Fed’s gamble: A cut that stirs chaos and uncertainty

DAR ES SALAAM: THE Federal Reserve’s decision to cut interest rates by 0.25 percentage points on December last Wednesday, reflects a complex and increasingly scrutinised strategy for navigating persistent inflation, a cooling labour market and heightened global uncertainties.

The move, which lowered the benchmark rate to a target range of 4.25 per cent–4.5 per cent, is part of the Fed’s effort to stabilise financial conditions while balancing multiple risks. Inflation, while moderated from earlier peaks, remains elevated.

The Consumer Price Index (CPI) rose 2.7 per cent year-over-year in November, up slightly from 2.6 per cent in October, with core inflation—excluding volatile food and energy prices—holding steady at 3.1 per cent.

These levels are well above the Fed’s 2 per cent inflation target, signalling that inflationary pressures persist despite earlier rate hikes.

Federal Reserve Chair Jerome Powell defended the decision, calling it “the right call,” given the shifting dynamics of the economy. He acknowledged the evolving challenges by stating, “The calibration phase is now over. We are entering a new era of fogginess and unclarity at the moment” (Financial Times).

Powell emphasised the Fed’s focus on measured steps, noting, “Our focus remains on ensuring a measured approach, keeping inflation on track toward our 2 per cent goal without introducing unnecessary volatility.”

He also hinted at a heightened reliance on economic data, signalling that upcoming monetary policy decisions will likely hinge on key jobs and inflation metrics, reflecting a shift to a more data-dependent approach.

Critics, however, have raised questions about the Fed’s current strategy. Steve Chiveron, a market commentator, described the central bank’s actions as “the worst performance since 2021.” He pointed to what he characterised as a pattern of overreaction.

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“The Fed overreacted to labor market data in September, and now they’ve overreacted to inflation data,” Chiveron said.

He argued that the Fed’s inconsistent approach has eroded market confidence and contributed to increased volatility.

This view is echoed by Research observing, “The Fed seems to have shifted from forecasting to becoming entirely data-dependent, reacting to short-term movements in data rather than maintaining a steady course.”

This prompts a warning that such a reactive stance could amplify market instability. I strongly believe that by being whipped around by short-term data, the Fed risks creating more uncertainty and jeopardising its credibility.

This uncertainty has translated into sharp market reactions. The S&P 500 dropped by 2.0 per cent, marking one of its steepest declines in recent months, while the NASDAQ 100 fell 2.96 per cent.

Small-cap stocks, reflected by the Russell 2000 Index, suffered the most, plunging nearly 4 per cent. The underperformance of small caps highlights growing investor concerns about the vulnerabilities of smaller companies in the face of tighter financial conditions and slower economic growth.

The VIX, Wall Street’s so-called “fear index,” spiked by 15 per cent to 24.6, reflecting increased investor anxiety. Analysts have attributed this dramatic selloff to concerns about the Fed’s focus on inflation over providing conditions supportive of risk-taking.

Global bond markets also reacted to the Fed’s decision. US Treasury yields climbed sharply, with the 10-year yield rising to 4.75 per cent, its highest level since October, as investors digested the Fed’s commitment to inflation control. This rise in US yields exerted upward pressure on sovereign bonds in other regions. In Europe, German bund yields increased by 10 basis points to 2.85 per cent, while Italy’s 10-year bonds rose 15 basis points to 4.35 per cent, reflecting heightened risk aversion toward peripheral economies.

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In emerging markets, the impact was pronounced. Brazilian 10-year government bond yields rose 20 basis points to 11.1 per cent, while Mexico’s climbed to 9.2 per cent, as the stronger dollar and higher US yields prompted capital outflows.

In Asia, China’s 10-year bond yields edged up to 2.95 per cent, reflecting growing concerns about potential outflows due to the dollar’s strength.

India and South Africa also saw significant pressure, with their bond yields increasing to 7.4 per cent and 10.8 per cent, respectively, signalling the ripple effects of tighter US financial conditions on BRICS economies.

The foreign exchange market also saw volatility. The dollar index (DXY), which measures the greenback against a basket of currencies, climbed to 105.8, its highest level in six months.

The euro weakened by 0.5 per cent to US$1.06, while the Japanese yen depreciated by 0.8 per cent to 148.3 per dollar ahead of the Japan Open.

Emerging market currencies were particularly hard hit, with the Brazilian real dropping 1.5 per cent to 5.22 per dollar, the South African rand weakening 2 per cent to 18.3 per dollar, and the Indian rupee falling 1.2 per cent to 83.9 per dollar. I highlight the significance of the upcoming Japan Open in the FX market, stating, “Yes, the dollar is much stronger, but how much oxygen is left up here?”

Jeffrey Rosenberg, a portfolio manager at BlackRock, provided a nuanced view on the implications for risk-taking in 2025.

He noted, “Markets had hoped for more leniency on the labor side, which would have supported financial conditions and encouraged risk-taking. Instead, by prioritising inflation, the Fed is signaling a tighter stance.”

Rosenberg warned that this approach suggests the Fed may not reverse its policies quickly, creating unfavorable conditions for embracing market risk.

Sarah House, a senior economist at Wells Fargo, added a balanced perspective.

“The decision seems to be a bit of both,” she said, referring to whether the Fed’s move was influenced more by data or political considerations.

“When you assess the magnitude of the change in relation to the balance of risks, there is a bit of recentring the risks of the forecasts between the projections stated by Powell during a press release done around midnight (EAT) on December 18, 2024, in Washington, DC.”

The Federal Reserve’s recent rate cut aims to control inflation and cushion a slowing labor market amidst economic instability, yet critics argue that its reactive policies have led to significant stock market declines and heightened investor anxiety.

As central banks worldwide respond to their own interest rates and with Fed Chair Jerome Powell describing the period as a crucial inflection point for future financial stability, the global reaction of currencies, bond yields and equities highlights the Fed’s considerable challenges in navigating an uncertain financial landscape as 2025 approaches.