The Fed: Dovish but data dependent

In one of the most closely-watched meetings in years, the Fed shaved a quarter point to a 4.0%-4.25% fed funds rate as expected and forecast further cuts but continued to emphasise data dependence. The initial market response was muted and yields on 2s and 10s were slightly higher after the press conference than before the rate announcement.

In the Summary of Economic Projections (SEP) the median FOMC member expectation for end 2025 is two more cuts (to 3.6%). However, of the 19 members, 10 expect two more cuts while 7 see none and 2 see one. So, a close-run thing and likely to depend wholly on the data.

The SEP foresees one further cut by end-2026 (to 3.4%). A final cut forecast for 2027 would leave the FFR at 3.1%, just about at what the Fed judges to be neutral (3%). This path is also roughly the market view, see chart.

Note that these rate forecasts are about 25bps lower than in the June forecast for each of the three forecast years, despite higher growth forecasts. Powell explained this in terms of a shift in the balance of risks to higher unemployment.

Chair Powell made clear the overall thought process, which has not changed. Starting with the view that the ‘neutral rate’ is 3% the Fed is still not willing to slash rates all the way there just yet, despite urging from the President (who wants 1% rates) and the Treasury Secretary who, more reasonably, has suggested about 3%. The reasoning is that although the economy has slowed, it is not too bad, while inflation is clearly still above target. So the Fed, arguing that the employment risks have risen, wants to nudge towards neutral, hoping that inflation will come down in time.

What will incoming data suggest?

What are the next few months of data likely to show? My hunch is that the real economy will prove resilient. The GDP NowCast for Q3 from the Atlanta Fed is currently at 3.3%, which would raise the average growth rate for the first three quarters of the year from 1.4% to 1.9%. Pretty resilient.

It is true that the impact of tariffs on consumers’ real spending power is still working through. But the One Big Beautiful Bill Act is stimulatory and could offset this. It includes front-loaded tax cuts (on tips and social security), as well as enhanced business expensing. Moreover, it is plausible that weak hiring and investment (except for AI-related) was held back only temporarily by the April 2^nd ‘Independence Day’ shock and could pick up. So, the case for further cuts based on a weak economy may not be there. Especially if unemployment does not rise further or even falls from here, not implausible given the declining immigrant population.

Meanwhile, goods inflation could lift further, as tariffs bite. The Fed will rightly view that as temporary and be more focussed on services inflation. Here, much will depend on wage growth. Recently, there are signs that, just as for inflation generally, wage growth has stalled, at a slightly elevated level. If that is confirmed then services inflation will be stuck too high.

Overall then, the Fed is moving cautiously, in line with market expectations. Investors have to hope that the Fed is right that inflation will ease down next year and that growth will be resilient but not over-strong.