Federal Reserve calibrates policy to keep inflation in check

At its January 2025 meeting, the policymaking Federal Open Market Committee (FOMC) left the federal funds target rate unchanged at 4.25% to 4.50%. This comes after the FOMC cut rates in three consecutive meetings at the end of last year by a total of 1.0%.

At its previous meeting in December, FOMC members laid the groundwork for reduced rate cut expectations. At that time, they trimmed its projected 2025 rate cuts from four to two. It’s important to keep in mind that expectations can change based on economic developments.

In a statement after the January meeting, the Fed noted that risks to its full employment and low inflation goals are “roughly in balance.” The statement went on to say that the economic outlook is uncertain, and the Committee is attentive to risks on both sides of its dual mandate. The Fed also justified its position of not making another rate cut at this time by stating, “Economic activity has continued to expand at a solid pace (Gross Domestic Product grew at a 3% rate in mid-2024).¹ The unemployment rate has stabilized at a low level in recent months (4.1% in December 2024),² and labor market conditions remain solid. Inflation remains somewhat elevated (2.9% in December 2024)2.”³ Citing current economic conditions, Fed chair Jerome Powell added, “We do not need to be in a hurry to adjust our policy stance.”⁴

Powell indicated general optimism about the economy’s direction, stating, “We see things as (being) in a really good place for (Fed) policy and for the economy.”4 At the same time, he made clear that while there are encouraging signs, the Fed is still looking for further inflation progress.

“The Fed doesn’t want to see negative implications from its interest rate stance,” says Rob Haworth, senior investment strategist for U.S. Bank Asset Management. “They are likely to remain cautious about further interest rate cuts until they are convinced that inflation for this cycle is subdued.”

Tracking the Fed’s balance sheet

Along with interest rate actions, another Fed monetary policy tool is its balance sheet of financial assets. During recent challenging economic periods, the Fed tried to boost economic activity by purchasing fixed income assets, such as U.S. government bonds and mortgage-backed securities. The Fed’s market participation helped moderate interest rates. The balance sheet of assets grew to just under $9 trillion in 2022. Since that time, the Fed has reduced its balance sheet, now down to less than $7 trillion.⁵ In its January statement, the Fed indicated it continues to reduce its bond holdings.³

Haworth is watching whether the Fed tapers or ends its balance sheet liquidation strategy. The Fed’s reduced bond market participation may be a contributing factor to today’s elevated interest rates. 10-year U.S. Treasury yields moved from a low of 3.63% in September 2024, to 4.55% in late January 2025.⁶ “It seems like there’s some concern in the fixed income markets,” says Haworth. “If the Fed stops reducing its asset holdings, it could help offset bond market challenges that are helping keep interest rates elevated.” However, January’s Fed meeting offered no signs that an adjustment to the Fed’s balance sheet strategy is on the table.

Fed’s balancing act

The Fed’s primary purpose in raising rates and keeping them elevated was to combat the highest inflation since the early 1980s. At its peak, inflation, as measured by the Consumer Price Index (CPI), reached 9.1% for the 12 months ending in June 2022. The most recent CPI reading, for the 12 months ending in December 2024, showed inflation at a much improved 2.9%, although it has edged higher in recent months.² “There is a risk of a reacceleration of inflation,” says Haworth. “The potential for added tariffs under the new Trump administration could add to that risk.”

At the same time, says Haworth, “The Fed doesn’t want to see too much softness in the employment market.” That would contribute to a slowing economy. Although the nation’s unemployment rate moved above 4% in mid-2024, it appears to be holding steady.²

Haworth notes initial jobless claims provide a helpful “real-time” guide on the state of the jobs market. After a brief early December uptick, in early 2025, initial jobless claims again leveled off, an encouraging sign of labor market strength.⁸

Market reactions to Fed moves

Equity markets suffered a significant setback in mid-December when the Fed announced reduced expectations for 2025 rate cuts. On that day, the S&P 500 fell nearly 3%. The index has recovered most of the ground lost at that point, but investors still appear to have limited rate cut expectations.

10-year Treasury yields, a key measure of bond investor expectations, remain elevated given the Fed’s current rate stance.

Where does the Fed go from here

The policymaking FOMC next meets in mid-March 2025. Markets are expecting the Fed to hold the line on rates at that meeting, with little clarity about when the next potential fed funds rate adjustment may occur.⁹

As the Fed continues to address monetary policy, be sure to consult with your financial professional and review portfolio positioning. Explore whether changes might be appropriate given your goals, time horizon and feelings toward risk in today’s evolving interest rate environment.