Fed Cuts Rates for the Second Time This Year

The Federal Open Market Committee (FOMC) delivered another 25-basis-point interest rate cut at its October meeting. The cut is the second this year and was not a surprise, as Federal Reserve Chair Jerome Powell signaled its likelihood in a recent speech. However, there were two dissenting votes—one in favor of a 50-basis-point  rate cut and one opposed to any cut. The lack of consensus on the committee raises doubts about the future path of Fed policy.  In addition to the rate cut, the Fed indicated that it will end its quantitative tightening program–the process of allowing its balance sheet to shrink–as of December 1st.

In its accompanying statement, the Fed indicated that it lowered the federal funds rate—the rate that banks charge each other for overnight loans—to a range of 3.75% to 4.0% in response to growing evidence that the labor market is weakening. However, it noted that inflation has moved up since earlier in the year and that lack of government data was a challenge in setting policy.

We have been of the view that reducing interest rates further would be difficult without a drop in the inflation rate. The fed funds rate is now only 75 basis points (or 0.75%) higher than the inflation rate–which doesn't leave much more room for easing policy at this juncture.

The statement also said that balance sheet runoff will end on December 1st. The Fed will stop redeeming maturing Treasuries and maturing principal payments for mortgage-backed securities (MBS) will be reinvested in Treasury bills. This move had been widely anticipated. The Fed's balance sheet has declined by over $2.2 trillion in the past few years and reserves now stand at about 10% of gross domestic product (GDP). The Fed had indicated that it viewed a level of 8% to 10% of GDP as sustainable longer-term as it would leave enough reserves in the banking system to allow for proper functioning. The Fed's goal has been to reduce reserves from an "abundant" level to "ample."

Ahead of the announcement, the market had been discounting a series of rate cuts by the Fed with the federal funds rate falling below 3% by mid-2026. However, Powell indicated in the press conference following the meeting that there is no set path for monetary policy. With the committee increasingly divided on the outlook, short-term interest rate expectations may become more volatile. Intermediate- and long-term interest rates will continue to respond to expectations about economic growth and inflation. Overall, we expect the general trend in interest rates will continue to move lower into next year, but the path is likely to be bumpy. There is still a high level of policy uncertainty affecting the outlook for yields.

For bond investors, we continue to favor keeping average duration in the intermediate-term region of about five to 10 years. Staying in very short-term investments raises the potential for reinvestment risk, while investing in very long-term bonds could risk a lot of interest rate volatility.