The Federal Reserve is caught in the "neutral interest rate" dilemma; how far can Powell's "risk management" go?
2025-12-15 15:19:59
As widely expected, the Federal Open Market Committee (FOMC) cut interest rates by another 25 basis points at its December meeting, lowering the target range for the federal funds rate to 3.50%-3.75%. With this third rate cut now implemented, and Chairman Powell describing the resumption of rate cuts as a "risk management" tool, the more crucial question remains: what policies will the Fed prepare for the market in 2026? Will the voting members readjust the current "recalibration" path?
Back in September 2024, when the Federal Open Market Committee initiated this round of interest rate cuts, Chairman Powell referred to it as a "recalibration" of monetary policy. After the Fed has cut interest rates by a total of 175 basis points over the past 15 months, there seems to be a general inclination within the Fed to "wait for data guidance" to determine whether further easing of policy is indeed necessary at this stage.
Several regional Federal Reserve presidents have repeatedly emphasized this position, creating the impression of a "divided opinion" within the Fed. In fact, to facilitate this latest rate cut, Powell undoubtedly had to acknowledge the existence of disagreements and compromise on the future direction of monetary policy. However, this process did not quell the dissent of all voting members, and opposing voices reappeared in the policy statement.
Looking at the overall economic situation before the government shutdown, policy didn't seem to need to enter an "easing phase," but rather might only need to return to a "neutral" level. This is a view repeatedly emphasized by Powell and his colleagues. So, what is the neutral federal funds rate? This is the key point. If the market believes the neutral interest rate started around 3.50%, then the current situation is basically close to a neutral level.
However, the Federal Reserve, and indeed the entire money and bond market, has now returned to a highly data-dependent mode. Why emphasize "highly"? The federal funds rate has been lowered by a cumulative 75 basis points over the past three months, meaning the Fed's current policy lag is far less than it was before September. Therefore, future interest rate adjustments will directly depend on the economic data released subsequently.
With inflation still about one percentage point above the Fed’s 2% target, the Federal Open Market Committee would need to see further cooling in the labor market before considering further interest rate cuts.
What's troubling the Federal Reserve is that even with the government shutdown over, the data environment during the December meeting remains "ambiguous." The crucial November (and part of October) jobs report has yet to be released and is expected to be available on Tuesday (December 16).
Recent employment-related data have been mixed, but weekly unemployment claims data continue to indicate that the job market deadlock of "no hiring, no laying off" persists.
This Federal Reserve meeting did not provide clear directional guidance for the foreign exchange market, but instead transformed a policy turning point (continuous interest rate cuts) into a policy observation period. Its most significant impacts on the foreign exchange market are: 1. Establishing "data dependence" as the main trading logic for the coming months; 2. Increasing policy uncertainty by revealing internal disagreements.
The Federal Reserve's shift to "data-dependent cautious easing" has set a new trading paradigm for USD/JPY. The start of the rate-cutting cycle has established medium-term downward pressure on USD/JPY, but internal divisions and expectations of a slowdown have created "speed bumps" and "buffer zones" along the downside path.
The market can consider leveraging fluctuations in US economic data and shifts in market expectations regarding Federal Reserve policy, while respecting the long-term downward trend of US dollar interest rates and the narrowing interest rate differential, to grasp the rhythm of the USD/JPY rebound and decline. On Monday, the USD/JPY pair fell significantly, by approximately 0.50%.
(USD/JPY daily chart, source: FX678)
Key takeaway : With this unresolved rate cut decision now settled, the threshold for future rate cuts may have risen to some extent. In other words, the "rate cut camp" within the Federal Reserve has achieved its goal, and now it needs to rely on economic data to persuade more hawkish members to support further easing.
At 15:19 Beijing time, the US dollar was trading at 155.14/15 against the Japanese yen.
From recalibration to data dependence
Back in September 2024, when the Federal Open Market Committee initiated this round of interest rate cuts, Chairman Powell referred to it as a "recalibration" of monetary policy. After the Fed has cut interest rates by a total of 175 basis points over the past 15 months, there seems to be a general inclination within the Fed to "wait for data guidance" to determine whether further easing of policy is indeed necessary at this stage.
Several regional Federal Reserve presidents have repeatedly emphasized this position, creating the impression of a "divided opinion" within the Fed. In fact, to facilitate this latest rate cut, Powell undoubtedly had to acknowledge the existence of disagreements and compromise on the future direction of monetary policy. However, this process did not quell the dissent of all voting members, and opposing voices reappeared in the policy statement.
Looking at the overall economic situation before the government shutdown, policy didn't seem to need to enter an "easing phase," but rather might only need to return to a "neutral" level. This is a view repeatedly emphasized by Powell and his colleagues. So, what is the neutral federal funds rate? This is the key point. If the market believes the neutral interest rate started around 3.50%, then the current situation is basically close to a neutral level.
The Neutral Interest Rate Myth and the Fog of Employment Data
However, the Federal Reserve, and indeed the entire money and bond market, has now returned to a highly data-dependent mode. Why emphasize "highly"? The federal funds rate has been lowered by a cumulative 75 basis points over the past three months, meaning the Fed's current policy lag is far less than it was before September. Therefore, future interest rate adjustments will directly depend on the economic data released subsequently.
With inflation still about one percentage point above the Fed’s 2% target, the Federal Open Market Committee would need to see further cooling in the labor market before considering further interest rate cuts.
What's troubling the Federal Reserve is that even with the government shutdown over, the data environment during the December meeting remains "ambiguous." The crucial November (and part of October) jobs report has yet to be released and is expected to be available on Tuesday (December 16).
Recent employment-related data have been mixed, but weekly unemployment claims data continue to indicate that the job market deadlock of "no hiring, no laying off" persists.
Impact on the foreign exchange market – taking USD/JPY as an example
This Federal Reserve meeting did not provide clear directional guidance for the foreign exchange market, but instead transformed a policy turning point (continuous interest rate cuts) into a policy observation period. Its most significant impacts on the foreign exchange market are: 1. Establishing "data dependence" as the main trading logic for the coming months; 2. Increasing policy uncertainty by revealing internal disagreements.
The Federal Reserve's shift to "data-dependent cautious easing" has set a new trading paradigm for USD/JPY. The start of the rate-cutting cycle has established medium-term downward pressure on USD/JPY, but internal divisions and expectations of a slowdown have created "speed bumps" and "buffer zones" along the downside path.
The market can consider leveraging fluctuations in US economic data and shifts in market expectations regarding Federal Reserve policy, while respecting the long-term downward trend of US dollar interest rates and the narrowing interest rate differential, to grasp the rhythm of the USD/JPY rebound and decline. On Monday, the USD/JPY pair fell significantly, by approximately 0.50%.
(USD/JPY daily chart, source: FX678)
Key takeaway : With this unresolved rate cut decision now settled, the threshold for future rate cuts may have risen to some extent. In other words, the "rate cut camp" within the Federal Reserve has achieved its goal, and now it needs to rely on economic data to persuade more hawkish members to support further easing.
At 15:19 Beijing time, the US dollar was trading at 155.14/15 against the Japanese yen.
- Risk Warning and Disclaimer
- The market involves risk, and trading may not be suitable for all investors. This article is for reference only and does not constitute personal investment advice, nor does it take into account certain users’ specific investment objectives, financial situation, or other needs. Any investment decisions made based on this information are at your own risk.
