The outlook for another Fed rate cut in January

The Federal Open Market Committee delivered its third consecutive 25-basis-point rate cut in December, but central bank officials played down the likelihood of another reduction at its next meeting on Jan. 29.

The federal funds rate now sits in a range of 3.5% to 3.75%. At the same meeting, the Federal Reserve reduced the interest rate on excess reserves to 3.65% and the discount rate to 3.75%.

Even with the reductions, the tenor of the FOMC’s statement and remarks by Federal Reserve Chair Jerome Powell after the December meeting substantially raised the bar for a rate cut in January.

What’s more, the cumulative data included in the Summary of Economic Projections strongly implies a lack of consensus on moving the policy rate down to 3%, which is the Fed’s estimate of the terminal rate.

The strong upgrade to the growth outlook for 2026 and near-full employment beg the question: Why was the rate cut needed at all?

In addition, the FOMC’s subsequent revision of its summary language suggests a lack of conviction on the need for any cuts in the near term: “In considering the extent and timing of additional adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks.”

Powell said in his remarks afterward: “The fed funds rate is now within a broad range of estimates of its neutral value, and we are well positioned to wait to see how the economy evolves.”

Put another way, the Fed’s policy is not currently restrictive and additional cuts would require a deceleration in growth below the long-run 1.8% potential.

That remark implies confidence in getting inflation back to the Fed’s 2% target without maintaining restrictive monetary policy. Yet the Summary of Economic Projections indicates the Fed does not expect a return to the 2% target until 2028, suggesting weak spots in policy.

The median projection on the policy rate as seen in the Fed’s interest rate forecast, known as the dot plot, anticipates one more 25-basis-point cut in 2026, which is quite interesting given the three dissents within the FOMC. 

The votes reflected the growing rift over monetary policy within the Federal Reserve.

As expected, Governor Stephen Miran dissented in favor of a 50 basis-point cut. Two regional Fed presidents, Jeffrey Schmid of Kansas City, Missouri, and Austan Goolsbee of Chicago, dissented in favor of no rate cut.

The median FOMC projection is for an inflation rate of 2.4% by the end of 2026, down from 2.6% in September, with growth in gross domestic product rising to 2.3% from 1.8% previously.

Summary of Economic Projections

The Fed kept its long-run projection of economic growth of 1.8% but now has a much more constructive view of growth, projecting a rate of 2.3% in 2026, 2% in 2027 and 1.9% in 2028.

Estimating 4.2% unemployment as full employment, the Fed now expects unemployment to decline to 4.4% in 2026 and reach 4.2% thereafter.

Of note, the retirement of baby boomers and tight immigration policies are contributing to the Fed’s estimate of what constitutes full employment and its expectation for historically low unemployment rates.

Inflation in the personal consumption expenditures index, the Fed’s preferred gauge of inflation, is expected to ease to 2.4% in 2026, while core PCE, which is the better long-term predictor of overall inflation, is expected to ease to 2.5%.

The K-shaped economy

The United States has a bifurcated, or K-shaped, economy in which it is impossible to make policy that reconciles the needs of those with higher incomes on the upper spur of the K with the needs of those with lower incomes on the lower spur.

The Fed’s forecast of the terminal rate for the overall economy is almost certainly not appropriate for the lower spur of the K and too accommodative for those in the upper spur.

Its estimate of the terminal rate of 3% is 50 basis points lower than the RSM estimate of 3.5%.

The expansionary fiscal policies slated to begin in the new year will inject significant amounts of cash into the economy, pushing growth to 2.3% in 2026, the Fed estimates, as competition for scarce capital intensifies in both the public and private sectors.

In addition, all four of the models that we run to estimate the optimal policy rate strongly imply that a rate cut is not appropriate at this time.

One does not have to be a capital markets professional to understand that the primary impact of a rate cut will be to ease financial conditions for those in the upper spur, increasing their leverage.

If anything, an estimate of the terminal rate for the upper spur of the K suggests that a rate increase might be in order.

While people in the lower spur of the K will benefit from lower interest rates, there is no guarantee that long-term interest rates will not increase under current economic conditions.