only one rate cut next year. That's a bit more hawkish than the futures market, which baked in rates falling toward 3% or even below by late 2026. The dot plot could reflect another aspect of the statement, where the FOMC pointed out, "Inflation has moved up since earlier in the year and remains somewhat elevated."

Additionally, the dot plot showed a very wide range of views among policymakers as to where rates might go in coming months. Three "dots" were above the level where the rate was before today's cut. And one dot projects rates ending 2026 in the 2% to 2.25% range, well below all other projections. In general, projections reflected a wide dispersion of views.

While there were concerns about a "hawkish" cut, the updated projections were not particularly hawkish, with 12 of the 19 members projecting at least one more rate cut next year.

While the three dissents highlighted the wide range of views on the committee, economic projections for 2026 were mostly unchanged from the previous Summary of Economic Projections (SEP) in November, offering no big surprises.

That said, the dissent by Chicago Fed President Austan Goolsbee was a bit of a surprise as he voted for the cut in November.

Fed Chairman Jerome Powell, in his press conference after the decision, suggested that after 75 basis points of cuts since September 2025 and 175 basis points of cuts since September 2024, the current target range "is in a broad range of estimates of neutral value," and that the committee "is well positioned to wait and see how the economy evolves from here."

Treasury yields inched up after Powell said that, as he basically hinted a pause could be ahead.

Fed policymakers offered an upbeat view of where economic metrics might lead next year, raising the median projection for 2026 gross domestic product (GDP) growth to 2.3% from September's projected 1.8%, keeping 2026 unemployment steady at 4.4%—the same outlook as in the September SEP—and slightly lowering 2026 core Personal Consumption Expenditures (PCE) price growth to 2.5% from 2.6% in September. Though inflation projections ticked lower, they were still well above the Fed's 2% goal.

However, the Fed still expects PCE prices to nearly meet that goal in 2027, keeping its core PCE growth at 2.1% for that year. Policymakers expect GDP growth to fall to 2% in 2027 from 2.3% in 2026, but the 2027 GDP projection rose from 1.9% in the September SEP. Unemployment is seen falling to 4.2% in 2027, down from the September projection of 4.3%.

For this year, the SEP kept its projection for unemployment unchanged at 4.5% and raised its GDP growth estimate slightly to 1.7% from 1.6%. It expects core PCE inflation of 3%, down from 3.1% in the September SEP.

In his press conference, Powell said economic activity is "expanding at a moderate pace," and consumers appear "resilient." He added, however, that the housing market remains weak.

Disinflation appears to be continuing in the services sector, Powell added. Risks to inflation remain tilted to the upside while risks to employment have risen in recent months.

Ahead of the announcement, the market had been discounting several additional rate cuts by the Fed with the federal funds rate to around 3% by late-2026. With the committee increasingly divided on the outlook and Powell's term as chairman expiring in May, short-term interest rate expectations may become more volatile. Intermediate- and long-term interest rates will continue to respond to expectations about economic growth and inflation.

We see the Fed funds target rate at somewhere in the 3% to 3.5% area by the end of 2026, down 25 to 50 basis points from the current level. Unless the economy weakens considerably or inflation falls, that's about as low as it makes sense for rates to fall.

While we don't have up-to-date jobs data, the numbers we have suggest that the labor market has stalled, with little hiring taking place. Layoffs have started to pick up, although not at recessionary levels. The assumption is that 3% is the 'neutral rate,' meaning another rate cut would keep rates slightly above that level.

However, there is plenty of disagreement with that outlook within the FOMC, with evidence in today's dissents. Six "dots" were higher than the current rate and were likely from both voting and non-voting members, with the dots by non-voting members representing "silent dissents." Some of the non-voters whose projections implied higher rates will likely rotate in as voters next year.

Inflation has been stuck near 3% for most of the past year and doesn't appear to be moving toward 2% any time soon. Moreover, financial conditions are easy, and overall economic growth is picking up. There is also fiscal stimulus coming down the road from the "One Big Beautiful Bill." So the hawks are not in favor of more rate cuts at this juncture.

With that backdrop, the major trend continues to be the steepening of the yield curve. Ten and 30-year yields declined a bit following the meeting, but they have been trending higher lately even as the market discounts one or two more cuts next year. That's a signal that the market is nervous about inflation as well as rising supply due to high and increasing deficits. There is also a risk premium being built into the market for weakening the Fed's independence.

For bond investors, our guidance continues to be: stay intermediate-term duration in high-quality bonds.