How Trump's policy agenda could alter Fed's 2025 rate trajectory?

A 25-basis point cut is priced in for the FOMC meeting.

The Federal Reserve has a big rate decision to deliver around midnight, however, all eyes remain stuck on the future policy trajectory that the central bank will undertake in 2025. Several factors are at play--including the biggest 'what if'-- Trump's aggressive tariff proposals--which makes the Fed's future policy trajectory a tricky one.

After a steep decline from a 40 year peak high of 9.1 percent in mid-2022, US inflation has hovered around the 2.5 percent to 3 percent range for much of 2024, still stubbornly above the Fed's target of 2 percent.

On the other hand, the economy is surprisingly beat growth expectations and expanding at about a 3 percent pace and the labour market is holding strong. Complicating matters further, the incoming Trump administration’s proposed heavy tariffs present a significant wildcard. If Trump walks the talk,  these tariffs could drive inflation back up, complicating the Fed's decision-making.

Nomura analysts predict that the policies of the Trump administration will likely shape the outlook for growth and inflation in 2025. They expect a ramp-up in tariffs early next year, leading to higher inflation and slower investment growth. While the negative impact on growth may be partly offset by tax cuts and deregulation, the overall effect is expected to be inflationary, Nomura states in its Global Macro Outlook for 2025.

Also Read | Fed rate cut almost a certainty this week, but next year is a different story

Similarly, Morgan Stanley analysts expect tariffs and restrictive immigration policies to drive core inflation higher in 4Q25 and 1Q26, after a dip in mid-2025. The upside risks to inflation on the back of Trump's anticipated tariffs present a deja vu moment for markets as well as policymakers. These potential tariffs echo the trade war with China during Trump's first term, which raised inflation throughout 2018.

Given the risk of stalled inflation progress due to the tariffs, most experts believe the Fed will consider these policy shifts as it re-negotiates its dot plot for 2025. Amid the persistent inflationary concerns, the Fed is unlikely to take its foot off a cautionary stance. Nomura expects the central bank to pause its easing cycle in 2025, with only a single rate cut to 4.125 percent in Q1 2025, before potentially resuming cuts in 2026 once inflationary pressures from tariffs subside.

While Nomura's forecast is somewhat conservative, other analysts expect two to three rate cuts in 2025, though still fewer than the Fed's previous expectation of four. These predictions are reflected in futures markets as well.

Backing the view, S&P Global also anticipates the Fed to lower rates more gradually than previously expected, forecasting funds rate of 3.5-3.75 percent by the end of 2025, up from its earlier estimate of 3-3.25 percent, meaning slower and fewer rate cuts.

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