Fed's Data-Dependent Policy Prioritizes Labor Amidst Lasting Inflation

Key Quotes

"I think one key takeaway for me is the idea that the Fed is done with risk management rate cuts, and now we're back to data dependent. So, what does that mean? I mean, a risk management rate cut isn't necessarily about the data you have in hand and the data you see; it's your view about the distribution of risks around that. So, in some ways, you're not data dependent when you're making those cuts."

Michael Gapen explains that the Federal Reserve is shifting its approach from making rate cuts based on managing potential risks to making them based on incoming economic data. This signifies a change in how the Fed evaluates the need for monetary policy adjustments. Gapen notes that risk management cuts are not solely driven by current data but by an assessment of potential future uncertainties.

"But I think at the same time he did not want to communicate that the bar for those rate cuts were exceptionally high. But I think he threaded the needle quite well in transitioning from risk management cuts, which aren't data dependent to an outlook, which is now more data dependent. And I thought he did that artfully well. So, for me, that's the big key."

Michael Gapen highlights Fed Chair Powell's skillful communication in signaling a shift in policy without setting an overly stringent threshold for future rate cuts. Gapen believes Powell managed to convey that future cuts will be data-dependent while still indicating a willingness to act. This nuanced approach, according to Gapen, was a crucial element of the FOMC meeting's messaging.

"So, the BLS released a preliminary estimate of that benchmark revision several months ago, and if you apply that initial estimate, it would suggest that job growth in 2025 could be about 60,000 jobs per month, less than has already been reported. But at the same time, we know immigration controls are slowing growth in the labor force."

Michael Gapen discusses technical factors influencing labor market data, specifically annual benchmark revisions and immigration controls. Gapen points out that preliminary estimates suggest a significant downward adjustment to reported job growth. He also notes that immigration policies are contributing to a slower expansion of the labor force.

"So, I will use the dreaded T-word. We think ultimately inflation from tariffs will be transitory. And I agree with the Chair's timeline; inflation should peak in the first quarter of the year and then start to trend down. That said, we think inflation will be above the Fed's 2 percent target into 2027, and this is the cost of providing insurance to the labor market."

Michael Gapen expresses his view that inflation stemming from tariffs will be temporary, aligning with the Fed Chair's timeline. Gapen anticipates that inflation will reach its peak in the first quarter and subsequently decline. However, he projects that inflation will remain above the Fed's 2% target until 2027, attributing this to the Fed's efforts to support the labor market.

"So, there's a phenomenon that happens in all markets where investors often speculate on a potential outcome. And if the outcome is then delivered, the follow-on price action is underwhelming. That is colloquially known as buying the rumor and selling the fact."

Matthew Hornbach explains the market behavior observed around the FOMC meeting, describing the "buy the rumor, sell the fact" phenomenon. Hornbach notes that investors often anticipate outcomes, and when those outcomes materialize as expected, the subsequent market reaction can be less pronounced. This suggests that market participants had already priced in the expected rate cut.

"So, 10-year yields are relatively close to 4 percent at this juncture, and we expect them to drift modestly lower in the first half of 2026, as the Fed continues this process of lowering the policy rate. One point that's very important to make here is that the longer term Treasury yields today are now sitting well above the Fed's policy rate, and that hasn't been the case for many, many years now."

Matthew Hornbach provides his outlook on longer-term interest rates, specifically 10-year Treasury yields. Hornbach anticipates a slight decrease in these yields in the first half of 2026, correlating with the Fed's expected rate cuts. He also points out the significant divergence between current long-term Treasury yields and the Fed's policy rate, a situation not seen in many years.