The Fed Hits Pause

Episode Summary

Executive Summary: The episode reviewed strong but slightly cooling U.S. growth, sticky inflation, and the Fed’s decision to hold rates at 4.25%-4.5%. The hosts and guest Martin Worm argued the economy remains solid, but elevated PCE inflation, uncertain tariff/immigration policy, and a likely drifting neutral rate justify a pause. Most agreed rate cuts are unlikely near-term, with risks skewed toward fewer cuts or even hikes if inflation reaccelerates.

Main Topics: Q4 GDP and growth momentum (Priority: 5/5): The panel dissected Q4 GDP’s 2.3% annualized growth, noting consumer spending remained the main engine while inventories, equipment investment, and net exports created noise. They concluded underlying growth looks closer to mid-2% to near-3% than to a slowdown. Inflation and the PCE data (Priority: 5/5): December PCE showed inflation re-accelerating modestly, with headline and core measures still above target. Services and housing remained sticky, reinforcing the view that disinflation is proceeding slowly and unevenly. Fed policy decision and press conference takeaways (Priority: 5/5): Martin summarized the FOMC’s decision to keep the federal funds rate unchanged and framed the Fed’s stance as wait-and-see. The committee is balancing still-elevated inflation against a healthy economy. Reaction function and the neutral rate (Priority: 4/5): The discussion focused on how the Fed thinks about equilibrium/neutral rates, especially whether the current policy rate is already near neutral. They emphasized that neutral rates move with growth, rates sensitivity, and economic conditions. Policy uncertainty: tariffs, immigration, deregulation, fiscal policy (Priority: 5/5): The group repeatedly returned to the incoming administration’s policy agenda as a major source of uncertainty. Tariffs and immigration changes were seen as potentially inflationary and growth-negative, complicating the Fed’s next move. Financial conditions and QT (Priority: 3/5): Participants debated whether financial conditions are tight or easy, and how much QT matters. The conclusion was that QT’s direct impact on long rates is limited, though broader financing conditions remain mixed.

Key Arguments: The economy is still expanding at a solid pace, with consumer spending driving growth despite some quarter-to-quarter volatility. Inventories accounted for much of the GDP downside surprise; without them, underlying growth would look stronger. Tariff-related anticipatory inventory building was not obvious in the Q4 GDP report, though durable goods spending may have been affected by replacement/rebuilding demand. Inflation remains above the Fed’s target, especially in services and housing, so the Fed has little reason to cut immediately. The current funds rate appears close to the short-run neutral rate, supporting a pause rather than further easing. Policy uncertainty around tariffs, immigration, and fiscal changes makes the Fed more likely to wait for clearer data before acting. Financial conditions are mixed: stocks imply ease, but mortgage rates, Treasury yields, and bank caution point toward restraint. QT is not the same as QE in reverse; its effect on long-term rates is small and mostly operates through balance-sheet runoff rather than active selling. Looking ahead, the baseline forecast assumes the Fed holds until late 2025, then cuts as the neutral rate drifts lower in 2026. The upside risk to the baseline is fewer cuts or even hikes if tariffs and immigration restrictions lift inflation more than growth weakens.

Data Points: Q4 2024 GDP growth: 2.3% annualized - First GDP estimate for the fourth quarter, below Q3’s 3.1%. Q3 2024 GDP growth: 3.1% annualized - Prior quarter growth rate used for comparison. Full-year 2024 GDP growth: 2.8% - Yearly GDP growth after incorporating Q4. Full-year 2023 GDP growth: 2.9% - Comparison showing 2024 was nearly unchanged from 2023. Consumer spending in Q4: 2.8% - Main driver of GDP growth in Q4. GDP implicit price deflator: 2.2% - Q4 deflator, up from 1.9% in Q3. Q3 GDP implicit price deflator: 1.9% - Prior quarter comparison. PCE price index, monthly: 0.3% - December monthly increase, up from 0.1% in November. Headline PCE, year over year: 2.6% - December reading, up from 2.4% in November. Core PCE, year over year: 2.8% - Held steady in December. Core PCE, monthly: 0.2% - December monthly increase, up from 0.1% in November. PCE inflation target: 2.0% - Fed’s inflation objective referenced throughout the discussion. Employment Cost Index compensation, quarterly: 0.9% - Q4 total compensation, up from 0.8% in Q3. Employment Cost Index compensation, prior quarter: 0.8% - Q3 total compensation. ECI wage growth, year over year: 3.8% - Down from 3.9% previously, showing slow progress. Federal funds target range: 4.25% to 4.5% - Fed’s policy rate after the January meeting. Number of consecutive meetings with cuts before pause: 39 meetings - This was the first meeting in that stretch without a rate cut. Unemployment rate: around 4% - Used as evidence that labor markets are close to full employment. Year-over-year inflation estimate in our baseline: peaks in early 2026 - Martin’s description of the forecast under tariffs and migration policy assumptions. Potential future rate path in baseline: 3% by end of 2026 - Moody’s baseline assumes cuts resume later as neutral falls. QT impact on long rates: about 4–5 basis points per 1% of GDP - Martin’s estimate of the effect of balance-sheet runoff on long-term yields.

Pivotal Quotes: "It was the first meeting over the last 40 in which the Fed did not cut rates." — Martin Worm: Explaining the Fed’s January pause after a long easing cycle. "The economy is still solid." — Martin Worm: Summarizing why the Fed felt comfortable holding rates steady. "The last leg of this fight is going to be arduous." — Marissa: Describing how difficult it will be to finish the disinflation process.

Implications: Near-term rate cuts look unlikely unless growth weakens sharply. Persistent inflation and policy uncertainty mean the Fed is likely to stay on hold, with the bigger risk being fewer cuts than markets expect.