After two years of progress on inflation and surprisingly persistent economic growth, the Federal Reserve next week meets with one eye on new Trump administration policies and another on a bond market that has ratcheted up borrowing costs even as U.S. central bankers have been cutting interest rates.
Both pose potential challenges in an economy where inflation has edged slowly closer to the Fed's 2% target without the recession and large rise in unemployment that some central bank officials felt would be needed for price pressures to ebb.
The unemployment rate instead fell as low as 3.4% and ended 2024 at 4.1%, close to what many economists think the economy can support without reigniting price pressures; inflation has declined to perhaps just half a percentage point from the Fed's target. Companies added more than a quarter of a million jobs in December.
That so-far easy landing from the 2022 pandemic-era spike in prices, and the aggressive rate hikes that were delivered to tame it, could face fresh challenges in the coming months, with potentially significant shifts in U.S. international trade, immigration and other policies, and bond investors pushing up yields on U.S. government debt and basic consumer loans like home mortgages.
"The bond market feels incredibly fragile," with rates rising roughly a full percentage point in recent months and the average rate on 30-year fixed-rate mortgages again hitting 7%, Mark Zandi, chief economist at Moody's Analytics, said in an economic outlook seminar at the Travelers Institute last week.
While yields on a 10-year U.S. Treasury note in the mid-4% range may be normal historically, "I do think there's a meaningful risk that we could see much higher long-term interest rates," Zandi said.
'CAUTIOUS' APPROACH
The Fed is expected to hold its benchmark interest rate steady in the current 4.25%-4.50% range at its next policy meeting on Jan. 28-29, after reducing it by a full percentage point since September.
While the central bank's monetary policy statement may see little if any change, Fed Chair Jerome Powell in his post-meeting press conference will be able to set the tone for the months ahead.
Indeed, the uncertainty ahead was in full display on Monday as President Donald Trump was sworn in for a second term in the White House. He promptly followed through on some campaign pledges - issuing orders on border security and energy policy, for instance - but opted against the immediate imposition of import tariffs, an unexpected development that unleashed a slide in the dollar and a rally in global stock markets on a day when U.S. financial markets were closed.
The dollar pared some losses and equities surrendered some gains after Trump told reporters later on Monday that he was thinking about imposing 25% duties on imports from Canada and Mexico on Feb. 1.
Trump's inaugural address also indicated he remains committed to some form of tariff regime, and his campaign pledges have already amplified uncertainty for the Fed as officials wondered how sweeping any new import tariffs might be and whether they will trigger the sort of response from targeted countries and industries that could create more persistent inflationary pressure.
Deportations of undocumented immigrants, meanwhile, could detract from the growing supply of labor Fed officials say has boosted recent economic growth, creating potential wage and price pressures particularly in industries that rely more on foreign-born workers, such as the housing sector.
Indeed, weeks before Trump took office, a number of Fed officials were already trying to account for anticipated policy changes in their own policy outlooks, and Powell himself made half a dozen references to the need for a "cautious" approach from this point in his Dec. 18 post-meeting press conference.
However it plays out, and on whatever timetable, bond yields are already rising in ways that could become both a constraint on Trump administration plans that include major tax cuts - something Republicans in Congress are already starting to reckon with - and a challenge for the Fed to decipher.
The central bank's policy rate sets the short-term price of overnight loans among banks. While that influences a whole range of other interest rates, those other yields are set by market trading and can rise and fall for a variety of reasons - including investors' faith, or lack of it, in the Fed and government economic and fiscal policies.
If the rise in long-term yields was seen as a clear market bet on higher future inflation, and therefore a vote against the Fed, for example, central bankers might have to respond since managing inflation expectations is considered important to meeting their inflation goals.
YIELDS AND GROWTH
Yields on government inflation-linked securities and other market-based measures of inflation expectations have not triggered those sorts of worries yet. They have risen in recent months but are still considered in line with historical averages and consistent with the Fed's inflation goals.
But recent bond market developments have raised a longer-term concern about increased U.S. government borrowing and whether global investors will demand steadily higher returns for the perceived risks around the country's fiscal path.
Rates eased somewhat last week after Fed Governor Christopher Waller argued he was optimistic inflation would continue to fall and allow the Fed to cut its own rate again sooner and perhaps deeper than expected.
Long-term rates that move higher from here, however, could eventually weigh on the economy and put at risk what the central bank and elected officials hope will otherwise become an extended economic expansion.
Even in the shorter term that could raise important questions for the Fed, such as how much further officials should allow central bank holdings of long-term securities to decline, a process that, other things being equal, puts upward pressure on long-term bond yields.
So far, at least, policymakers say there's no immediate cause for concern.
"Rates at the levels they're at today are rates that are very consistent with 2004 to 2005. Those were not highly restrictive years for American businesses," Richmond Fed President Tom Barkin said last week. "I haven't seen anything in rates to date that makes me think our policy path needs to get affected."
