Federal Reserve cuts rates but ‘hawkish’ forecast hits stocks and sends dollar jumping

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The Federal Reserve cut interest rates by a quarter of a percentage point but signalled a slower pace of easing next year, sending the dollar racing to a two-year high and igniting a sell-off in US stocks.

The Federal Open Market Committee on Wednesday voted to reduce benchmark rate to 4.25 per cent to 4.5 per cent, its third cut in a row. Cleveland Fed president Beth Hammack casting a dissenting vote, preferring to hold rates steady.

Officials’ projections for rates in 2025 also pointed to fewer cuts than forecast, underscoring policymakers’ concern about lingering inflation. In a sign of those worries, policymakers also raised their inflation forecast for next year.

“This was an unabashedly hawkish message from the Fed,” said Aditya Bhave, senior US economist at Bank of America, adding that officials’ forecast for two quarter-point rate cuts in 2025, rather than the three expected by some economists, represented a “wholesale shift”.

Morgan Stanley concurred, saying the Fed’s forecasts were “much more hawkish than we anticipated”.

Wall Street stocks dropped sharply after the decision, with the S&P 500 sinking nearly 3 per cent and tech-heavy Nasdaq off 3.6 per cent. Many of the biggest winners in a powerful 2024 equities rally pulled back: Elon Musk’s carmaker Tesla fell 8.3 per cent, Facebook parent Meta dropped 3.6 per cent and Amazon gave up 4.6 per cent.

Shares in smaller publicly listed companies, which are considered particularly sensitive to fluctuations in the US economy, sustained a heavy blow, knocking the Russell 2000 down 4.4 per cent.

US government bonds also fell in price, with the policy-sensitive two-year Treasury yield rising 0.11 percentage points to 4.35 per cent. The dollar jumped 1.2 per cent against a basket of six peers to the highest level since November 2022.

The US currency has risen since Donald Trump’s election victory last month on expectations tariffs will cause a fresh jolt of inflation, but Wednesday’s Fed decision “puts more fuel on the fire”, said Mike Pugliese, senior economist at Wells Fargo.

Fed chief Jay Powell said following Wednesday’s cut, the central bank’s policy settings were “significantly less restrictive” and policymakers could be “more cautious” as they consider additional easing. The December decision had been a “closer call” than at previous meetings, he said.

Inflation was moving “sideways”, Powell added, while risks to the labour market had “diminished”.

The Fed’s goal is to apply enough pressure on consumer demand and business activity to push inflation back to the US central bank’s 2 per cent target without harming the jobs market or the economy more broadly.

The core personal consumption expenditures price index, the Fed’s preferred inflation gauge that strips out food and energy prices, rose at an annual rate of 2.8 per cent in October.

Concerns inflation is stalling above 2 per cent contributed to Fed officials projecting half a percentage point worth of cuts in 2025, to 3.75 per cent to 4 per cent.

Powell also said officials had begun to include in their forecasts assumptions about Trump’s planned policies.

Four policymakers pencilled in one or no quarter-point cuts next year. Fed officials had forecast a full percentage point of 2025 rate cuts in the previous “dot plot”, released in September.

Wednesday’s projections showed most officials expect the policy rate to fall to 3.25 per cent to 3.5 per cent by the end of 2026, also higher than their previous forecast.

They also raised their forecasts for core inflation to 2.5 per cent and 2.2 per cent in 2025 and 2026, respectively, and predicted the unemployment rate would steady at 4.3 per cent for the next three years.

The Fed kicked off a rate-cutting cycle in September with a bumper half-point cut, but fears about the labour market have ebbed since then and the economic outlook has brightened. The economy’s resilience in the face of higher borrowing costs has changed the calculus for officials as they try to find a “neutral” rate that neither constrains growth nor drives it too high.

The central bank has described recent cuts as a “recalibration” of monetary policy that reflects its success in knocking inflation from a peak of about 7 per cent in 2022.

Powell on Wednesday said the Fed was in a “new phase in the process”, as borrowing costs close in on the neutral rate.

Fed officials raised that estimate for the neutral rate again, with a majority now putting it at 3 per cent, up from 2.5 per cent a year ago.

The Fed meeting came just weeks before Trump returns to the White House, having vowed to raise tariffs, deport immigrants and slash taxes and regulations. Economists recently polled by the Financial Times said the policy combination could trigger a new bout of higher inflation and hit growth.

Additional reporting by Eva Xiao in New York