Fed Officials Really Don't Want a Downturn

Just compare what they were willing to accept back in June to what they hope will happen now.

Traders did not like what Federal Reserve officials had to say about the outlook for interest rates and the economy on Wednesday, although regular readers of this publication should not have been surprised.

Monetary policymakers admitted that inflation is more entrenched than they had previously believed, and that short-term interest rates will need to be higher for longer. “Under appropriate monetary policy,” inflation will not return to the Fed’s 2% goal until 2027. When that finally happens, officials expect that short-term interest rates will settle down around 3-3.25%—not much lower than the current level of 4.25-4.5%. “Appropriate” short-term interest rates in 2025 and 2026 are now expected to be 50 basis points higher than when the previous batch of projections were released in mid-September, while short rates in 2027 are expected to be roughly 25 basis points higher.

But the latest projections also revealed something else that was missed in the negative market reaction: the median policymaker seems willing to accept almost any outcome that prevents unemployment from getting worse. Comparing the Fed’s latest projections to those from mid-June shows that officials are now happy to accept more inflation, faster real growth, and lower interest rates—whatever it takes to keep the jobless rate capped.

In other words, they seem to be following the path I laid out in my previous note:

The most straightforward approach for the Fed is to hold the line on growth even if that means waiting longer (forever?) for inflation to return to the longer-run goal of 2% a year. Compared to the alternatives, this would probably be consistent with slightly higher interest rates as well as richer valuations for risk assets [tbd?].

Jobs, Jobs, Jobs

Back in June, Fed officials believed that short rates “under appropriate monetary policy” would end up around 5-5.25% at the end of this year, and be around 4-4.25% by the end of 2025. By the end of 2026, short rates would have dropped to around 3-3.25%. Over that time, the inflation-adjusted value of goods and services produced in the U.S. would have grown by 2.1% in 2024, by 2% in 2025, and 2% in 2026, while core inflation was expected to come in at 2.8% in 2024, 2.3% in 2025, and 2.0% in 2026.¹

Six months later, the real growth trajectory has improved, the inflation trajectory has worsened, and short rates are lower now than then.

Yet what has happened to the rate outlook for 2025?