【MACRO Insight】Fed may adjust rate cut expectations in response to productivity growth and economic

As Federal Reserve policymakers prepare to hold their final meeting of the year this week, markets widely expect a 25 basis point rate cut. However, more attention will be paid to their latest assessment of the economic outlook and the path of rate cuts. The Fed is currently facing a debate over productivity growth, which may affect their views on economic capacity and inflation control.

Productivity growth in the United States shows signs of stabilizing, with annual growth in output per worker hour rising from 1.5% to 1.8% since 2019 and even higher recently. The persistence of this growth has profound implications for the economy, including the trajectory of the federal debt and the impact of Trump administration policies.

This productivity growth has significantly changed the perception of the U.S. economy's “low-growth” status, from almost certain to less than 60 percent likely. James Kahn, an economics professor at Yeshiva University in New York, said that while it's too early to tell whether productivity has truly shifted, the likelihood is growing. John Fernald, an economics professor at INSEAD in France, is also cautiously optimistic about productivity growth, reflecting the focus on productivity issues within the Fed.

Before the pandemic, the Fed's estimates of the U.S.'s sustainable long-term growth rate had been revised downwards, in part because productivity lagged. However, economic growth often exceeds the Fed's estimates of potential, and productivity growth may be a key factor. If this trend persists, the Fed may need to reassess the direction of the economy and underlying inflation, as well as its estimate of the long-term “neutral” interest rate that U.S. markets can tolerate.At its upcoming meeting, the Fed will reassess the economy's potential and discuss whether recent trends will continue.

Chicago Fed President Goolsby stressed that the possibility of continued productivity growth must be carefully considered and its policy implications understood. He noted that companies struggling to recruit and turning to labor-saving technologies could help sustain productivity growth. In economics, increased productivity can be seen as a panacea that allows wages and profits to rise without triggering inflation.

Fed Governor Kugler said recent strong productivity is “very important” for the economy and the central bank, but changes in global tariffs and trade policies could pose risks. He stressed that it will be important to study the specific details of the policies of the new administration and Congress as they come out, because trade policies could affect productivity and prices.

The market is almost certain that the Fed will cut interest rates this week, but discussions about expectations of a rate cut in 2025 are increasing. The dot plot shows each Fed official's forecast for the direction of the federal funds rate, and current inflation readings and officials' comments put the 2025 forecast in question.

Former Cleveland Fed President Loretta Mester said last year's forecast of four rate cuts “has to be reconsidered” and predicted that the pace will be “slower” in 2025. She believes that “two or three rate cuts seem appropriate to me.” However, there is also a view that Fed officials will stick to the estimate of four rate cuts in 2025. Fed Chairman Powell has left the Fed enough room to take a slower pace if necessary. He said in early December: “We can afford to be a little more cautious” because the economy is stronger than expected earlier in the fall.

The expected pullback is due to two unexpected developments in late 2024: First, the job market showed no new signs of weakness. Second, inflation has remained sticky this fall, refusing to make the final move down toward the Fed's 2% target. The latest inflation data showed that the Consumer Price Index (CPI) rose 2.7% year-on-year in November, and the core CPI climbed 3.3% year-on-year, remaining at the same level for the fourth consecutive month. Traders reacted positively to the new readings, further raising bets on a Fed rate cut this week, pushing the probability to more than 95%. Some expect no change to the Fed's 2025 forecast, with the median target rate forecast still between 3.25% and 3.5%.

As productivity gains could change economic potential and inflation expectations, Fed policymakers must find a balance between maintaining economic growth and controlling inflation. Fed officials need to pay close attention to the specific details of the incoming Trump administration's policies and how these policies affect productivity, inflation, and overall economic health. In the process, the Fed's decisions will have a profound impact on global financial markets, and market participants need to remain vigilant to adapt to possible policy changes and economic trends.