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The Federal Reserve left short-term interest rates unchanged at its January 29 meeting, marking the first pause since starting to lower rates last September. The reason for the pause was likely that December data for the labor market were stronger than usual, and there was little progress in reducing inflation that month. But the reason for delaying another cut until late spring or midyear will likely be to allow the Trump administration’s policies and their implementation to become clear. Any tariffs that look to be lasting, plus government fiscal policy, will affect the Fed’s evaluation of the near-term outlook for both inflation and the economy. Also, progress on reducing inflation has slowed recently, and the Fed will want to see whether further reductions in inflation are forthcoming.
Fed Chair Jerome Powell softened his previous optimism that inflation will continue to trend down in 2025 and 2026, but he is not ready to turn pessimistic yet. Powell believes that current Fed policy is still restrictive, so more progress on inflation is still realistic. But he will wait to see what the data show. An interesting conundrum he may face is that the headline inflation numbers in the first half of the year are likely to improve, but then worsen in the second half. The economists at the Fed will be busy evaluating the underlying detail of each monthly report this year, and will be relying less on headline numbers to see if there is true progress being made. Another question will be whether to count any increase in inflation caused by the imposition of tariffs as important or not. Tariffs cause prices to rise once, but they factor into the long-term inflation rate only if they have secondary effects, such as causing consumers’ inflation expectations to rise, or if they trigger cost-of-living adjustments that push up wage growth.
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The 10-year Treasury yield will probably meander in the mid-4% range, due to the higher near-term inflation forecast. Uncertainty about future government policy will keep any clear trend from developing, but eventually this will resolve itself. If further tax cuts are made, injecting more money into the economy, then rates will probably move up closer to 5%.
The Fed will continue to reduce its Treasury securities portfolio. Powell has emphasized that it is still the Fed’s goal to lower the overall amount of Treasury debt and mortgage-backed securities it holds, in order to get its portfolio back to a historically more normal level. This gradual reduction in the Fed’s balance sheet could also push yields on longer-term Treasury bonds higher by a small amount, since the market will have to soak up more of Washington’s debt, and investors may demand a higher yield to do so.
Recent declines in mortgage rates stopped once long-term Treasury yields started rising again. Thirty-year mortgage rates will stay around 7.0% for now, and 15-year rates will stay a little above 6.0%. Mortgage rates are still higher than normal, relative to Treasuries, but Fed cuts in short-term rates will boost banks’ lending margins, which should eventually lower mortgage rates a bit.
Top-rated corporate bond yields have edged up in tandem with Treasury yields, but low-rated bond yields have continued on a downward path as recession fears fade almost completely. AAA-rated long-term corporate bonds are yielding 4.9%; BBB-rated bonds, 5.5%; and CCC-rated bonds, 11.4%.
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