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Fed Remains in Wait and See Mode

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In a widely anticipated move, the Federal Reserve remained on pause with respect to rate cuts at the conclusion of its March meeting, maintaining the federal funds rate in the 4.25% to 4.5% range. While the central bank acknowledged that the economy remains solid, it emphasized a data- and policy-dependent approach to future monetary policy decisions due to increased uncertainty. According to Chair Powell, the Fed “is not in any hurry” to enact policy change and is well positioned to wait to make future interest rate moves.

However, in a small dovish step, the Fed slowed the pace of its balance sheet reduction, but only for Treasuries. The Treasury security runoff will be reduced from $25 billion a month to $5 billion. The mortgage-backed security run-off process will remain at a $35 billion a monthly rate. Chair Powell stated that the change was not a signal of broader economic issues and was just a technical adjustment to the long-run goal of balance sheet reduction.

Although the Fed did not directly address ongoing trade policy debates (and particularly trade and tariff details expected on April 2) and their economic implications, it reaffirmed that future monetary policy assessments would consider “a wide range of information, including readings on labor market conditions, inflation pressures, and inflation expectations, and financial and international developments.”

With respect to prices, the Fed’s March statement noted that “inflation remains somewhat elevated.” For example, the CPI is at a 2.8% year-over-year growth rate. Shelter inflation, while improving as noted by Chair Powell, continues to run at an elevated 4.2% annual growth rate, significantly above the CPI. These costs are driven by challenges such as financing costs, regulatory burdens, rising insurance costs, and the structural housing deficit.

The March Fed statement highlighted the central bank’s dual mandate, noting its ongoing assessment of the “balance of risks.”  Crucially, the Fed reiterated its “strong commitment to support maximum employment and returning inflation to its 2 percent objective.”

The Fed also published its updated Summary of Economic Projections (SEP). The central bank reduced its GDP outlook for 2025 from 2.1% growth to just 1.7% (measured as percentage change from the fourth quarter of the prior year to the fourth quarter of the year indicated). Policy uncertainly likely played a role for this adjustment.

The Fed made only marginal changes to its forecast for unemployment, pointing to a 4.3% jobless rate for the fourth quarter of 2025. The Fed did lift its inflation outlook, increasing its forecast for Core PCE inflation from 2.5% for the year to 2.8%. Forecasters, including NAHB, have lifted inflation estimates for 2025 due to tariffs, although tariffs may only produce a one-off shift in the price level rather than a permanent increase for the inflation rate. Nonetheless, Chair Powell noted that tariffs have already affected inflation forecasts for 2025. The Fed’s SEP also indicated that the Fed may cut twice this year, placing the federal funds rate below 4% during the fourth quarter of 2025. However, those FOMC members who saw less than two rate cuts this year were more likely to forecast no rate cuts at all for 2025.

Looking over the long run, the SEP projections suggest that the terminal rate for the federal funds rate will be 3%, implying six total twenty-five basis point cuts in the future as rates normalize. This is lower than our forecast, which suggests a higher long-run inflation risk path and a terminal rate near 3.5%. A lower federal funds rate means lower AD&C loan rates for builders, which can help with housing supply and hold back shelter inflation.

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A Pause for the Fed

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In a widely anticipated announcement, the Federal Reserve paused on rate cuts at the conclusion of its January meeting, holding the federal funds rate in the 4.25% to 4.5% range. The Fed will continue to reduce its balance sheet, including holdings of mortgage-backed securities. The Fed noted the economy remains solid, while specifying a data dependent pause. Chair Powell did qualify current policy as “meaningfully restrictive,” but the central bank appears to be in no hurry to enact additional rate cuts.

While the Fed did not cite the election and accompanying policy changes today, the central bank did note that its future assessments of monetary policy “will take into account a wide range of information, including readings on labor market conditions, inflation pressures, and inflation expectations, and financial and international developments.” Given the ongoing, outsized impact that shelter inflation is having on consumers and inflation, an explicit mention to housing market conditions would have been useful in this otherwise exhaustive list.

Chair Powell did state in his press conference that housing market activity appears to have “stabilized.” A reasonable assumption is that this is a reference to an improving trend for rent growth (for renters and owners-equivalent rent), but the meaning of this statement is not entirely clear given recent housing market data and challenges. While improving, shelter inflation is running at an elevated 4.6% annual growth rate, well above the CPI. These housing costs are driven by continuing cost challenges for builders such as financing costs and regulatory burdens, and other factors on the demand-side of the market like rising insurance costs. And more fundamentally, the structural housing deficit persists.

From the big picture perspective, the Fed faces competing risks for future policy given changes in Washington, D.C. Tariffs and a tighter labor market from immigration issues represent upside inflation risks, but equity markets have cheered prospects for an improved regulatory policy environment, productivity gains and economic growth due to the November election. These crosswinds may signal a lengthy pause for monetary policy as the Fed continually seeks more short-term data.

While the Fed targets short-term interest rates, long-term interest rates have risen significantly since September, as a second Trump win came into focus. A future risk for long-term interest rates and inflation expectations will be fiscal policy and government debt levels. Extension of the 2017 tax cuts will be good for the economy, but ideally these tax reductions should be financed with government spending cuts. Otherwise, a larger federal government debt will place upward pressure on long-term interest rates, including those for mortgages.

The January Fed statement acknowledged the central bank’s dual mandate by noting that it would continue to assess the “balance of risks.” There was no language in today’s statement pointing to a future cut, although markets still expect one or two reductions in 2025 if inflation remains on a moderating trend.

Importantly, the Fed reemphasized that it is “strongly committed to support maximum employment and returning inflation to its 2 percent objective.” That seemed like a shot across the bow for those speculating that the Fed might be satisfied with achieving an inflation rate closer to but not quite 2%. While there is merit to debating the 2% policy, the emphasis today on the 2% target is a reminder of how important the housing market and housing affordability is for monetary policy and future macroeconomic trends.

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Fed Cuts But Signals Slowing Pace of Easing Ahead

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In a widely anticipated move, the Federal Reserve’s Federal Open Market Committee (FOMC) reduced the short-term federal funds rate by an additional 25 basis points at the conclusion of its December meeting. This policy move reduces the top target rate to 4.5%. However, the Fed’s newly published forward-looking projections also noted a reduction in the number of federal funds rate cuts expected in 2025, from four in its last projection to just two 25 basis point reductions as detailed today.

The new Fed projection envisions the federal funds top target rate falling to 4% by the end of 2025, with two more rate cuts in 2026, placing the federal funds top target rate to 3.5% at the end of 2026. One final rate is seen occurring in 2027. Furthermore, the Fed also increased its estimate of the neutral, long-run rate (sometimes referred to as the terminal rate) from 2.9% to 3%, which is reflective of stronger expectations for economic growth and productivity gains.

For home builders and other residential construction market stakeholders, the new projections suggest an improved economic growth environment, one in which there is a smaller amount of monetary policy easing, leading to higher than previously expected interest rates for acquisition, development and construction (AD&C) loans. Thus, more economic growth but higher interest rates.

The statement from the December FOMC summarized current market conditions as:

Recent indicators suggest that economic activity has continued to expand at a solid pace. Since earlier in the year, labor market conditions have generally eased, and the unemployment rate has moved up but remains low. Inflation has made progress toward the Committee’s 2 percent objective but remains somewhat elevated.

The Fed’s broader economic projections generally experienced positive revisions. The central bank lifted its forecast for GDP growth in 2025 to 2.1%. It sees the unemployment rate at 4.3% at the end of 2025, down from 4.4%.

However, the Fed also increased its inflation expectations. The central bank now sees 2.5% core PCE inflation at the end of 2025, up from its prior projection of 2.1%. While long-run expectations of the FOMC remained anchored at the 2% inflation target, the increase for the 2025 expectation for inflation is the reason for taking two rate cuts off the table for 2025, leaving just two remaining in the forecast.

Despite 100 basis points of easing for the short-term federal funds rate since September, long-term interest rates (which are set by markets and investors), including mortgage rates, have increased. This reflects market expectations of firmer inflation and a slower path for monetary policy easing. Policy concerns over government deficits and perhaps tariffs are also affecting investor outlooks. The size of the government deficit will be key for future inflation and long-term interest rates, particularly given a significant debate on taxes and government spending set for the start of 2025. And the slower path of monetary policy easing pushed the 10-year Treasury rate to 4.5%.

The pace of overall inflation is moving lower albeit slowly. Shelter inflation continues to be a driver of overall inflation, with gains for housing costs responsible for 65% of overall inflation over the last year. This kind of inflation can only be tamed in the long-run by increases in housing supply. Fed Chair Powell has previously noted it will take some time for rent cost growth to slow although it is moving lower. Given recent tight financing conditions, however, the Fed noted that while consumer spending is resilient, “…activity in the housing sector has been weak.” A slower path of Fed rate cuts for 2025 will keep builder and developer construction loan interest rates higher than previously expected and act as an additional headwind for gains in housing supply.

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A Rate Cut from the Fed: What Will the Terminal Rate Be?

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The Fed cut the short-term federal funds rate by an additional 25 basis points at the conclusion of its November meeting, reducing the top target rate to 4.75%. However, while the Fed noted it is making progress to its 2% inflation target, it did not provide post-election guidance on the pace and ultimate path for future interest rate cuts. The bond market is not waiting, with the 10-year Treasury rate rising from 3.6% in mid-September to close to 4.3% due to changing growth and government deficit expectations.

Today’s statement from the Fed noted:

“Recent indicators suggest that economic activity has continued to expand at a solid pace. Since earlier in the year, labor market conditions have generally eased, and the unemployment rate has moved up but remains low. Inflation has made progress toward the Committee’s 2 percent objective but remains somewhat elevated.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. The Committee judges that the risks to achieving its employment and inflation goals are roughly in balance. The economic outlook is uncertain, and the Committee is attentive to the risks to both sides of its dual mandate.”

Inflation risks for 2025 are evolving. The policy risks for the central bank had recently been between inflation (decreasing risks) and concerns regarding the health of the labor market (risks rising). However, the 2024 election result changes this outlook somewhat. In particular, the election increases the probability of additional economic growth, a tighter labor market, larger government deficits, and higher tariffs. All of these factors can be inflationary, even if they yield other macroeconomic benefits.

Consequently, the Fed will need to recalibrate its economic and policy outlook given the large number of changes that markets have digested in just the past week alone. In particular, how far will the Fed ultimately cut into 2025 and perhaps 2026? A 3% terminal federal funds rate is unlikely. Some commentators have suggested a 4% rate would at least be a threshold of reevaluation. NAHB’s outlook is for a terminal rate of 3.25%, perhaps 3.5%. However, that decision, or destination, will be dependent on factors like tariff adoption.

Markets and analysts will receive additional information at the conclusion of the December Fed meeting, which will include an update of the central bank’s Summary of Economic Projections. Given the election discussion, is worth noting that the Fed does not try to anticipate changes to future fiscal policy. The Fed will study and model anticipated changes, but such impacts would not be formally incorporated into the Fed’s outlook until such proposals are, at the very least, fully detailed and analyzed. All market participants should be aware that rising government debt levels will push nominal long-term interest rates higher.

While the question of the future policy path matters for long-term interest rates, there is a direct benefit to current easing like today’s rate cut. For example, the November rate reduction will be felt for builder and land developer loan conditions. Interest rates for such loans should move lower by approximately 25 in the coming weeks.

A reduction for the cost of builder and developer loans is a bullish sign for housing affordability. The pace of overall inflation has remained elevated due to the growth of housing/construction costs and elevated measures of shelter inflation, which can only be tamed in the long-run by increases in housing supply. Fed Chair Powell has previously noted it will take some time for rent cost growth to slow. Given recent tight financing conditions, however, the Fed noted that while consumer spending is resilient, “…activity in the housing sector has been weak.”

All things considered, with inflation having moved lower (the September core PCE measure of inflation is at 2.7%, down from 3.7% a year ago), there is clearly policy room for future rate reductions as the Fed normalizes monetary policy. A further cut to the federal funds rate in December, to a 4.5% top rate, seems likely. After that, given expected changes for fiscal policy and fiscal policy impacts, the Fed is likely to slow its pace of rate cuts, perhaps moving to one 25 basis point cut per quarter in 2025 to the ultimate terminal rate. As noted earlier, the level of this terminal rate is likely to be reevaluated in the coming months.

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